Financial Markets
Feature The GAA DM Equity Country Allocation model is updated as of February 28, 2019. The quant model increased allocations to Spain, Italy, Sweden and Germany at the expense of the U.S., the Netherlands and Switzerland. As such, now the model underweights the U.S., Japan, the U.K, France, Canada (downgraded from overweight) and Australia, while overweighting Germany, Spain, Italy, Switzerland and Sweden (upgraded from underweight), as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark by 18 bps in February, with a 54 bps of outperformance from the Level 2 model offset by a 9 bps of underperformance from Level 1. Since going live, the overall model has outperformed by 148 bps, with Level 2 outperforming by 267 bps and Level 1 outperforming by 29 bps. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model We are happy to reintroduce the GAA Equity Sector Selection model after we suspended it as of October 2018 following the GICS adjustments to global sector composition. As noted in our September 2018 Special Alert and October 2018 Quarterly, the most notable changes occurred in the new Communication Services sector (previously known as Telecommunication Services) and the Information Technology sector, whereas the Consumer Discretionary sector had various yet insubstantial movements in and out of the sector. Having received historical performance of the revised data, we have retested and adjusted various inputs in the model to match the cyclicality of the revised sectors. We were able to backtest the model to only June 2008 as this was the starting point of the revised data. Given the nature of firms that are now included in the global Communication Services sector, we revised our classification of this sector from a defensive to a cyclical. Hence, it will be positively impacted by the model’s growth component. Furthermore, we have introduced Real Estate as its own sector (following its removal from Financials in August 2016). Additionally, we have neutralized the impact of the liquidity component on the Real Estate sector; in other terms, we found no evidence that the Fed cycle affects this sector in any of its four phases. We also revised the valuations component by shortening the confirming signal of our technical indicator from a 12-month to a 6-month moving average. To properly assess the model’s adjusted performance, we have reset the “since going live date” to begin in March 2019. However, the historical backtested performance of the model will still be shown in Chart 4. Additionally, we show the old model’s performance vs. its benchmark (Table 3). Chart 4Overall Model Performance Given the above, and following our Monthly Update that was released yesterday, the model corroborates our slightly cyclical stance by overweighting Industrials and Materials (Table 4). Additionally, the model’s biggest underweight shift from last month was on Consumer Staples as the momentum indicator significantly deteriorated. The model is overweight Utilities due to positive inputs from its momentum and liquidity components. Table 3Old Model’s Performance Table 4Current Model Allocations For more details on the model, please see the Special Report “Introducing The GAA Equity Sector Selection Model,” dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com
Feature Recommendations Two Key Questions For Asset Allocators Stocks have rallied this year – MSCI ACWI is up 17% from its late December low – despite the fact that economic growth outside the U.S. has continued to deteriorate. The PMI in Germany has fallen to 47.6, in Japan to 48.5, and the average in Emerging Markets to 49.5 (Chart 1). Chart 1PMIs Ex-U.S. Still Falling U.S. growth remains robust, though recent data have showed some signs of weakness. The Citigroup Economic Surprise Index has fallen sharply, capex indicators have slipped, and December retail sales were terrible (Chart 2). The New York Fed NowCast for Q1 is now pointing at only 1.2% real GDP growth. Most of the slippage, however, was caused by the six-week government shutdown, and should be reversed in Q2. And the retail sales number appears “rogue”, perhaps caused by irregular data-collection methods during the shutdown, since other retail data do not support it (Chart 2, panel 3). The tightening of financial conditions in the last months of 2018 – which has now partly reversed – may have added to the slowdown (Chart 3). BCA’s view is that U.S. GDP growth is likely to come in well above 2% in 2019, slower than last year’s 2.9% but still above trend. Chart 2Should We Worry About U.S. Growth Too? Chart 3Financial Conditions Now Easing Our recommendation, therefore, is to continue to overweight equities (particularly U.S. equities), which should be supported by decent earnings growth (our top-down model points to 12% EPS growth for the S&P500 this year, compared to a bottom-up consensus forecast of only 5%), reasonable valuations, and sentiment that appears still to be damaged by the Q4 sell-off (Chart 4). Chart 4Environment Still Positive For U.S. Equities Two key questions will determine which asset allocation will be optimal this year. First, how long will the Fed stay “patient” and keep rates on hold? The futures market has almost completely priced out the possibility of any rate hikes in 2019, and even assigns a 15% probability of a cut (Chart 5). We still see upside risk to inflation, with core PCE likely to print above the Fed’s target of 2% by mid-year, partly because of the year-on-year base effect (in January 2018, monthly inflation was especially high), but also because underlying inflation pressures remain (Chart 6). Chart 5Is The Fed Really Going To Cut Rates? Chart 6Inflation Pressures Haven't Gone Away The market has misunderstood two of the Fed’s recent messages. Its mooted plan to end balance-sheet reduction by year-end is not intended as part of monetary policy. It is simply that bank excess reserves will have reached USD1-1.2 trillion, the level required to operate monetary policy using current tools, rather than those used before 2007 when reserves were zero (Chart 7). Second, recent discussions about changing the Fed’s inflation target from 2% a year to a price-level target will probably become effective only when the effective lower bound is hit in the next recession and, anyway, no decision will be taken until mid-2020. Chart 7Excess Reserves Will Be At Equilibrium Soon The market has taken this talk as dovish. We read recent comments by Fed Chairman Jay Powell to mean that if, by June, the economy is robust, risk assets are still rebounding, and inflation is ticking up, the Fed will continue to hike, maybe two or three times by year-end. This implies long-term bond yields will rise too. Equities may wobble initially but, as long as the Fed is hiking because growth is solid and not because of an inflation scare, this should not undermine the 12-month case for equity outperformance. The second key question is whether China has now abandoned its focus on deleveraging and switched to a 2016-style liquidity-driven stimulus. Certainly, the January total social financing number pointed in that direction, with new credit creation of almost 5 trillion RMB ($750 billion) and the first signs of an easing of restrictions on shadow banking (Chart 8). But the jury is still out on whether this is the massive reflation the market has been waiting for. Premier Li Keqiang criticized the increase, saying, “the increase in total social financing appears rather large…it may also bring new potential risks”. A PBOC official commented that the big increase was “due to seasonal factors” and emphasized that China was not embarking on “flood irrigation-style” stimulus. The recent more positive noises on the U.S./China trade war may also alleviate the pressure on China to stimulate. Chart 8First Signs Of Chinese Reflation? If and when Chinese growth does rebound, this will have major implications for asset allocation. It would signal a bottoming of the global cycle, which would favor stocks in Emerging Markets, Europe and Japan. It would push up commodity prices, and imply a weaker dollar. For now, we are not positioning ourselves like this, since global growth remains weak. Nonetheless, the first signs of a bottoming are appearing with, for example, the diffusion index of the global Leading Economic Index (which often leads the LEI itself) turning up (Chart 9). We may shift in this direction mid-year, and