Currencies
Highlights We expect both the Australian dollar and Chinese RMB to move higher in the coming months. A key catalyst is broad-based weakness in the US dollar. The composition of goods benefiting from the US-China Phase I deal are a small portion of Australia’s export basket, limiting substitution. Remain long AUD/NZD and AUD/CAD. Place a limit buy on AUD/USD at 0.68. Feature The three key obstacles that have been hijacking currency markets are finally being addressed. First, the lack of dollar liquidity that was creating a funding crisis in repo markets has been curtailed via significant expansion of the Federal Reserve’s balance sheet. The Libor-OIS spread - a measure of banking stress - is rapidly narrowing (Chart I-1). Second, the US-China trade deal has cemented a cap on economic policy uncertainty for now. At minimum, this should allow for an increase in cross-border flows, which tends to be positive for growth. As a counter-cyclical currency, the US dollar will continue to depreciate as global growth improves. The third obstacle giving way is political risk. The biggest uncertainty for the dollar was the surge in far-left populist candidates, especially Elizabeth Warren. The result would be a highly polarized election campaign, heightening uncertainty. The near-term reaction would be a surge in safe-haven demand, even though far-left policies could significantly knock down expected returns on US assets, which would be negative for the dollar. Chart I-1An Improvement In Dollar Liquidity Chart I-2The Dollar And Election Outcomes Chart I-2 shows that the ebb and flow in the dollar in recent months has eerily matched the probability of a Donald Trump–Elizabeth Warren contest. With a centrist like former Vice President Joe Biden now likely the next democratic nominee, the likelihood of a knee-jerk rally in the dollar has subsided. Unless these risks flare up again, this suggests that for the next few months, US dollar long positions face asymmetric downside risk. This creates a growing number of trading opportunities on the short side. Australian Growth And The Fires One of the FX market’s current favorite short positions is the Australian dollar (Chart I-3). Granted, most incoming data over the past year have been negative for the Aussie dollar, and typical global reflation indicators are just beginning to show tentative signs of a bottom. Among our favorite indicators on whether or not easing liquidity conditions are fuelling higher global growth are the copper-to-gold and oil-to-gold ratios. The signal is usually strongest when they are moving in tandem with US bond yields, another global growth barometer. The message so far has been one of stabilization rather than a renewed reflation cycle (Chart I-4). Chart I-3Lots Of AUD Shorts Chart I-4Reflation Barometers The devastating fires that are sweeping through Australia are the worst in decades. As we go to press, the death toll has risen to at least 25, and the cumulative damage is expected to exceed A$4.4 billion.1 Given that we are still in the middle of the summer months, both are likely to keep ramping up. Tourist arrivals are already down significantly, and both business and consumer confidence are approaching fresh lows. This augurs a swift and powerful policy response. Tourist arrivals are already down significantly, and both business and consumer confidence are approaching fresh lows. This augurs a swift and powerful policy response. So far, at A$2 billion, the fiscal pledge will do little to alter Australia’s economic fortunes (Chart I-5). But given the scale of this season’s fires, the effects are rapidly spilling over into urban populated areas and tourist hot spots compared to the past. This suggests more fiscal stimulus will be forthcoming. Chart I-5The Fiscal Impulse Is Minuscule Naturally, the odds of the Reserve Bank of Australia cutting rates at its next policy meeting are rapidly rising. The RBA views the risks from climate change through the lens of financial stability.2 With insurance companies slated to rack up significant losses, along with the immediate impact of slower economic growth, lower rates will likely be the policy of choice. The probability of a rate cut next month is currently being priced at 55%. That said, we would still be buyers of the AUD today despite an impending rate cut. Bottom Line: The latest fires have hit the Australian economy at a time when growth is weak. We expect the RBA to cut rates. How To Trade The Aussie For most small, open economies, external conditions tend to be more important for asset prices than what is happening domestically. In the case of the Australian dollar, the commodity cycle has been the most important driver (Chart I-6). Similarly, the most important catalyst for multiple expansion in Australian equities is Chinese credit demand. This makes sense, since over 35% of Australian exports go to China (Chart I-7), generating tremendous income for domestically-listed concerns. Chart I-6AUD Tracks Commodities Chart I-7Australian Equities And Chinese Credit Australian exports have remained resilient in recent weeks, and are unlikely to be affected much by the Phase I trade deal. This is because the composition of goods that have been spared additional tariffs or seen much-reduced export duties are mostly consumer goods that make up a small portion of Australia’s export basket. This means that the path of least resistance for Aussie assets will continue to be dictated by Chinese reflationary efforts. On that front, we have seen a number of green shoots, notably the rise in the manufacturing PMI, retail sales, imports and exports. Last night’s credit numbers were also robust. Meanwhile, interest rates in China continue to be lowered. For most small, open economies, external conditions tend to be more important for asset prices.In the case of the Australian dollar, the commodity cycle has been the most important driver. Our favorite indicator for Chinese domestic demand is the lag between the drop in bond yields (more and more credit is being intermediated through the bond market) and the pick-up in import demand. This suggests a very healthy recovery in Chinese consumption (Chart I-8). Chart I-8Chinese Imports And Bond Yields How to trade the Aussie will depend on time horizons. In the near-term, improving global growth will likely be accompanied by a weakening dollar. This means the most potent trade in the short term will be long AUD/USD. Given our bias that we will get a dovish surprise from the RBA next month, we are instituting a limit-buy on AUD/USD at 68 cents today. Over the longer term, we believe the Australian dollar will outperform its commodity-currency counterparts. In our portfolio, we are already both long AUD/CAD and AUD/NZD. This bullish view is predicated on three key developments: Commodity Prices: One bright spot for the Aussie dollar has been rising terms of trade. However, the media often focuses on rising steel and iron ore prices as a catalyst for rising terms of trade in Australia. While true, often overlooked is the rising share of liquefied natural gas in the export mix (Chart I-9). Beijing has a clear environmental push to shift its economy away from coal electricity generation and towards natural gas. Given that reducing if not outright eliminating pollution is a long-term strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie dollar will get a boost (Chart I-10). In a nutshell, this is a bet that terms of trade in Australia will continue to outpace those in Canada and New Zealand over the medium-term. Chart I-9LNG Will Be A Game-Changer For Australia Chart I-10A Terms-Of-Trade Tailwind Construction Activity: All things equal, natural disasters tend to be ultimately positive for GDP, since the destruction in the capital stock does not go into the GDP equation, but reconstruction efforts do. This is especially the case when the economy is running well below capacity. The downturn in Australian housing on the back of macro-prudential measures has been negative for consumption via the wealth effect and the outlook for residential construction activity. At a minimum, this downturn should stabilize as reconstruction efforts pick up (Chart I-11). Meanwhile, policy has become supportive for Aussie homebuyers at the margin. The government now guarantees first-time homebuyers in Australia below a certain income threshold access to the housing market, with just a 5% down payment instead of the standard 20%. Should labor market conditions improve, it will also help household income levels. Already, the Liberal-National coalition has left in place “negative gearing”3 and kept the capital gains tax exemption from selling properties at 50% (the pledge from the center-left Labour party was to reduce it to 25%). Aussie home prices are further along their downward adjustment path than, say, Canada or New Zealand. Most importantly, Aussie home prices are further along their downward adjustment path than, say, Canada or New Zealand. The mirror image has been that Aussie banks have massively underperformed those in Canada (Chart I-12). Over the medium term, we could see a reversal of these fortunes. Chart I-11Capex Should Rise In Australia Chart I-12Aussie Banks Versus Canadian Banks Valuation And Sentiment: We will show in an upcoming report that while currency valuation is a poor timing tool, it is excellent for calibrating longer-term returns. One