are now making some minor changes to our recommendations (see below) to hedge against this risk. But for the moment we prefer U.S. equities, expect further USD appreciation, and remain cautious on EM. Chart 9Is The LEI Close To Bottoming? Equities: We prefer U.S. equities given their better growth, reasonable valuations, and depressed sentiment (despite their outperformance year-to-date). But we are watching for an opportunity to increase our weighting in Europe, where growth still looks poor but may rebound in H2 due to fiscal stimulus, improving wage growth, a dovish turn by the ECB, and an eventual recovery in exports to China (Chart 10). We still see problems in EM, since earnings growth expectations need to be revised down further and stock prices have risen prematurely on expectations of a Chinese recovery (Chart 11). But we reduce the size of our underweight bet, to hedge against Chinese credit growth continuing to accelerate. We are also raising our recommendation for the industrials sector (with its large weight in capital goods companies dependent on exports to China) to overweight for the same reason. We fund this by cutting consumer staples to underweight. We also raise our weighting on the energy sector, given our positive view on oil prices (see below). This gives our sector weightings a slightly more cyclical tilt, in line with our macro view. Chart 10Some Good News In Europe Too Chart 11EM Has Further Downside Fixed Income: It has been a conundrum this year why equities have risen and credit spreads tightened significantly, but the 10-year Treasury yield remains stuck below 2.7%. One explanation is that inflation expectations have been dampened by the crude oil price and if, as we forecast, oil continues to recover, the inflation component of the yield will rise (Chart 12). U.S. yields have also been dragged down by weak growth in other developed markets, where bond yields have therefore fallen. The spread between U.S. and German and Japanese yields reached record high levels in late 2018 (Chart 13). The term premium also is deeply into negative territory because many investors remain highly bearish and have hedged this view by buying Treasuries. If our view of robust U.S. growth, rising inflation, and more Fed hikes is correct, we would see 10-year Treasury yields rising towards 3.5% over the next 12 months. Accordingly, we are underweight global government bonds. We raised credit to neutral last month, but continue to have some qualms about this asset class, and prefer equities as a way of taking exposure to further upside for risk assets. Besides high leverage among U.S. corporates, we are worried about the deterioration in the quality of the credit market, since duration has been extended, covenants weakened, and the average credit rating fallen (Chart 14). Chart 12Inflation Expectations Driven By Oil Chart 13U.S. Yields Pulled Down By Europe And Japan Chart 14Deterioration In Credit Market Fundamentals Currencies: We see some more upside in the U.S. dollar over the next few months, given U.S. growth and monetary policy relative to the euro area and Japan (Chart 15). This may reverse, however, if global cyclical growth rebounds in the second half. The dollar is particularly vulnerable if macro conditions change, since it looks around 10% overvalued relative to other major DM currencies, and speculative positions are predominantly long dollar (Chart 16). Chart 15Relative Rates Support USD Chart 16But Dollar Vulnerable To Macro Shifts Commodities: With demand likely to grow steadily this year, but supply under pressure because of production cuts by OPEC and Canada, lower U.S. shale oil output, and disruptions in Venezuela and elsewhere, our energy strategists see drawdowns in inventories throughout the year (Chart 17). They forecast Brent to average $75 a barrel during 2019 (compared to $66 now), with WTI $5 a barrel lower. Industrial commodities continue to be driven by China which means, given our view expressed above, that we may see further weakness short-term, with a possible rebound in H2 (Chart 18). Chart 17Oil Supply/Demand Is Tight Chart 18When Will Metal Prices Bottom? Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com GAA Asset Allocation
Highlights Global growth is still slowing. Having rallied since the start of the year, global stocks will likely enter a “dead zone” over the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout. We think they will appear in the second quarter, setting the scene for a reacceleration in global growth in the second half of the year, and an accompanying rally in global risk assets. Investors should overweight stocks and spread product while underweighting safe government bonds over a 12-month horizon. The U.S. dollar will strengthen a bit over the next few months, but should start to weaken in the summer as the global economy catches fire. Stronger global growth and a weaker dollar in the back half of the year will benefit EM assets and European stocks. Feature I skate to where the puck is going to be, not to where it has been. — Wayne Gretzky Gretzky's Doctrine To paraphrase Gretzky, a mediocre macro strategist draws conclusions based solely on incoming data. A good macro strategist, in contrast, tries to figure out where the data is heading. How can one predict how the economic data will evolve? Examining forward-looking indicators is helpful, but it is not enough. One also has to understand why the data is evolving the way it is. If one knows this, one can then assess whether the forces either hurting or helping growth will diminish, intensify, or remain the same. What Accounts For The Growth Slowdown? There is little mystery as to why global growth slowed in 2018. Chinese credit growth fell steadily over the course of the year, which generated a negative credit impulse. Unlike in the past, China is now the most important driver of global credit flows (Chart I-1). Meanwhile, the global economy was rocked by rising oil prices. Brent rose from $55/bbl on October 5, 2017 to $85/bbl on October 4, 2018. Government bond yields also increased, with the 10-year U.S. Treasury yield rising from 2.05% on September 7, 2017 to 3.23% on October 5, 2018 (Chart I-2). In an ironic twist, Jay Powell’s ill-timed comment that rates were “a long way” from neutral marked the peak in bond yields. Unfortunately, the subsequent decline in yields was accompanied by a vicious stock market correction and a widening in credit spreads. This led to an overall tightening in financial conditions, which further hurt growth (Chart I-3). The critical point is that all of these negative forces are behind us: Financial conditions have eased significantly over the past two months; oil prices have rebounded, but are still well below their 2018 highs; and as we explain later on, Chinese growth is likely to bottom by the middle of this year. This means that global growth should start to improve over the coming months. The United States: Better News Ahead The latest U.S. economic data has been weak, with this morning’s disappointing ISM manufacturing print being the latest example. The New York Fed’s GDP Nowcast is pointing to annualized growth of 0.9% in the first quarter. While there is no doubt that underlying growth has decelerated, data distortions have probably also contributed to the perceived slowdown. For instance, the dismal December retail sales report reduced the base for consumer spending going into 2019, thus shaving about 0.4 percentage points off Q1 growth. The drop in real personal consumption expenditures (PCE) cut the New York Fed’s Q1 growth estimate by a further 0.15 percentage points. We suspect that much of the weakness in December retail sales and PCE was linked to the government shutdown. The closure caused some of the surveys used to compile these reports to be postponed until January, which is historically the weakest month for retail sales. The Johnson Redbook Index – which covers 80% of the retail sales surveyed by the Department of Commerce – as well as the sales figures from Amazon and Walmart all point to strong spending during the holiday season (Chart I-4). Fundamentally, U.S. consumers are in good shape (Chart I-5). As a share of disposable income, household debt is over 30 percentage points lower than it was in 2007. The savings rate stands at an elevated level, which gives households the wherewithal to increase spending. Job openings hit another record