of our favorite metrics for gauging the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 18% (Chart I-13). In terms of currency performance, a lot of the bad news already appears priced in the Australian dollar, which is down 15% from its 2018 peak, and 37% from its 2011 peak. Meanwhile, Australian dollar short positions appeared to have already hit a nadir. This suggests outright short AUD bets are at risk from either upside surprises in global growth or simply the forces of mean reversion (Chart I-14). Chart I-13AUD Is Cheap Chart I-14Still Lots Of AUD Shorts Bottom Line: Place a limit buy on AUD/USD at 0.68. Remain long AUD/NZD and AUD/CAD. Notes On The RMB The currency details from the Phase I trade deal were vague, suggesting monitoring export balances and FX reserves, data that is already available publicly. Our guess is that there was some kind of handshake accord agreed upon to ensure that the RMB does not depreciate significantly in the coming months. More importantly, the RMB will also be a beneficiary from increased cross-border trade, given that it has been trading like a pro-cyclical currency. The USD/CNY has been moving tick-for-tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-15). It has also closely mirrored the broad trade-weighted dollar (Chart I-16). Chart I-15CNY And EM Assets Chart I-16CNY And The Dollar This has implications for developed market currencies, since the RMB is often a signaling mechanism on the efficacy of China’s reflationary efforts. Fundamentally, the RMB has more upside. In a world of rapidly falling yields, Chinese rates remain attractive. Historically, the USD/CNY has moved in line with interest rate differentials between the US and China. The current divergence pins the USD/CNY near 6.7 (Chart I-17). Chart I-17USD/CNY Could Touch 6.7 Bottom Line: Remain positive on the RMB. Housekeeping The Canadian dollar is one of the strongest currencies this year. The most recent catalyst was good news from the Bank of Canada’s business outlook survey, a key input into policy decisions. Canadian firms are now expecting an acceleration in both domestic and international sales throughout 2020, particularly outside the energy sector (Chart I-18, top panel). Chart I-18BoC Business Outlook Survey Hiring intentions among surveyed firms edged up in Q4. Meanwhile, many firms reported facing capacity pressures, particularly related to a shortage of labor (Chart I-18, middle panel). This will allow the BoC to overlook weak labor market data in October and November. That said, it is not all clear blue skies for the CAD. The balance of opinion for capex intentions among surveyed Canadian firms plunged in Q4 (Chart I-18, bottom panel). We will be monitoring these developments but remain short CAD/NOK and long AUD/CAD for the time being. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Keith Bradsher and Isabella Kwai, “Australia’s Fires Test Its Winning Growth Formula,” The New York Times, January 13, 2020. 2 Please see “Financial Stability Risks From Climate Change,” Financial Stability Review, Reserve Bank Of Australia, October 2019. 3 The practice of using investment properties that are generating losses to offset one’s income tax bill. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mixed: On the labor market front, nonfarm payrolls increased by 145K in December, the smallest increase since May. Average hourly earnings growth slowed to 2.9%, while the unemployment rate was unchanged at 3.5%. Lastly, initial jobless claims fell to 204K for the week ended January 10th. The NFIB business optimism index declined to 102.7 from 104.7 in December. Headline inflation increased to 2.3% year-on-year in December, while core inflation was unchanged at 2.3%. Both the NY Empire State and Philly Fed manufacturing indices rose to 4.8 and 17, respectively in January. The DXY index fell by 0.3% this week. While both headline and core inflation remain close to target, the bearish job report last Friday is likely to reduce the scope for the Fed to raise rates in the near term. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: The seasonally-adjusted trade balance fell by €4.8 billion to €19.2 billion in November. Industrial production fell by 1.5% year-on-year in November. German GDP grew by 0.6% year-on-year in 2019, down from 1.5% the previous year. Car registrations rose by a remarkable 21.7% in December. The euro rose by 0.3% against the US dollar this week. "Incoming data since the last monetary policy meeting pointed to continued weak but stabilizing euro area growth dynamics," according to the ECB Meeting Accounts this Thursday. Moreover, both private and government consumption accelerated in 2019, while capex and exports slowed down. A pickup in global growth will be bullish the euro. 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 mixed: Both the coincident and leading indices fell to 95.1 and 90.9, respectively in November. That said, they were above expectations. The current account balance fell to ¥1,437 billion from ¥1,817 billion in November. The trade balance shifted from a surplus of ¥254 billion to a small deficit of ¥2.5 billion. The Eco Watchers' Survey recorded an improvement of current conditions to 39.8 in December, while the outlook index marginally dropped to 45.7. Preliminary machine tool orders continued to plunge by 33.6% year-on-year in December. However, machinery orders increased by 5.3% year-on-year in November. The Japanese yen depreciated by 0.4% against the US dollar this week. The recent Eco Watchers' Survey was cautiously positive on the Japanese outlook. We continue to recommend the Japanese yen as a safe-haven hedge. 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 weak: Core CPI fell to 1.4% while core PPI declined to 0.9%. The total trade balance (including EU) rose from a deficit of £1.3 billion to a surplus of £4 billion in November. Industrial production fell by 1.6% year-on-year in November; manufacturing production also fell by 2% year-on-year in November. The notable improvement was in car registrations that rose 3.4% year-on-year in December. The British pound fell by 0.2% against the US dollar this week. The recent drop in inflation has undoubtedly put more pressure on the BoE to reduce rates in the coming policy meeting late January. The market is now pricing in a 66% probability for a rate cut, up from 40% a week ago, while a 25 bps cut is fully priced in by May. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly negative: The AiG services PMI fell to 48.7 from 53.7 in December. Retail sales increased by 0.9% month-on-month in November. Melbourne Institute headline inflation fell to 1.4% from 1.5% year-on-year in December. Home loans increased by 1.8% month-on-month in November, higher than expectations of a 1.4% increase. The Australian dollar is flat this week. The ongoing wildfires continue to impact the Australian economy, particularly the tourism industry. Please refer to our front section for a more in-depth analysis on Australia. 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 soft: Building permits fell by 8.5% month-on-month in November. REINZ house prices grew by 1.2% month-on-month in December. The New Zealand dollar has been flat versus the US dollar this week. The recent quarterly survey from the New Zealand Institute of Economic Research (NZIER) showed that a net 21% of firms surveyed expected business conditions to deteriorate, an improvement from 40% in the previous survey. Improving data has led speculators to close NZD shorts. Stay long AUD/NZD. 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 positive: The unemployment rate fell further to 5.6% from 5.9% in December. Average hourly wage growth slowed to 3.8% from 4.4% year-on-year in December. 35.2K new jobs were created compared to a loss of 71.2K jobs the previous month. The Canadian dollar increased by 0.1% against the US dollar this week. The recent BoC Business Outlook Survey indicator edged up in Q4, lowering the probability that the BoC will cut interest rates next week. That said, the forecast for weak investment spending is worrisome. 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 There was scant data out of Switzerland this week: The unemployment rate was unchanged at 2.3% in December. The Swiss franc has appreciated by 1% against the US dollar, making it the best performing G10 currency this week. It is an open question whether the US Treasury’s move to put the Swiss franc on the currency manipulation watch list was a catalyst. What is clear is that interventions in recent weeks have been weak. Meanwhile, the last inflation reading from Switzerland was positive, reducing the urge for the SNB to intervene. EUR/CHF is approaching our limit buy position at 1.06. Stay tuned. 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 mixed: The producer price index fell by 2.2% year-on-year in November. Both headline and core inflation fell to 1.4% and 1.8% year-on-year, respectively in December. The trade surplus increased to NOK 25.6 billion from NOK 18.8 billion in December. The Norwegian krone has been flat against the US dollar this week. Both inventory reports from API and EIA have been bearish on oil prices, which put a cap on petrocurrencies this week. However, going forward, we continue to believe that the combination of expansionary monetary and fiscal policy will support commodity demand growth in 2020, which is bullish for the Norwegian krone. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production increased by 0.4% year-on-year in November. Manufacturing new orders fell by 1.2% year-on-year in November. Headline inflation was unchanged at 1.8% year-on-year in December. The Swedish krona rose by 0.2% against the US dollar this week. The Swedish government cut the forecast of GDP growth to 1.1% this year, down from the previous figure of 1.4% in September. Moreover, it forecasted negative rates going forward. That said, valuations and improving global growth will remain strong catalysts for long SEK positions. 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
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…
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 An analysis on Indonesia is available below. We intend to maintain our long EM stocks position, initiated on December 19, as long as the MSCI EM equity index does not break below our stop point of 6% below current levels. Global trade will improve on a rate-of-change basis. Nevertheless, both money and bank asset impulses in China have already rolled over, and the credit impulse could relapse in the first half of 2020. As a result, the staying power of China’s recovery remains doubtful. For now, we continue to recommend underweighting EM equities, currencies and credit markets versus their DM counterparts. Feature Chart I-1Investors Are Very Bullish On US Stocks EM share prices and currencies are at a crossroads. On one hand, some green shoots have recently emerged in Asia’s business cycle. On the other hand, global stocks are overbought and investor sentiment is very bullish, as evidenced by the record large net long position held by asset managers and leveraged funds in US equity indices futures (Chart I-1). The clash between these forces will define trading in EM risk assets in the coming weeks. If EM share prices and currencies consolidate their recent gains without a major relapse, it will signal that a sustainable rally lies ahead. Alternatively, if EM stocks and exchange rates drop considerably, it will indicate that improving investor sentiment and flows (technicals) rather than a durable recovery in corporate profitability (fundamentals) are what produced the recent rebound. We initiated a long position in EM stocks on December 19 and intend to maintain it unless the MSCI EM equity index breaks below our stop point of 1050, which is 6% below current levels. Green Shoots In Asia There are a number of green shoots beginning to emerge in Asia. December data point to a budding recovery in Asia’s business cycle: manufacturing PMIs rose in December in Korea, Taiwan and Singapore (Chart I-2). The measure was flattish in China and slightly down in Japan (Chart I-2, bottom two panels). Korean exports have begun recovering on a rate-of-change basis (Chart I-3, top panel). What’s more, the average of new and backlog orders rose for Chinese NBS and Taiwanese manufacturing PMIs in the past couple of months (Chart I-3, middle and bottom panels). Chart I-2Green Shoots In Asia Chart I-3Asian Exports To Improve On A Rate-Of-Change Basis Chart I-4DRAM And NAND Prices Have Improved Post December 15 Finally, following the announcement of the US-China phase one trade deal on December 13, semiconductor NAND and DRAM prices rose (Chart I-4). It seems that the phase one trade deal has boosted sentiment not only among investors worldwide but also among business executives in Asia. Even though US ISM and European PMI manufacturing data remain lackluster, we continue to emphasize that what matters for – and is an indication of – EM growth is China’s and emerging Asia’s manufacturing cycles. In a nutshell, we put much more weight on Asian rather than DM manufacturing data when gauging trends in EM stocks and currencies. The marginal improvement in Asian manufacturing provides veracity to the recent rally in EM equities and currencies. Chart I-5China: Credit And Fiscal Versus Broad Money Impulses China’s credit and fiscal impulse continues to point up (Chart I-5, top panel), also supporting the notion that global trade will be improving on a rate-of-change basis. In addition, we have entered the second year of the global trade/manufacturing contraction, and the base effects are much more benign – Asian exports started shrinking in late 2018. Hence, odds are that global trade will be contracting at a reduced pace from a year ago, and by mid-2020 may even post slightly positive growth. Looking beyond the near term, however, the Chinese money and bank asset impulses have already rolled over (Chart I-5, middle and bottom panels). Given that they have often led the credit and fiscal spending impulse, odds are that the latter will roll over in the coming months. If this is indeed the case, the improvement in China’s growth will be short-lived. What does it all mean? Investors should play this EM rally with tight stop points. The near-term growth outlook is benign, but the sustainability of this recovery is not yet assured. Having rebounded in recent months, EM financial markets could soon start looking through the current improvement in economic conditions in China and could become preoccupied with its growth outlook in the second half of 2020. Market Signals Are Mixed Apart from China’s money and credit impulses, we are watching numerous market signals to corroborate or reject the hypothesis of a durable recovery in both China’s business cycle and global trade. Several of these market signals have not yet confirmed this hypothesis. Chinese and Korean government bond yields have drifted lower in recent weeks, a phenomenon that is typically associated with weakening growth in China and global trade (Chart I-6). Apart from semiconductor stocks, global cyclical sectors have not outperformed the global equity index. Specifically, global industrials, materials, autos, as well as freight and logistics, have been flat to down versus the global aggregate stock index (Chart I-7). Chart I-6Yellow Flags From Bond Yields In China And Korea Chart I-7Global Cyclicals Have Not Outperformed Yet Chart I-8No Breakout In Industrial Metals Prices Industrial metals in general – and copper prices in particular – have not yet broken out (Chart I-8). Correspondingly, the broad trade-weighted US dollar has corrected sharply but has not yet broken down. So far, the greenback’s retrenchment is more consistent with a correction rather than a bear market. A breakout in industrial metals prices and a breakdown in the broad trade-weighted dollar would confirm that China’s growth and global trade have entered a period of lasting expansion. Finally, our Risk-On/Safe-Haven currency ratio1 has so far been inconclusive. This ratio strongly correlates with the EM equity index (Chart I-9). Barring a major breakout in this indicator, the medium- and long-term outlook for EM stocks will remain opaque. Chart I-9Cyclical Versus Safe-Haven Currencies And EM Stocks Bottom Line: While some global growth-sensitive markets have broken out, signposts from other markets are not yet flashing green. In the coming weeks, price actions in EM financial markets will reveal if EM stocks and currencies have entered a genuine and lasting bull market or if their recent rebound has been driven by euphoria surrounding the US-China trade deal. Asset Allocation: EM Versus DM We recommended buying EM stocks on December 19 but we stopped short of outright upgrading EM versus DM stocks. We are seeking confirmation from the market signals listed above before upgrading our allocation to EM within a global equity portfolio from underweight to overweight. While some global growth-sensitive markets have broken out, signposts from other markets are not yet flashing green. First, EM per-share earnings (EPS) continue to underperform DM EPS in both local and common currency terms (Chart I-10). So long as EM EPS lag DM peers, EM equities, currencies and credit markets will trail their DM counterparts. Second, growth woes in EM are not limited to China or global trade. Domestic demand in many EM economies outside China, Korea and Taiwan continues to slump (Chart I-11, top and middle panel). Besides, core inflation has fallen to a record low, dampening corporate profits (Chart I-11, bottom panel). Chart I-10EM EPS Continues To Lag DM Chart I-11EM Ex-China, Korea and Taiwan: Domestic Demand Is Very Weak Chart I-12EM Ex-China, Korea And Taiwan: Need Lower Lending Rates Even though EM central banks have reduced interest rates, in many economies lending rates in real, inflation-adjusted terms have risen rather than declined (Chart I-12). The basis is that inflation has dropped more than lending rates. High lending rates explain why credit demand is poor. In a nutshell, many EM economies require much more easing to recover. Third, EM equity valuations are not more attractive than DM ones. While EM stocks are cheaper compared to their US counterparts, they are more expensive versus euro area equities. Overall, EM equities command a neutral valuation both in absolute terms and relative to their DM counterparts (Chart I-13). In short, there is no strong valuation case for favoring EM versus DM. Finally, we have been speculating since March 2019 that the absolute and relative performance of EM stocks is more likely to resemble their profiles in 2011-14 rather than in 2016-17. This thesis has so far been playing