high, while wage growth continues to trend upwards. The housing market should improve. Rising mortgage rates weighed on housing last year. However, rates have been declining for several months now, which augurs well for home sales and construction over the next six months (Chart I-6). While capex intention surveys have come off their highs, they still point to reasonably solid expansion plans (Chart I-7). Rising labor costs and high levels of capacity utilization will induce firms to invest in more capital equipment, which should support business spending. Government expenditures should also recover. By most estimates, the shutdown shaved one percentage point from Q1 growth. This is likely to be completely reversed in the second quarter. The End Of The Chinese Deleveraging Campaign? The popular narrative about weaker Chinese growth has focused on the trade war. While trade uncertainty undoubtedly hurt growth last year – and has continued to weigh on growth so far this year – most of the weakness in the Chinese economy can be traced to the deleveraging campaign which started in 2017, long before the surge in trade flow angst. Fixed investment spending in China is generally financed through credit markets. Chart I-8 shows that the contribution of investment spending to GDP growth has declined in tandem with decelerating credit growth. Chinese credit growth has typically reaccelerated whenever it has dipped towards trend nominal GDP growth. We may have already reached this point (Chart I-9). New credit formation came in well above expectations in January. Given possible distortions caused by the timing of the Chinese lunar new year, investors should wait until the February data is released in mid-March before drawing any firm conclusions. Nevertheless, it is starting to look increasingly likely that credit growth has bottomed. The 6-month credit impulse has already surged (Chart I-10). The 12-month impulse should also begin moving up provided that month-over-month credit growth simply maintains its recent trend (Chart I-11). On the trade front, President Trump’s decision to delay the implementation of tariffs on $200 billion in Chinese imports is a step in the right direction. Nevertheless, gauging whether the trade war will continue to de-escalate is extraordinarily difficult. There is no major constituency within the Republican Party campaigning for protectionism. It ultimately boils down to what one man – Trump – wants. Our best guess is that President Trump will try to score a few political points by “declaring victory” – deservedly or not – in his battle with China in order to pivot to more pressing domestic issues such as immigration. However, there can be no assurance of this, which is why China’s leaders are likely to prioritize growth over deleveraging, at least for the time being. They know full well that the only way they can credibly threaten to walk away from the negotiating table is if their economy is humming along. Europe: From Headwinds To Tailwinds? Slower global growth, higher oil prices, and a spike in Italian bonds yields all contributed to the poor performance of the European economy last year. Economic activity was further hampered by a decline in German automobile production following the introduction of more stringent emission standards. The good news is that these headwinds are set to reverse course. Italian bond yields are well off their highs, as are oil prices (Chart I-12). German automobile production is recovering (Chart I-13). In addition, the European Commission expects the euro area fiscal thrust to reach 0.40% of GDP this year, up from 0.05% of GDP last year (Chart I-14). This should add about half a percentage point to growth. Finally, if our expectation that Chinese growth will bottom out by mid-year proves correct, European exports should benefit. Brexit still remains a risk, but a receding one. The political establishment on both sides of the British channel will not accept anything resembling a hard Brexit. As was the case with the EU treaty referendums involving Denmark and Ireland in the 1990s, the European political elites will insist on a “No fair! Let’s play again! Best two-out-of-three?” do-overs until they get the result they want. Theresa May’s efforts to cobble together a parliamentary majority that precludes a hard Brexit, along with the Labor Party’s increasing willingness to pursue a second vote, is consistent with our thesis. Fortunately for the “remain” side, public opinion is shifting in favor of staying in the EU (Chart I-15). Focusing on the minutiae of various timetables, rules, and regulations is largely a waste of time. If neither the political establishment nor the general public favor Brexit, it will not happen. Investment Conclusions Global growth is still slowing. Having rallied since the start of the year, global stocks will likely enter a “dead zone” for the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout. We think they will appear in the second quarter, setting the scene for a reacceleration in global growth in the second half of the year, and an accompanying rally in global risk assets. The dollar is a countercyclical currency, meaning that it moves in the opposite direction of the global business cycle (Chart I-16). The greenback will strengthen a bit over the next few months, but should start to weaken in the summer as the global economy catches fire. We do not have a strong view on EM versus DM equities at the moment, but expect to shift EM to overweight once we see more confirmatory evidence that Chinese growth is stabilizing. In conjunction with our expected upgrade on EM assets, we will move European equities to overweight. Stronger global growth will benefit European multinational exporters, while brisker domestic growth should allow the market to price in a few more ECB rate hikes starting in 2020. The latter will lead to a somewhat steeper yield curve which, along with rising demand for credit, should boost financial sector earnings (Chart I-17). This will give European bank stocks a welcome boost. Japanese equities will also benefit from faster global growth, but domestic demand will suffer from the government’s ill-advised plan to raise the sales tax in October. As such, we do not anticipate upgrading Japanese stocks. We also expect the yen to come under some pressure as the BoJ is forced to maintain its ultra-accommodative monetary policy stance, while bond yields elsewhere move modestly higher. Peter Berezin Chief Global Investment Strategist March 1, 2019 Next Report: March 28, 2019 II. Troubling Implications Of Global Demographic Trends Developed economies are challenged by two powerful and related demographic trends: declining growth in working-age populations, and a rapidly-aging population structure. Working-age populations are in absolute decline in Japan and much of Europe and growth is slowing sharply in the U.S. An offsetting acceleration in productivity growth is unlikely, implying a marked deceleration in economic growth potential. The combination of slower growth in the number of taxpayers and rising numbers of retirees is toxic for government finances. Future generations face sharply rising debt burdens and increased taxes to pay for entitlements. The correlation between aging and asset prices is inconclusive but common sense suggests it is more likely to be bearish than bullish. Population growth remains rapid throughout most of the developing world, China being a notable exception. It is especially strong in Africa, a region that has historically faced economic mismanagement and thus poor economic prospects for most of its inhabitants. Migration from the emerging to developed world is a logical solution to global demographic trends, but faces a backlash in many countries for both economic and cultural reasons. These tensions are likely to increase. Making accurate economic and market forecasts is daunting because there are so many moving parts and unanticipated events are inevitable. Quantitative models are destined to fail because of the unpredictability of human behavior and random shocks. Demographic forecasts are a lot easier, at least over the short-to-medium term. If you want to know how many 70-year olds there will be in 10 years’ time, then count how many 60-year olds there are today and adjust by the mortality rate for that age group. Demographic trends are very incremental from year to year and their impact is swamped