out. Chart I-14 illustrates an overlay of share prices in EM and DM as well as EM’s relative equity performance to DM. The overlay compares the period from 2017 to present with the one from 2011-14. Chart I-13EM Equities Command Neutral Valuations Chart I-14EM And DM Stocks Are Tracking Their 2012 Profiles DM share prices rallied substantially in 2011-14 but EM equities, currencies and credit markets as well as commodities prices have been flat to down. As a result, EM massively underperformed DM during that global bull market (Chart I-14, bottom panel). EM equities command a neutral valuation both in absolute terms and relative to their DM counterparts. That occurred because EM domestic fundamentals were poor back in 2011-14 and China’s growth stabilized but failed to stage a meaningful recovery (please refer to the bottom panel of Chart I-2 on page 2). Bottom Line: We continue to recommend underweighting EM equities, currencies and credit markets versus their DM counterparts. Review Of Some Of Our Open Positions We are closing the following strategic position: short EM equities / long US 30-year Treasurys. In the past 10 years, US bonds have done much better than EM equities on a total return basis in common currency terms (Chart I-15). This position had been profitable till October but our gains have evaporated since then and we are closing it flat. We are booking a 8.3% gain on long Asian / short US semiconductor stocks, a position initiated on June 13, 2019. Asian semis stocks have already rallied a lot and potential weakness in the US dollar will help US semis while cap upside in Asian semis stocks. We are reiterating the long gold / short oil and copper trade recommended on July 11, 2019 (Chart I-16). In any feasible global macro scenario, gold will continue outperforming oil and copper. The basis is that global real interest rates will stay low. Chart I-15Close Short EM Equities / Long US 30-Year Treasurys Position Chart I-16Stay With Long Gold / Short Oil And Copper Trade Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indonesia: Struggling Under High Real Rates Indonesian commercial banks have been the only leg holding up the Indonesian stock market (Chart II-1). However, their cyclical outlook is uninspiring as their share prices risk selling off. The critical issue is that lending rates in the Indonesian economy are too high for borrowers. Hence, banks are facing a lose-lose dilemma: Either bank lending rates will have to drop, squeezing Indonesian commercial banks’ net interest rate margins, or non-performing loans (NPL) will mushroom as debtors cannot afford such high borrowing costs. In both cases, bank profits will suffer. Both of these scenarios are bearish for commercial banks’ share prices. Given that banks account for 47% of the overall MSCI Indonesia stock market capitalization and the rest of the equity market has been struggling due to worsening corporate profitability, the outlook for this bourse is downbeat. We continue recommending underweighting Indonesian stocks within an EM equity portfolio. The Indonesian economy is facing strong deflationary pressures. Both headline and core consumer price inflation have dropped to the bottom of the central bank’s inflation target band (Chart II-2, top panel). Meanwhile, corporate pricing power as measured by the GDP deflator has weakened significantly (Chart II-2, bottom panel). Chart II-1Indonesia: Financials Are The Only Sector Rallying Chart II-2Indonesia: Inflation Is Undershooting Disinflationary forces have caused the nation’s nominal GDP growth to plummet dangerously below bank lending rates (Chart II-3). This makes it more difficult for borrowers to service their debt and will ensure rising NPL in the banking system. Crucially, it also discourages new credit demand. The top panel of Chart II-4 shows that bank loan growth is decelerating. Chart II-3Borrowing Costs Are Excessive Chart II-4Policy Rate Cuts Did Not Translate To Much Lower Bank Lending Rates Although the central bank has cut its policy rate by 100 basis points in 2019, bank lending rates dropped by only 17 basis points and currently stand at 10.2% in nominal terms (Chart II-4, middle panel). In real (inflation-adjusted) terms, bank lending rates remain very elevated (Chart II-4, bottom panel). Consistent with excessive borrowing costs, both the consumer and business sectors are struggling: Retail sales (excluding vehicles) volume growth is hovering around zero (Chart II-5, top panel). Retail sales of specific items are contracting (Chart II-5, middle panel). Meanwhile, motorcycle and car unit sales are shrinking (Chart II-5, bottom panel). Industrial activity is also lackluster. Freight traffic is very weak, capital goods imports are contracting and domestic cement consumption remains anemic (Chart II-6). Consistently, EBITDA of non-financial publically-listed companies is flirting with contraction (Chart II-7). Chart II-5A Major Deceleration In The Consumer Sector Chart II-6Indonesia: Industrial Activity Is Subdued Overall, the Indonesian economy needs much lower lending rates and a fiscal boost. The government is focused on keeping the budget deficit in check and no major fiscal stimulus should be expected. Therefore, monetary policy/lower interest rates should be the only source of stimulus. Overall, the Indonesian economy needs much lower lending rates and a fiscal boost. With rate cuts by the central bank failing to translate into much lower bank lending rates, the sole viable option for authorities is to force commercial banks to reduce their lending rates. This strategy appears to be already in place, as demonstrated by President Joko Widodo’s November speech where he explicitly encouraged commercial banks to lower their lending rates. Such moral suasion or regulatory push by the authorities will likely intensify in the coming months. Doing so, however, will squeeze commercial banks’ net interest rate margins and hit banks’ profits (Chart II-8). Alternatively, if banks refuse to drop their lending rates meaningfully, their NPL will proliferate, damaging their profits. Chart II-7Indonesia: Corporate Profits Are About To Contract Chart II-8Commercial Banks' Net Interest Margins Will Fall Importantly, Indonesian commercial banks are expensive with a PBV ratio of 2.7; therefore, banks’ share prices will be extremely sensitive to negative news regarding their profit growth outlook. Investment Recommendations Chart II-9Indonesian Stocks Relative To The EM Equity Benchmark Equity investors should continue underweighting this bourse. Chart II-9 shows that relative equity performance versus EM is teetering. Our short position in the rupiah versus the US dollar remains in place but we are instituting a stop point at 13500 USD/IDR to manage risks. The basis for rupiah depreciation is as follows: In an economy that is facing unbearable high real borrowing costs and no willingness or ability to stimulate fiscally, the currency will likely serve as an adjustment valve. It will probably depreciate to boost exports and encourage import substitution as well as generate inflation. Critically, when the economy is stumbling due to excessive real interest rates, the latter do not typically engineer currency appreciation. In fact, the currency tends to depreciate rather than appreciate in cases when the return on capital is below borrowing costs. Indonesia fits this profile very well. Consistent with our expectations for currency depreciation, we continue underweighting Indonesian domestic bonds and sovereign credit within their respective EM benchmarks. We will alter this stance if our stop on the rupiah is triggered. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1 Average of CAD, AUD, NZD, BRL, MXN, RUB, CLP & ZAR total return indices relative to average OF JPY & CHF total return indices. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Incoming economic data suggests that China’s economy is in the process of bottoming, but also that the intensity of a recovery is likely to be more muted than it has been during past economic cycles. Recent Chinese equity market performance is consistent with a bottoming in the economy: cyclicals are outperforming defensives, and both the investable and domestic markets have broken above their respective 200-day moving averages versus global stocks. We continue to recommend that investors cyclically overweight Chinese domestic and investable stocks relative to the global benchmark. However, there is more potential upside for investable than domestic stocks, and the gains in both markets may be front loaded in the first half of the year. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, several indicators now suggest that China’s economy is in the process of bottoming, but these indicators also imply that the intensity of a recovery in economic activity is likely to be more muted than it has been during past economic cycles. We see this as consistent with the views presented in our December 11 Weekly Report,1 which laid out four key themes for China and its financial markets for 2020. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, recent developments are also consistent with the view that Chinese economic activity will modestly accelerate and that a Sino-American trade truce will last until the US presidential election in November 2020. Chinese stocks have rallied both in absolute terms and relative to global equities over the past month, and cyclical stocks are clearly outperforming defensives on an equally-weighted basis in both markets. The RMB has also appreciated modestly, with USD-CNY having now durably fallen back below the 7 mark. We continue to recommend that investors cyclically overweight Chinese domestic and investable stocks relative to the global benchmark, with the caveat that we expect more potential upside for investable than domestic stocks and the gains in both markets may be front loaded in the first half of the year. We expect modest further gains in the RMB over the coming few months, as we see the PBoC is unwilling to allow rapid appreciation. In reference to Tables 1 and 2, we provide several detailed observations below concerning developments in China’s macro and financial market data: Chart 1A Bottoming In China's Economic Growth Is Now Likely Underway On a smoothed basis, the Bloomberg Li Keqiang index (LKI) rose in November, driven largely by an improvement in electricity output (Chart 1). While our alternative LKI is weaker than Bloomberg’s measure, we see the improvement in the latter as a sign of a bottoming process for growth that is now underway (Bottom panel, Chart 1). Our leading indicator for the Li Keqiang index was essentially flat in November, with the large gap that has persisted between the degree of monetary accommodation and money & credit growth still present. There was a notable improvement in the Bloomberg Monetary Conditions Index (MCI) in November, but this can be attributed to a surge in headline inflation (which depressed real interest rates). This underscores that the ongoing uptrend in our LKI leading indicator is modest, and that an improvement in economic activity this year is thus unlikely to be sharp or intense. With the pace of pledged supplementary lending (PSL) injections and Tier 1 housing price appreciation as exceptions, all of the housing market data series that we track in Table 1 deteriorated in November. On a smoothed basis, residential housing sales rose at a slower pace and the previous surge in housing construction waned, in line with our expectation (Chart 2). House prices have continued to deviate from housing sales; deteriorating affordability and tight housing regulations have contributed to this divergence. Although funding from the PBoC’s PSL program improved in November, even further funding assistance is likely necessary in order to expect a strong uptrend in housing sales given the affordability and regulatory headwinds (Bottom panel, Chart 2). Both China’s Caixin and official manufacturing PMIs continue to signal positive signs for Chinese economic activity. While the Caixin PMI fell slightly in December, it stayed in expansionary territory for the fifth consecutive month. The official PMI also provided positive signs: the overall index remained above 50 for the second month, the production component rose further into expansionary territory, and the new export orders moved above the 50 mark. All told, China’s PMI data now clearly suggests that a bottoming in China’s economic growth is underway. Although the overall PMI data is sending a positive signal, Chart 3 highlights two series that are somewhat less positive. First, while the import component of the official PMI is rising, it is lagging other key sub-components and remains below 50. In addition, the PMI for small enterprises, which led the early phase of the 2016 recovery in the official PMI, has not meaningfully changed over the past few months. For now, these series suggest that a recovery in growth is likely to be muted compared with previous episodes over the past decade. Chart 2More Accommodative Funding Is Needed For Stronger Housing Sales Chart 3Weaker PMI Sub-Components Suggest A More Muted Recovery In USD terms, China’s equity markets (both investable and domestic) have rallied more than 8%-9% in absolute terms over the past month. In relative terms, both investable and A-share markets have also outperformed the global benchmark. It is notable that the relative performance trend of Chinese investable stocks has broken clearly above its 200-day moving average, which is the first time since the trade talks collapsed in May of last year (Chart 4A). The strong rally in China’s stock prices over the past month, particularly in the investable market, largely reflect the likely signing of a trade truce between the US and China. In our view, more accommodative monetary and fiscal support in 2020, as well as an ongoing truce, provide a sound basis to overweight China’s stocks within a global equity portfolio over both a tactical and cyclical horizon. However, we expect that China’s investable market has more upside potential than its domestic peer, given how much further the former fell in 2019. From an equity sector perspective, the most notable development over the past month is that cyclical sectors have outperformed defensives in both the investable and domestic markets and have broken above their respective 200-day moving averages (Chart 4B). Among cyclical sectors, industrials, energy, consumer discretionary, especially materials and telecommunication services, have all contributed to cyclical outperformance over the past month. The outperformance of cyclical sectors is strongly consistent with continued outperformance of Chinese stocks versus the global average, and strengthens our conviction that investors should be overweight Chinese markets within a regional equity portfolio. China’s 3-month repo rate fell meaningfully over the past week, in response to a 50 bps cut in the reserve requirement ratio (RRR). The decline has merely returned the repo rate back to the level that prevailed on average in 2019, but it does underscore the PBoC’s desire to modestly ease liquidity on a net basis. We will be presenting a Special Report on China’s government bond market later this month, but for now, our view remains that easier monetary policy is unlikely to materially impact Chinese government bond yields this year, unless the PBoC decides to target sharply lower interbank repo rates (which is not our expectation). Chart 4AThe Meaningful Rally In China's Equity Markets Sends A Positive Signal Chart 4BThe Outperformance Of Cyclicals Over Defensives Is Consistent With An Economic Recovery China’s onshore corporate bond spread has risen slightly over the past month alongside falling corporate yields. Despite persistent concerns of rising defaults on China’s onshore corporate bonds, the overall default rate remains quite low compared with those in developed economies, and China’s corporate bond market will benefit from even a modest improvement in economic growth this year. As such, we expect a continued uptrend in China’s onshore corporate bond total return index, and would favor onshore corporate over duration-matched Chinese government bonds. Chart 5A Modest Further Downtrend In USD-CNY This Year Is Likely The RMB has gained more than 1.35% versus the U.S. dollar over the last month, which caused USD-CNY to durably break below 7 (Chart 5). The rise was clearly in response to news that the US and China will agree to a trade truce, and we expect a further modest downtrend in USD-CNY as China’s economy continues to improve. Investors should note that we are likely to close our long USD-CNH trade (currently registering a gain of 1%) following the signing of the Phase One deal on Jan 15, given that we opened the trade as a currency hedge for our overweight towards Chinese stocks (denominated in USD terms). As such, upon the signing of the deal, we would recommend that investors favor Chinese stocks versus the global benchmark in unhedged terms. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report "2020 Key Views: Four Themes For China In The Coming Year," dated December 11, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Feature Recommended Allocation Since BCA published its 2020 Outlook,1 and the December GAA Monthly Portfolio Update,2 nothing has happened to make us fundamentally change our views. We see the global manufacturing cycle rebounding over the coming quarters, but major central banks remaining dovish. This combination of accelerating growth and easy monetary policy should be positive for risk assets. We accordingly continue to recommend an overweight on equities versus bonds, prefer the more cyclical euro zone and EM equity markets over the US, and selectively like credit (particularly the riskier end of the US junk bond universe). In the 2020 Outlook, we laid out a series of milestones that would indicate how our scenario is playing out: whether we need to reconsider it, or whether we should be adding further to risk (Table 1). Here is how those milestones are progressing. Table 1Milestones For The 2020 Outlook Chinese growth. Total Social Financing picked up in November (CNY1.75 trillion versus CNY619 billion the previous month) and the most recent hard data (notably retail sales and industrial production) showed improvement. But the momentum of credit creation and activity generally remain weak (Chart 1). We expect that Chinese growth will begin to accelerate in early 2020, due to the lagged effect of monetary stimulus in the first half of last year, and easier fiscal policy. Moreover, December’s annual Central Economic Work Conference pointed to greater government emphasis on growth stability.3 The clampdown on shadow banking also seems