by economic, political and financial events. Thus, it rarely makes sense to blame demographics for cyclical swings in the economy or markets. In some respects, demographics can be likened to glaciers. You will quickly get bored standing by a glacier to watch it move. But, over long time periods, glaciers cover enormous distances and can completely reshape the landscape. Similarly, over the timespan of one or more generations, demographics can have powerful effects on economies and societies. Some important demographic trends have been going on for long enough that their effects are visible. The most common concern about global demographics has tended to be overpopulation and pressure on resources and the environment. And this is hardly new. In 1798, Thomas Malthus published his “Essay on The Principles of Population” in which he argued that population growth would outstrip food supply, leading to a very miserable outcome. Of course, what he missed was the revolution in agricultural techniques that meant food supply kept up with population growth. In 1972, a group of experts calling themselves The Club of Rome published a report titled “The Limits to Growth” which argued that a rising world population would outstrip the supply of natural resources, putting a limit to economic growth. Again, that report underestimated the ability of technology to solve the problem of scarcity, although many still believe the essence of the report has yet to be proved wrong. Phenomena such as climate change and rising numbers of animal species facing extinction are seen as supporting the thesis that the world’s population is putting unsustainable demands on the planet. Rather than get into that debate, this report will focus on three particular big-picture problems associated with demographic trends: Declining working-age populations in most major industrialized economies during the next several decades. Population aging throughout the developed world. Continued rapid population growth in many of the world’s poorest and most troubled countries. According to the UN’s latest projections, the world’s population will increase from around 7.5 billion today to almost 10 billion by 2050.1 The population growth rate peaked in the 1970s and is expected to slow sharply over the next several decades (Chart II-1). Despite slower percentage growth rates, the population keeps going up steadily because one percent of the 1970 global population was about 3.7 million, while one percent of the current population is about 7.5 million. But here is an important point: virtually all future growth in the global population will come from the developing world (Chart II-2). The population of the developed world is expected to be broadly flat over the period to 2050, and this has some significant economic implications. Let’s first look at why population growth has stagnated in the developed world. Population growth is a function of three things: the birth rate, the death rate and net migration. Obviously, if there are more births than deaths then there will be a natural increase in the population and net migration will either add or subtract to that. Over time, there have been major changes in some of these drivers. In the developed world, a stable population requires that, on average, there are 2.1 children born for every woman. The fact that it is not exactly 2 accounts for infant mortality and because there are slightly more males than females born. The replacement-level fertility rate needs to be higher than 2.1 in the developing world because of higher infant mortality rates. After WWII, the fertility rate throughout most of the developed world was well above 2.1 as soldiers returned home and the baby boom generation was born. But, by the end of the 1970s, the rate had dropped below the replacement level in most countries and currently is a lowly 1.5 in Japan, Germany and Italy (Table II-1). It has stayed higher in the U.S. but even there it has dipped below the critical 2.1 level. This trend has reflected lot of factors including more widespread use of birth control and more women entering the labor force. In the developed world, the birth rate is expected to drop below the death rate in the next ten years (Chart II-3). That means there will be a natural decrease in the population. In the case of Japan, Germany, Italy and Portugal that change already occurred between 2005 and 2010. In the U.S., the UN expects birth rates to stay just above death rates in the period to 2050, but the gap narrows sharply. Births exceed deaths throughout most of the developing world meaning that populations continue to grow. Notable exceptions to this are Eastern Europe where populations are already in sharp decline and China, where deaths begin to exceed births in the 2030s. Although life expectancy is rising, death rates in the developed world will rise simply because the rapidly growing number of old people more than offsets the impact of longer lifespans. Of course, the population of a country can also be boosted by immigration, and that has been true for much of the developed world. In Canada and most of Europe, net migration already is the dominant source of overall population growth and it will become so in the U.S. in the coming decades, based on current trends (Chart II-4). This is the background to the first key issue addressed in this report: the declining trend in the growth of the working-age population in the developed world. Slowing Growth In Working-Age Populations An economy’s growth potential depends on only two things: the number of people working and their productivity. If the labor force grows at 1% a year and productivity also increases by 1%, then the economy’s trend growth rate is 2%. In the short-run, the economy may grow faster or slower than that, depending on issues like fiscal and monetary policy, oil prices etc. Over the long run, growth is constrained by people and productivity. The potential labor force is generally regarded to be the people aged 15 to 64. The growth trend in this age segment has slowed sharply in recent years in the major economies and is set to weaken further in the years ahead (Chart II-5). The problem is most severe in Japan and Europe where the working-age population is already declining. In the case of the U.S., growth in this age cohort slows from an average 1.5% a year in the 1960s and 1970s to a projected pace of less than 0.5% in the coming decades. While this generally is not a problem faced by the developing world, a notable exception is China, now reaping the consequences of its one-child policy. Its working-age population is set to decline steadily in the years ahead. Thus, it is inevitable that Chinese growth also will slow in the absence of an acceleration of productivity growth The slowing trend in the working-age population could be offset if we could get more 15-64 year olds to join the labor force, or get more older people to stay working. In the U.S., almost 85% of male 15-64 year olds were either employed or were wanting a job in the mid-1990s. This has since dropped to below 80% - a marked divergence from the trend in most other countries (Chart II-6). And the female participation rate in the U.S. also is below that of other countries. The reason for the decline in U.S. labor participation rates for prime-aged adults is unclear. Explanations include increased levels of people in full-time education, in prison, or claiming disability. A breakdown of male participation rates by age shows particularly sharp drops in the 15-19 and 20-24 age groups, though the key 20-54 age category also is far below earlier peaks (Chart II-7). The U.S. participation rate has recently picked up but it seems doubtful that it will return to earlier highs. Other solutions to the problem would be getting more people aged 65 and above to stay in the labor force, and/or faster growth in productivity. The former probably will require changes to the retirement age and we will return to that issue shortly. There always are hopes for faster productivity growth, but recent data have remained disappointing for most developed economies (Chart II-8). New technologies hold out some hope but this is a contentious topic. On a positive note, the shrinking growth of the working-age population may be easier to live with in a world of robotization and artificial intelligence where machines are expected to take over many jobs. That would support a more optimistic view of productivity but it remains to be seen how powerful the impact will be. Another important problem related to the slowing growth of the working-age population relates to fiscal burdens. In 1980, the level of government debt per taxpayer (ages 20-64) was around $58,000 in the U.S. in today’s money and this is on track for $104,000 by 2020 (Chart II-9). But this pales in comparison to Japan where it rises from $9,000 to $170,000 over the same period. Canada looks more favorable, rising from $23,000 in 1980 to $68,000 in 2020. These burdens will keep rising beyond 2020 until governments start running budget surpluses. Our children and grandchildren will bear the burden of this and won’t thank us for allowing the debt to build up in the first place. There will be a large transfer of privately-held assets from the baby boomers to the next generation, but the ownership of this wealth is heavily skewed. According to one study, the top 1% owned 40% of U.S. wealth in 2016, while the bottom 90% owned 20%.2 And it seems likely that this pool of wealth will erode over time, providing a smaller cushion to the following generation. This leads in to the next topic – aging populations. Aging Populations In The Developed World The inevitable result of the combination of increased life expectancy and declining birth rates has been a marked aging of populations throughout the developed world. Between 2000 and 2050, the developed world will see the number of those aged 65 and over more than double while the numbers in other age groups are projected to show little change (Chart II-10). As long as the growing numbers of those aged 65 and above are in decent health, then life is quite good. Fifty years ago in the U.S., poverty rates were very high for those of retirement age compared to the young (i.e. under 18). But that has changed as the baby boomer generation made sure that they voted for increased entitlement programs. Now poverty rates for the 65+ group are far below those of the young (Chart II-11). At the same time, real incomes for those 65 and older have significantly outperformed those of younger age groups. A major problem is that aging baby boomers are expensive because of the cost of pensions and medical care. As would be expected, health care costs rise dramatically with age. For those aged 44 and under, health care costs in the U.S. averaged around $2,000 per person in 2015. For those 65 and over, it was more than $11,000 per person. And per capita spending doubles between the ages of 70 and 90. So here we have the problem: a growing number of expensive older people supported by a shrinking number of taxpayers. This is illustrated by the ratio of the number of people between 20 and 64 divided by those 65 and older. In other words, the number of taxpayers supporting each retiree (Chart II-12). In 1980, there were five taxpayers for every retiree in the U.S., four in W. Europe and seven in Japan. These ratios have since dropped sharply, and in the next few decades will be down to 2.5 in the U.S., 1.8 in Europe and 1.3 in Japan. For each young Japanese taxpayer, it will be like having the cost of a retiree deducted from their paycheck. Throughout the developed world, the baby boomers’ children and grandchildren face a growing burden of entitlements. Some of the statistics related to Japan’s demographics are dramatic. In the first half of the 1980s there were more than twice as many births as deaths (Chart II-13). They become equal around ten years ago and in another ten years deaths are projected to exceed births by around three million a year. In 1990, the number of people aged four and under was more than double the number aged 80 and above. Now the situation is reversed with those aged 80 years and above more than double those four and under. That is why sales of adult diapers reportedly exceed those of baby diapers – very depressing!3 What’s the solution to aging populations? An obvious one is for people to retire later. When pension systems were set up, life expectancy at birth was below the age pensions were granted - typically around 65. In other words, not many people were expected to live long enough to get a government pension. And the lucky ones who did live long enough were not expected to be around to receive a pension for more than a few years. By 1950, those males who had reached the age of 65 were expected, on average, to live another 11 to 13 years in the major developed countries (Table II-2). This rose to 16-18 years by 2000 and is expected to reach 22-23 years by 2050. Governments have made a huge error in failing to raise the retirement age as life expectancy increased. Pension systems were never designed to allow people to receive government pensions for more than 20 years. Some countries have raised the retirement age for pensions, but progress on this front is painfully slow. Other solutions would be to raise pension contributions or to means-test benefits. Not surprisingly, governments are reluctant to take such unpopular actions. At some point, they will have no choice, but that awaits pressures from the financial markets. Currently, not many people aged over 65 remain in the workforce. The participation rate for men is less than 10% in Europe and less than 25% in the U.S. And it is a lot lower for women (Chart II-14). The rate in Japan is much higher reflecting the fact that it is at the leading edge of aging. Participation rates are moving higher in Europe and the U.S. and further increases are likely in the years ahead if Japan’s experience is anything to go by. Having people staying in the workforce for longer will help offset the decline in prime-age workers, but there is a downside. While it is a contentious topic, many studies point to a negative correlation between age and productivity after the age of 50. As we age, there is some decline in cognitive abilities and older people may be less willing or able to adapt to new technologies and working practices. These would only be partly offset by the benefits of experience that comes with age. Therefore, an aging workforce is not one where one would expect productivity growth to accelerate, other things being equal. An IMF study concluded that a 1% increase in the labor force share of the 55-64 age cohort in Europe could reduce the growth in total factor productivity by 0.2% a year over the next 20 years.4 Another study published by the NBER paper estimated that aging will reduce the U.S. economic growth rate by 1.2% a year this decade and 0.6% a year next decade.5 Other studies are less gloomy but it would be hard to argue that aging is actually good for productivity. Another aging-related issue is the implications for asset prices. It is generally believed that aging will be bad for asset prices as people move from their high-saving years to a period where they will be liquidating assets to supplement their incomes. This is supported by a loose correlation between the percentage of the labor force between 35 and 64 (the higher-saving years) and stock market capitalization as a percent of GDP (Chart II-15). However, other studies cast doubts on this relationship.6 One might think real estate is even more vulnerable than stocks to aging. However, in late 1988, two high-profile economists (Greg Mankiw and David Weil) published a report arguing that real house prices would fall substantially over the next two decades as the baby boom generation aged.7 That forecast was catastrophically wrong. Of course, that does not mean that the more dramatic aging occurring over the next couple of decades will not have a major negative impact on home prices. Numerous studies have been carried out on the relationship between demographics and asset prices and the conclusions are all over the place.8 Time and space constraints prevent a more in-depth discussion of this topic. Nonetheless, common sense would suggest that aging is more likely to be bearish than bullish for asset prices. Thus far, we have addressed two demographic challenges facing the developed world: slowing growth in the number of working-age people and a marked aging of the population. Much of the developing world has the opposite issue: continued rapid population growth and large numbers of young people. This is my third topic. Rapid Population Growth In The Developing World We already noted that nearly all future growth in global population will occur in the developing world, China being a