to be easing (Chart 2). However, we need to see further signs of Chinese growth accelerating before, for example, we become more bullish on Emerging Markets and commodities. Chart 1Chinese Credit And Activity Remain Weak Chart 2Clampdown On Shadow Banking Easing? Trade war. The last-minute agreement to cancel the December 15 rise in US tariffs on Chinese imports represents the “ceasefire” we expected, rather than “phase one” of a more profound agreement. It is still unclear whether previous tariffs will be rolled back (Chart 3). China’s supposed promise to increase imports of US agricultural products from $10 billion a year to $40 billion-$50 billion seems unrealistic. Progress on more fundamental topics such as China’s subsidies for state-owned companies seems far off. For now, President Trump has done enough to minimize the negative impact on the US economy in an election year. But there remains a possibility that trade war reemerges as a risk during 2020. Chart 3How Far The Rollback? Progress against these milestones suggests that our current asset allocation recommendation structure – moderately risk-on, but with hedges against downside risk – is appropriate for now. Global growth. Data confirming the rebound in the manufacturing cycle remain mixed. Economic surprises have generally been positive in the euro zone, but have slipped in the US and Japan, and remain soft in the Emerging Markets (Chart 4). In Germany, the manufacturing PMI slipped back to 43.7 in December, but the Ifo and ZEW surveys both rebounded (Chart 5). There is, however, still little sign that the weakness in manufacturing is spilling over into consumption and services. In Germany, unemployment remains at a record low and wages are strong. In the US, wage growth continues to trend up, and there is no indication in the weekly initial claims data that companies are starting to lay off workers at more than the seasonally normal pace (Chart 6). Market indicators of the cycle are also showing some positive signs. Among commodities, the price of copper – the most cyclical metal – has begun to rise. Chinese cyclical stocks are outperforming defensives. But the US dollar has not yet showed any significant depreciation (Chart 7). Chart 4Economic Surprises Mixed Chart 5Germany Showing Signs Of Bottoming Chart 6No Problems In The Labor Market Chart 7Some Positive Signs From The Markets US politics. President Trump’s approval rating has picked up slightly – we warned that its slipping might cause him to get aggressive on trade or foreign policy (Chart 8). Markets might worry at the possibility of “President Warren” given her focus on increased regulation of industries such as finance, energy, and technology. But she has fallen a little in the polls. Even in liberal California (where the primary will be unusually early next year – March 3), she is only level with Biden and Sanders in opinion polls. Our geopolitical strategists see US politics as one of the key geopolitical risks this year,4 but the risk seems subdued for now. Chart 8Trump’s Approval Rating Stable To Rising Fed tightening. Expansions usually end when inflation rises, either causing the Fed to raise rates to choke it off, or with the Fed ignoring the inflation and allowing debt and asset bubbles to form. Any signs, therefore, that inflation, or inflation expectations, are rising would signal that we are truly in the “end game”. For now, there are no such signs. US inflation is likely to soften over the next six months, as a result of the economic slowdown and strong dollar. And TIPS breakevens imply the market believes the Fed will miss its inflation target by an average of 80-90 BPs a year over the next decade (Chart 9). The Fed is likely to sound very dovish over the coming year. The review of its monetary policy framework, probably to be announced in July, may result in some sort of “catch-up” policy: under this, if inflation undershoots the Fed’s target, the target automatically rises the following year.5 Its efforts to support the repo market, including short-term Treasury securities purchases of $60 billion a month, will increase the Fed’s balance-sheet, and represent a “mini-QE” (Chart 10). The Fed is likely to be reluctant to turn more hawkish ahead of the presidential election. These dovish moves – and continued accommodative policies from the ECB and Bank of Japan – mean that monetary policy will be supportive for risk assets throughout 2020. Chart 9Inflation Remains Subdued These milestones suggest, therefore, that our current asset allocation recommendation structure – moderately risk-on, but with hedges (long cash and gold) against downside risk – is appropriate for now. Chart 10A "Mini-QE"? Equities: We shifted last month to an underweight on US equities, with an overweight on the euro zone, and neutral on Emerging Markets. The US tends to underperform during upswings in the global manufacturing cycle (Chart 11). Europe looks attractive because of its heavy weighting in sectors we like such as Financials, Autos and Capital Goods. Europe’s returns will also be boosted by the appreciation in the euro and pound that we expect (our equity recommendations assume no currency hedging). For EM, we would turn more positive if we saw a clear pickup in Chinese credit and economic growth. Chart 11US Underperforms When Growth Picks Up Chart 12Fed Won't Cut As The Market Expects Fixed Income: Our positive view on global growth implies that long-term rates will rise. We see the US Treasury 10-year yield reaching 2.5% by mid-2020. The market still expects the Fed to cut rates once over the next 12 months. If it stays on hold, as we expect, that slight hawkish surprise would be compatible with a moderate rise in rates (Chart 12). Core euro zone rates might rise by a little less, perhaps by 30-40 BPs, and Japanese government bond yields by 10-15 BPs. We, therefore, continue to recommend a small underweight on duration and an overweight on TIPS which look particularly cheaply valued. Within credit, our preferences are for European investment grade (not as expensive as in the US, and with the ECB buying corporate debt again) and the lower end of the US junk-bond universe (since CCC-rated bonds missed out on 2019’s rally). In a rebounding global economy, the US dollar should depreciate, particularly since it looks somewhat over-valued, and with speculative positions long the dollar. Currencies: In a rebounding global economy, the US dollar should depreciate, particularly since it looks somewhat over-valued (Chart 13), and with speculative positions long the dollar (Chart 14). But its performance is likely to vary depending on the currency pair. Our FX strategists expect the dollar to weaken to 1.18 against the euro and 1.40 against the pound over the next 12 months, and even more against currencies such as the NOK, SEK, and AUD.6 But the dollar is likely to strengthen against the yen (an even more counter-cyclical currency) and against currencies in EM, where central banks will continue to cut rates and inject liquidity aggressively to support their economies. Chart 13Dollar Looks Expensive... Chart 14...And Speculators Are Long Commodities: Supply in the oil market remains tight, with OPEC deepening its production cuts to 1.7 million barrels/day. The crude oil price was held down in 2019 by weakening demand, which should recover along with the cycle in 2020 (Chart 15). Our energy strategists expect Brent to average $67 a barrel in 2020 (compared to $66 now), with WTI $4 lower. Metal prices could rise in 2020 as Chinese growth recovers and the US dollar depreciates – the two most important factors that drive them (Chart 16). Given the uncertainty over both, we remain neutral for now, but would turn more positive (including on commodity-related assets, such as Australian or EM equities) if we see clear signs of their moving in the right direction. We see gold as a good downside hedge in a world of ultra-low interest rates, especially since central banks may allow inflation to overshoot over the coming years. Chart 15Supply/Demand Balance Points To Higher Oil Price Chart 16Metals Are Driven By The Dollar And China Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1 Please see "Outlook 2020: Heading Into The End Game," dated 22 November 2019, available at bca.bcaresearch.com. 2 Please see "GAA Monthly Portfolio Update: How To Position For The End Game," dated 2 December 2019, available at gaa.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "A Year-End Tactical Upgrade," dated 18 December 2019, available at cis.bcaresearch.com 4 Please see Geopolitical Strategy "Strategic Outlook: 2020 Key Views: The Anarchic Society," dated 6 December 2019, available at gps.bcaresearch.com 5 For example, if the Fed's inflation target is 2% but inflation is only 1.7% one year, the target would automatically rise to 2.3% the following year. 6 Please see Foreign Exchange Strategy, "2020 Key Views: Top Trade Ideas," dated December 13, 2019, available at fes.bcaresearch.com GAA Asset Allocation