notable exception. With birth rates remaining far above death rates, emerging countries will not have the aging problem of the developed world and this has some positives and negatives. On the positive side, a rapidly-growing young population creates the potential for strong economic growth – the opposite of the situation in advanced economies. But this assumes that the institutional and political framework is conducive to growth. Unfortunately, the history of many developing countries is that corrupt and incompetent governments prevent economies from ever reaching their potential. This means there will be a growing pool of young people likely facing a dim economic future. In some cases, these young people could be an excellent recruiting ground for extremist groups. It is unfortunate that there is particularly rapid population growth in some of the most troubled countries in the world. The Institute for Economics and Peace ranks countries by whether they are safe or dangerous.9 According to their ranking, the eight most dangerous countries in the world will see their population grow at a much faster pace than the developing world as a whole (Chart II-16). Some individual country comparisons are striking. The UN’s projections show that Nigeria’s population will exceed that of the U.S. by 2050, The Democratic Republic of Congo’s population will match that of Japan by 2030 and by 2050 will be 80% larger (Chart II-17A and B). Similarly, Afghanistan will overtake Italy in the 2040s. Most incredibly, Africa’s overall population surpassed that of the whole of Europe in the second half of the 1990s and is projected to be 3.5 times larger by 2050. That suggests that the numbers seeking to migrate from Africa to Europe will increase dramatically in the next couple of decades. Controlling these flows will become an increasing challenge for countries in Southern Europe. Migration is the logical solution to declining working-age populations in the developed world and expanding young populations in the developing world. However, there currently is a backlash against immigration in many developed countries. Anti-immigration political parties are gaining strength in many European countries and immigration was a major factor influencing the Brexit vote in the U.K. And it is a hot-button political issue in the U.S. Concerns about immigration are twofold: competition for employment and potential cultural change. Employment fears have coincided with a long period of severely depressed wages for low-skill workers in many developed economies and immigration is an easy target for blame. Meanwhile, the cultural challenge of absorbing large numbers of immigrants clearly has fueled increased nationalist sentiment in a number of countries. In the U.S., projections by the Bureau of the Census show that the non-Hispanic white population will fall below 50% of the total by 2045. That has implications for voting patterns and lies behind some of the concerns about high levels of immigration. There is no simple solution to this controversial issue and an in-depth discussion is beyond the scope of this article. Conclusions We have only touched on some aspects of demographic trends. It is a huge topic and has many other implications. For example, the political and cultural views of each generation are shaped by the environment they grow up in and this changes over time. This year, the number of millennials (those born from the early 1980s to the mid-1990s) in the U.S. is expected to surpass those of baby boomers and that will have important political and social implications. Again, that is beyond the scope of this report. The demographic trends we have discussed will pose serious challenges to policymakers. In the developed world, the baby boom generation has accumulated huge amounts of government debt, partly to fund generous entitlement programs and did not have enough children to ease the burdens on future generations. The young have good reason to feel frustrated by the actions of their elders (see cartoon). In the developing world, the challenge will be to provide economic opportunities for a growing pool of young people. The biggest problems will be in Africa, a continent where economic success stories have been few and far between in the past. Failure to deal with this will have troubling implications for geopolitical stability. Martin H. Barnes Senior Vice President Economic Advisor III. Indicators And Reference Charts Our tactical equity upgrade is beginning to pay off, and an increasing proportion of our proprietary indicators is confirming that stocks have more upside over the next few quarters. Our Willingness-to-Pay (WTP) indicator for the U.S. has stopped falling. This pattern is also evident in both Europe and Japan. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. After clearly pulling funds out of the equity markets, investors are beginning to tip their toes back in. Our Revealed Preference Indicator (RPI) has clearly shifted back into stocks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. According to BCA’s composite valuation indicator, the U.S. stock market remains overvalued from a long-term perspective, despite the dip in multiples since last fall. It is a composite of 11 different valuation measures. Moreover, our Monetary Indicator has shifted out of negative territory for stocks, and is now decisively in stimulative territory. The Fed pause, along with some dovish-sounding commentaries have improved the monetary backdrop by removing expected rate hikes from the money market curve. Our Composite Technical indicator for stocks broke down in December, providing a clear ‘sell’ signal, and has not yet delivered a ‘buy’. However, if the recent improvement in this indicator can continue, the S&P 500 will likely be able to punch above the 2800 level. The 10-year Treasury yield is in the neutral range according to our valuation model. Bonds are not overbought, but they have now fully worked out their previously deeply-oversold conditions. The Adrian, Crump & Moench formulation of the 10-year term premium remains close to its 2016 nadir, suggesting that yields are unsustainably low. Our bond-bearish bias is consistent with the view that the Fed rate hike cycle is not over. The U.S. dollar is still very expensive on a PPP basis. Our Composite Technical Indicator is not as overbought as it once was, but it is far from having reached oversold levels either. This combination suggests that the greenback could experience further downside over the coming month. It remains to be seen if this wave of depreciation will mark the beginning of the cyclical bear market required to correct the dollar’s overvaluation. EQUITIES: FIXED INCOME: CURRENCIES: COMMODITIES: ECONOMY: Mark McClellan Senior Vice President The Bank Credit Analyst Footnotes 1 Most of the data referred to in this report comes from the medium variant projections from the United Nation’s World Population Prospects report, 2017 revision. There is an excellent online database tool that allows users to access numerous demographic series for every country and region in the world. This can be found at https://population.un.org/wpp/DataQuery/ 2 Edward N. Wolff, Household Wealth Trends in the United States, 1962 to 2016. NBER Working Paper 24085, November 2017. Available at: https://www.nber.org/papers/w24085. 3 This is not a joke: https://www.businessinsider.com/signs-japan-demographic-time-bomb-2017-3 4 The Impact of Workforce Aging on European Productivity. IMF Working Paper, December 2016. Available at: https://www.imf.org/en/Publications/WP/Issues/2016/12/31/The-Impact-of-Workforce-Aging-on-European-Productivity-44450 5 The Effect of Population Aging on Economic Growth, the Labor Force and Productivity. NBER Working Paper 22452, July 2016. Available at https://www.nber.org/papers/w22452.pdf 6 For example, see “Will Grandpa Sink The Stock Market?”, The Bank Credit Analyst, September 2014. 7 The Baby Boom, The Bay Bust, and the Housing Market. NBER Working Paper 2794. Available at: https://www.nber.org/papers/w2794 8 For those interested in this topic, we recommend the following paper: Demographics and Asset Markets: A Survey of the Literature. Available at: https://pdfs.semanticscholar.org/912a/5d6d196c3405e37b3a50d797cbf65a27ba44.pdf 9 Global Peace Index, 2018. Available at: http://visionofhumanity.org/app/uploads/2018/06/Global-Peace-Index-2018-2.pdf. According to this index, the eight least-safe countries are (starting with the most dangerous): Syria, Afghanistan, South Sudan, Iraq, Somalia, Yemen, Libya, and Democratic Republic of the Congo. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:
Highlights Trade talks have been the primary driver of the rally in Chinese stocks and China-related assets over the past five months. While trade is important to China’s economy, Chinese domestic demand is the primary driver of China-related asset fundamentals, meaning that the recent equity rally has occurred on the back of a largely false narrative. The January surge in credit has brought the first concrete sign that Chinese domestic demand will eventually bottom, but the current pace of money & credit growth suggests that investable earnings are facing a “catch up” period of potentially material weakness. The need for a stabilization in the outlook for earnings argues against an immediate shift to overweight, but we agree that investors should put Chinese investable stocks on upgrade watch for the coming few months. Feature Chart 1 reviews the recent performance of the Chinese investable equity market, and highlights two important facts: Chinese equity performance bottomed in both absolute and relative terms at the end of October, and The relative performance trend versus global stocks has now retraced roughly 40% of the decline that occurred in 2018 Chart 1A Sizeable Retracement, Based On A (Largely) False Narrative For investors looking for an appropriate allocation to Chinese stocks and China-related assets more generally over the coming 6-12 months, it is important to understand what has driven this post-October outperformance. In our view, it is only the January surge in credit growth that has brought the first concrete sign that Chinese domestic demand will eventually bottom, meaning that China plays have been rallying for the past five months on a largely false narrative. This significantly complicates the cyclical investment outlook, even under the assumption of an imminent trade deal with the U.S. As we will detail below, several factors argue against an immediate shift to overweight, but we agree that investors should put Chinese investable stocks on upgrade watch. We will be watching closely over the next few months for confirmation that above-average credit growth will be sustained, and that the outlook for Chinese earnings is stabilizing. Dissecting The Rally: Mostly Driven By Trade Optimism, Not Easing During the week of October 29th, the equity market was buoyed somewhat by a statement emerging from the late-October politburo meeting. The statement cited the need for the government to take “more timely steps” to counter increasing downward pressure on the economy, which catalyzed a 6% bounce in investable stocks (3% for the domestic market) by Thursday, November 1st. However, to most investors, news of a much more significant event came on Friday, November 2nd: President Trump was looking to make a deal with China at the late-November G20 meeting in Argentina, and had asked key officials to begin drafting potential terms.1 The investable market rallied over 3% on the day in response to the news, and continued to rise until Monday December 3rd, the day after the 3-month trade talk agreement was struck. Chart 1 shows that while investible stocks nearly hit a new 2018 low in December, this was due to a significant sell off in global stocks: relative performance was flat during this period, and resumed its uptrend once global stocks began to rise. Chart 2 provides confirmation that trade talks have been the primary driver behind the rally in China-related assets as well. The chart shows the BCA Market-Based China Growth Indicator alongside a diffusion index of its 17 components, with the vertical line denoting the point where the prospect of a deal became public. The Fed’s shift to a more dovish posture following its December rate hike has certainly helped propel the global rally in risky assets, but Chart 2 makes it clear that a shift in the outlook for trade between the U.S. and China has been the more important factor driving the prices of China-related assets over the past few months. Chart 2Trump's Desire For A Deal Was The Turning Point For The Market In terms of its relative importance for the Chinese economy, the focus of investors on trade is mostly wrongheaded. Trade is important to China’s economy, but the domestic demand trend is a far more important driver for the fundamental performance of China-related assets. We have highlighted over the past year that investor attention has been focused on the wrong factor, underscoring the rally in Chinese stock prices over the past few months has been driven by a largely false narrative. From Trade, To Credit Chart 3 compares our leading indicator for the Chinese economy with a measure of coincident economic activity, and highlights that the sharp slowdown in growth that has occurred over the past few months represents a reversion to a level that would be more consistent with that of our leading indicator (which has been pointing to weaker economic activity for the better part of the past 18 months). In fact, Chart 3 implies that actual growth is still stronger than what monetary conditions, money, and credit growth would imply, meaning that a further slowdown should be expected over the coming several months. Chart 3Economic Activity Is Recoupling With Our Leading Indicator However, judging by January’s credit release, this further slowdown in growth may occur against the backdrop of a durable uptrend in our leading indicator. Our calculation of adjusted total social financing grew by nearly 5 trillion RMB in January, a very substantial rise that has seldom occurred over the past few years (Chart 4). Legitimate questions about the seasonal effects of the Lunar New Year remain, but Chart 5 shows that the January data was large enough to cause a visible tick higher in the YoY growth rate, caused a sharp rise in our ratio of new credit to GDP, and occurred alongside an easing in the contraction of shadow credit as a percent of total credit. These are clear signs that reluctant policymakers are responding to the need to stabilize a weak economy. Chart 4A Very Strong Surge In January Credit...Chart 5...Has Led To A Visible Uptick In Annual Growth The magnitude of the January surge suggests that there is now a legitimate basis to forecast an eventual bottom in Chinese domestic demand. Our December 5 Weekly Report outlined our key views for 2019,2 and in it we noted that “our base case view is that growth will modestly firm in the second half of 2019, which would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China”. The odds of a firming in growth have certainly gone up as a result of January’s data, although it remains unclear how strong the upturn in credit growth will ultimately be over the course of 2019. This, along with the desynchronizing effect of trade front-running and a truce-driven rally in Chinese stocks, significantly muddles the 6-12 month investment strategy outlook. From Credit, To Investment Strategy We noted in our December key views report that a tactical overweight stance towards Chinese stocks was probably warranted over the coming three months, in recognition of the fact that investors could bid up the market in the lead-up to a possible trade deal with the U.S. We argued that the conditions for a cyclical overweight stance (6-12 months) were not yet present but could emerge sometime this year, particularly if money & credit growth begin to pick up. Is the January surge in adjusted total social financing a sign that investors should increase their allocation to Chinese equities today? We agree that investors should put Chinese investable stocks on upgrade watch for the next few months, but three factors continue to argue against an immediate shift: Investors appear to have bid up Chinese stocks assuming not only that the trade deal with the U.S. will occur, but that it will result in a durable resolution to the dispute (including, presumably, the rolling back of all tariffs that have been imposed). Even under the assumption that a deal does occur, it may be less comprehensive than investors are assuming and could still cause some lasting negative implications for global trade. While the odds of a credit overshoot have legitimately risen,3 January’s credit number is only one data point and the month-over-month change in credit is always abnormally strong in the first month of the year. At a minimum, investors should wait until the February credit data is released in mid-March to judge whether a higher pace of credit growth will be sustained over the course of the year. The recent quarrel between Premier Li Keqiang and the PBOC over whether the January credit spike represented “flood irrigation-style” stimulus suggests that policymakers are still somewhat reluctant to significantly boost credit,4 underscoring the need to monitor whether the recent pace of growth will be sustained. As first highlighted in Chart 3 above, the inflection point in credit growth implies that economic activity will improve at some point in the months ahead, but the current pace of money & credit growth suggests that both activity and, crucially, the level of earnings are facing a “catch up” period of potentially material weakness before they durably bottom. Chart 6 illustrates this potential weakness by comparing the current circumstance of our leading economic indicator, our measure of coincident economic activity, and the level of forward earnings to the 2015/2016 episode. The chart shows that by comparison to today, the 2015/2016 episode had clearer sequencing: our leading indicator fell, coincident activity followed, and stock prices bottomed only once forward earnings had contracted materially. Chart 6In 2015/2016, Our Leading Indicator Led Activity, Earnings, And Relative Stock Performance This time around, our leading indicator peaked in Q1 2017, but activity remained stronger than our indicator would have suggested even though it peaked relatively soon afterwards. Incoming data over the past three months suggest that economic activity is now catching up to the downside, and forward earnings remain elevated. Chart 7 shows that Chinese net earnings revisions remain firmly in negative territory, at levels that have been historically been associated with contracting forward earnings growth. Chart 7Earnings Weakness Looks Set To Continue Panel 4 of Chart 6 is emblematic of the fact that the recent rally in Chinese relative performance, driven largely by a false narrative, has significantly complicated the cyclical investment outlook. If the January improvement in credit had instead come in late October when Chinese relative performance was near its low, it would have been much easier for us to recommend that investors move to an overweight stance in response to a legitimate fundamental improvement and to take the risk of being somewhat too early. Now, a razor sharp focus on the earnings outlook is necessary, and we are unlikely to recommend an increased allocation to Chinese stocks unless that outlook stabilizes. Table 1 presents one of the tools that we will be using to judge the outlook for earnings, based on a model that we presented in two recent reports.5 The table shows a series of earnings recession probabilities that are based on a variety of credit and exchange rate scenarios and conditional on a material improvement in Chinese exporter sentiment. Light colored cells represent an earnings recession probability of less than 1/3rd, and the circled cell shows roughly where we would be today if the new export order component of the NBS manufacturing PMI were to rise sharply back to its June 2018 level. Table 1Credit Needs To Rise Further And RMB Appreciation Needs To Slow For The Earnings Outlook To Stabilize The table makes two key points. First, even given January’s surge, new credit will have to improve relative to GDP over the coming months in order to stabilize the earnings outlook. Second, the more that China’s currency appreciates in response to a trade deal with the U.S., the higher the hurdle rate for credit. Chart 8 shows that CNY-USD is already deviating quite significantly from the level implied by interest rate differentials, suggesting that significant further currency appreciation may not be in the cards. But the bottom line for investors is that a rising currency has the potential to negate some of the reflationary effects of stronger credit, and is a risk that must be monitored alongside the effort to gauge the sustainable rate of credit growth. Chart 8While Policymakers Or Rate Differentials Drive CNY-USD Over The Coming Year? Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see “Trump Said To Ask Cabinet To Draft Possible Trade Deal With Xi”, dated November 2, 2018, available at Bloomberg News 2 Please see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy and Geopolitical Strategy Special Report “China: Stimulating Amid The Trade Talks”, dated February 20, 2019, available at cis.bcaresearch.com. 4 Please see “Chinese Premier In Rare Spat With Central Bank”, Financial Times. 5 Please see China Investment Strategy Special Report “Six Questions About Chinese Stocks”, dated January 16, 2019, and Weekly Report “A Gap In The Bridge”, dated January 30, 2019 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Low Bond Volatility: Weakening non-U.S. growth and a more dovish Fed have crushed global government bond volatility, especially in Europe and Japan where yields are struggling to stay above 0%. Treasury-Bund and Treasury-JGB spreads, which now largely reflect long-run real growth differentials between the U.S and Europe/Japan, are likely to stay range bound. USTs vs Bunds/JGBs: Stay overweight Bunds & JGBs versus Treasuries, on a hedged basis in U.S. dollars, given the boost to returns from hedging into higher-yielding dollars. Feature Bond Yields Are In Winter Hibernation Developed market (DM) government bonds, never the most exciting of asset classes to begin with, have become boring of late. While benchmark 10-year yields since the end of January have moved in line with our recommended country allocations - lower in Germany (-7bps), Japan (-3bps), the U.K. (-5bps) and Australia (-11bps) where we are overweight, higher in the U.S. (+5bps), Canada (+2bps) and Italy (+19bps) where we are underweight – government bonds have settled into trading ranges and lack direction. The proximate trigger for the muted yield volatility was the Federal Reserve shifting to a neutral stance on U.S. monetary policy in January. Investors have priced out any possibility of a Fed rate hike over the next year, and now even discount a modest rate cut, according to the U.S. Overnight Index Swap (OIS) curve. Yet while most of the attention for bond investors have been focused on the U.S., there are developments in other major economies that are also depressing yields – namely, weakening economic momentum and sluggish inflation. In particular, the downturn has shown no signs of stabilizing in the eurozone and Japan, with the latest readings on manufacturing PMIs now below the 50 line, signaling a contraction (Chart of the Week). The latest data in both regions still shows that core inflation is nowhere near the inflation targets of the European Central Bank (ECB) and Bank of Japan (BoJ). The story is much different in the U.S, with the manufacturing PMI still well above 50 and core inflation hovering close to the Fed’s 2% inflation target. Yet Treasury yield volatility has collapsed, with the MOVE index of Treasury options prices now back to the lows of this cycle. Chart Of The WeekAre Treasuries Leading Or Following? For the time being, non-U.S. factors are driving the direction of global bond yields. We think that will change later this year, as steady U.S. growth and surprisingly firm U.S. inflation readings will prompt the Fed to begin hiking rates again. Yet until there are signs that non-U.S. growth is stabilizing, the low yields in Europe and Japan will act as an anchor on U.S. Treasury yields, particularly given how wide U.S./non-U.S. yield differentials already reflect faster growth and inflation in the U.S. Decomposing Treasury-Bund & Treasury-JGB Spreads When looking at the pricing of the “Big 3” DM government bond markets – the U.S., Germany and Japan – there are some major differences but also some similarities as well. Even with the benchmark 10-year U.S. Treasury sitting at 2.68% compared to a mere 0.11% and -0.03% on the 10-year German Bund and 10-year Japanese government bond (JGB), respectively. Simply looking at the breakdown of those nominal 10-year yields into the real and inflation expectations components, there is not much of a comparison (Chart 2). The real 10-year Treasury yield is in positive territory at 0.6%, compared to -1.4% and +0.