Dear Client, In addition to this short weekly report, you will also receive a Special Report on investment themes over the next decade, penned by our colleagues in the US Equity Strategy and Geopolitical Strategy services. The implications for the dollar could be profound, and I hope you will find it insightful. This will be our final publication for the year. We will resume publication on January 10, 2020. Thank you for your readership and wishing you a prosperous New Year. Best regards, Chester Ntonifor Highlights We expect the USD/CAD to fall to 1.20 in the coming months. However, we recommend favoring both the aussie and the euro over the loonie. Stand aside on sterling for now. Feature We expect CAD/USD to gravitate higher in the next few months. In a somewhat hawkish shift, the Bank of Canada kept rates on hold at its last policy meeting. It may however later view this move as a policy mistake, not because the economy was under pressure, but because other central banks have been mostly cutting rates this year (Chart I-1). Upward pressure on the CAD will tighten domestic financial conditions. This will ensure that while CAD/USD may touch 0.80-0.82 cents in the next few months (Chart I-2), it will likely underperform its procyclical peers. Chart I-1Peak ##br##Divergence? Chart I-2Interest Rate Differentials Could Push USD/CAD To 1.20 More recently, Canadian data is beginning to take a surprising turn to the downside. The November jobs report was the worst since the financial crisis. This was the second consecutive monthly drop, with losses spread across both part-time and full-time (Chart I-3). Most importantly, the unemployment rate in Canada has tended to stage powerful V-shaped recoveries, and the rise in November suggests caution (bottom panel). Manufacturing and resources in Quebec, Alberta and British Columbia bore the brunt of the employment declines. Chart I-3Worst Job Report Since 2007 Chart I-4Uneven Housing Recovery Housing remains a pillar of household wealth in Canada, and the recovery in prices remains uneven (Chart I-4). The risk is that this continues to restrain spending in Canada, which has remained weak despite robust wage growth. Nationwide house price growth has slowed to a standstill. A study by the Reserve Bank of New Zealand shows that on average, the elasticity of consumption growth to house price changes is asymmetric to the downside.1 Negative housing shocks tend to hurt consumption by more than the boost received from positive shocks. This makes sense since at very elevated debt levels, leveraged gains are used to pay down debt aggressively, whereas leveraged losses hit bottom lines directly. Housing remains a pillar of household wealth in Canada, and the recovery in prices remains uneven. The increase in the budget deficit next year is mainly due to the increase in pension liabilities (low rates led to lower returns), rather than significant new spending (Chart I-5).2 This means the scope for the BoC to raise rates could be much less compared to other central banks, should the global economy pick up steam next year. Fiscal spending looks much more forthcoming in Europe, Japan and the US (Chart I-6). Chart I-5Projected Federal Budgetary Balance The latest inflation print shows that domestic prices in Canada remain well anchored at the midpoint of the BoC’s target band. However, there are downside risks from the lagged effect of softening producer prices (Chart I-7). Chart I-6Higher Budget Deficits Outside Canada Chart I-7Risk To Canadian Inflation More importantly, terms of trade in Canada have been slowing, especially when compared to its commodity peers (Chart I-8). Rising energy prices, as we expect, will be a tailwind, but the Western Canadian Select discount and persistent infrastructure problems are headwinds. Fiscal spending looks much more forthcoming in Europe, Japan and the US. We favor the aussie over the loonie since the downturn in the Australian housing market appears much further advanced compared to Canada. Historically, policy divergences between the RBA and the BoC have followed the relative growth profiles of their biggest export markets, and the message so far is that the RBA is well ahead of the curve in its dovish bias (Chart I-9). Our expectation is that the recent green shoots in Chinese growth are a prelude to another mini-up cycle, in line with the view of our colleague Jing Sima from BCA’s China Investment Strategy service Chart I-8CAD, AUD, NZD And Terms Of Trade Chart I-9Buy AUD/CAD This week, we are also recommending investors buy EUR/CAD. First, valuations and balance-of-payment dynamics favor the euro versus the Canadian dollar. Second, we estimate there is more scope for long-term interest rate expectations to rise in the euro area than in Canada. This is just a matter of mathematics, since European rates have already fallen to rock-bottom levels. Meanwhile, economic surprises are inflecting higher in the Eurozone relative to Canada (Chart I-10). Chart I-10Buy EUR/CAD EUR/CAD is sitting at the bottom of the upward trending channel that has existed since 2012. On a technical basis, the downside has been eliminated for now. Meanwhile, initial upside resistance rests at the triple top, a nudge above 1.6 (Chart I-11). Chart I-11EUR/CAD Technicals: Limited Downside Housekeeping We were stopped out of our long GBP/JPY trade for a profit of 9.6%. On a tactical basis, we are standing aside for now as volatility could rise, especially amid thin holiday trading. Meanwhile, on a technical basis, EUR/GBP is also due for mean reversion (Chart I-12). That said, our eventual target for GBP/USD is 1.40 for clients willing to stomach the volatility. Chart I-12Tactical Upside For EUR/GBP Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Mairead de Roiste, Apostolos Fasianos, Robert Kirkby, and Fang Yao, “Household Leverage and Asymmetric Housing Wealth Effects - Evidence from New Zealand,” Reserve Bank of New Zealand, Discussion Paper Series, (April 2019). 2 Jordan Press, “Morneau’s fiscal update shows Canada’s deficit increased by billions for next 2 years,” Global News, The Canadian Press, December 16, 2019. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mixed: Markit flash manufacturing PMI marginally fell to 52.5, while services PMI increased to 52.2 in December. The New York Empire State Manufacturing index increased to 3.5 from 2.9 in December, while the Philly Fed Manufacturing index fell sharply to 0.3 from 10.4. On the housing market front, NAHB housing market index increased to 76 from 71 in December. Both building permits and housing starts increased by 1.5 million and 1.4 million month-on-month, respectively in November. The DXY index increased by 0.3% this week following the recent plunge. Various dollar indicators continue to point to the downside, including interest rate differentials, the bond-to-gold ratio, portfolio inflows, and rebounding global growth. We went short the DXY index last week. Stay with it. 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 mostly positive: Markit manufacturing PMI fell to 45.9 from 46.9 in December, while services PMI increased to 52.4. The trade surplus increased to €24.5 billion from €18.7 billion in October. Headline and core inflation were both unchanged at 1% and 1.3% year-on-year, respectively in November. EUR/USD fell by 0.2% this week. The weaker-than-expected manufacturing PMI releases on Monday were not adequate to alter our positive view on global growth. Both German and Korean exports have been stabilizing, which signals that global trade is on a recovery path. We expect the euro to outperform in the near term and we suggest to play the euro strength via the Canadian dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Manufacturing PMI fell marginally to 48.8 from 48.9 in December. The trade deficit widened to ¥82.1 billion in November. Exports and imports both plunged by 7.9% and 15.7% year-on-year, respectively. USD/JPY increased by 0.2% this week. On Wednesday, the BoJ held its interest rate unchanged. With the key short-term cash rate at -0.1%, and asset purchases already tapering, the BoJ has little room to act. On the fiscal front however, the recently announced stimulus package brightens the Japanese economy’s outlook. We continue to recommend the Japanese yen as a safe-haven hedge. 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 mixed: Both Markit manufacturing and services PMIs fell to 47.4 and 49 in December. The ILO unemployment rate was unchanged at 3.8%. Average earnings continued to grow by 3.2% year-on-year in October, however this slowed from 3.7% the previous month. Both headline and core inflation were unchanged at 1.5% and 1.7% year-on-year respectively, in November. Retail sales grew by 1% year-on-year in November. The British pound fell by 2.5% against the US dollar this week, erasing the gains from positive election news last week. Meanwhile, the BoE kept interest rates unchanged at 0.75% as widely expected, with two dissenting members that favored a cut. The pound is likely to stay volatile until January 31st, but the ultimate resting spot for GBP/USD is around 1.40. We will stand aside for now, ahead of thin holiday trading. 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 I-10AUD Technicals 2 Recent data in Australia have been positive: Both manufacturing and services PMIs fell to 49.5 and 49.4, respectively in December, but the decline was not specific to Australia. 40K new jobs were created in November, including 36K new part-time jobs and 4K new full-time jobs. The unemployment rate fell further to 5.2% in November. The Australian dollar fell by 0.4% against the US dollar this week. In its latest meeting minutes, the RBA stated that “the depreciation (in the Australian dollar) reflected the reduction in the interest differential between Australia and the major advanced economies, and had occurred despite an increase in the terms of trade over this period.” The fact that Australian balance of payments is improving tremendously suggests that the exchange rate is on the cheaper end. 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 positive: The Westpac consumer index increased to 109.9 from 103.1 in Q4. ANZ business confidence increased to -13.2 from -26.4 in December. ANZ activity outlook also increased by 17.2% month-on-month in December. The current account deficit widened to NZ$6.4 billion from NZ$1.1 billion in Q3. The trade deficit narrowed to NZ$753 million from NZ$1,039 million in November. Exports rose 7.6% year-on-year, and imports also increased by 2% year-on-year. GDP growth accelerated by 0.7% quarter-on-quarter in Q3, compared with only 0.1% the previous quarter. NZD/USD fell by 0.4% this week. Both hard data and soft data in New Zealand are starting to look up, which is consistent with our positive view on global growth. The New Zealand dollar is likely to outperform along with the economic expansion in 2020. 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, 201 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mixed: Manufacturing sales fell by 0.7% month-on-month in October. Core inflation was unchanged at 1.9% year-on-year in November. Headline inflation, however, soared to 2.2% from 1.9% in November, mostly attributable to higher gasoline prices. ADP recorded an increase of 31K jobs in November, lower than the expectations of 67K. The Canadian dollar rose by 0.4% against the US dollar this week, post the inflation print. While we believe that the loonie will outperform the USD, it is likely to underperform its petrocurrency peers and other high-beta currencies. Please refer to our front section this week for a more in-depth analysis on the loonie. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: The trade surplus narrowed slightly to CHF 2.2 billion in November 2019, the smallest trade surplus since August. The Swiss franc appreciated by 0.4% against the US dollar this week. In the Q4'19 Quarterly Bulletin released this week, the SNB stated that “the franc remains highly valued, and that negative interest rates and the willingness to intervene counteract the attractiveness of Swiss franc investments and thus ease upward pressure on the currency.” Moreover, the SNB lowered its inflation projection compared with the previous forecast in September. Our bias is that EUR/CHF will appreciate in the coming months, as the SNB stems appreciation in its currency. 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 trade surplus came in at NOK 18.8 billion in November. This is an improvement compared with a surplus of only NOK 5.9 billion the previous month and a deficit of 1.4 billion in September. The Norwegian krone appreciated by 0.6% this week, supported by rising energy prices. WTI crude oil prices are up 16% since the bottom in October this year. The Norges Bank kept its interest rate on hold at 1.5% this week. The still attractive interest rate differential and positive oil outlook both suggest that the krone will be one of the best performing currencies going into next year. 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 Recent data in Sweden have been positive: The consumer confidence index increased to 94.1 from 92 in December. USD/SEK fell by 0.7% this week. On Thursday, the Riksbank raised its interest rate by 25 bps to 0%, abandoning negative interest rates after almost 5 years. The bank also said in a statement that “the conditions are good for inflation to remain close to the target going forward.” Interest rate differentials are moving in favor of the SEK. Moreover, we believe that the previous weakness in the Swedish krona had been mostly led by soft data, while hard data remain resilient. We continue to recommend long SEK as our high-conviction trade for next year. 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
Feature The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart 1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart 1Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Chart 2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart 2De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. And its decline was pre-written into its “source code.” Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Reconstructed S&P 500 profits and sales data date back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated (Chart 3). Chart 3Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart 4). Chart 4Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are more often than not business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart 4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart 4). Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart 5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. Chart 5It’s A Small World After All The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart 6). Chart 6Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more main stream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. The caveat? If President Trump strikes a short-term deal with China ahead of the 2020 election, the de-globalization theme will suffer a setback. But our geopolitical strategists expect a ceasefire at best, not a durable deal, and also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US. Investment Implication #4: Defense Fortress One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart 7). Our October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s. These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Chart 7Stick With Pure-play Defense Stocks Table 1 China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact SIPRI data on global military spending by 2030 (Table 1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries to rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions “include not only cost but also product quality, variety, and innovation.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has signed its own version of the law – the Consumer Privacy Act – which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and what companies that data is being shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, and the US court system is a source of uncertainty, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest US market of the states. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Tack on the threat of federal regulation and this represents another major headwind for profits and net profit margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart 8)! This is unsustainable and will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom overhead, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. Chart 8Regulation Will Squeeze Tech Margins The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks that has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart 9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart 9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Chart 9Software Is Eating The World Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate will gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the U.S. Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart 10). Chart 10Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and derivative industries. Further, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership themes noted in the report above lead us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart 11). Chart 11Buy BCA’s Millennial Equity Basket Investors seeking long term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.1 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind the as reported in the FT “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last Wednesday, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart 12). Chart 12Areas To Avoid As ESG Becomes Mainstream Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we deem will play out, and centered recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart 13). Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart 13). However, if the four decade bull market in Treasury bonds is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart 14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart 13Unsustainable Debt Profiles Chart 14Greenback’s Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked. Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector (Chart 14). If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. Chart 15Twin Deficits Will Weigh On The US Dollar The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Marko Papic Chief Strategist, Clocktower Group marko@clocktowergroup.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com References Please click on the links below to view reports: Peak Margins - October 7, 2019 The Polybius Solution - July 5, 2019 War! What Is It Good For? Global Defense Stocks! - October 31, 2018 The Dollar: Will The U.S. Invoke A "Nuclear" Option? - August 30, 2018 Is The Stock Rally Long In The FAANG? - August 1, 2018 Millennials Are Not Coming Of Age; They Are Already Here - June 11, 2018 Brothers In Arms - October 31, 2016 The End Of The Anglo-Saxon Economy? - April 13, 2016 Apex of Globalization - November 12, 2014 Footnotes 1 https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament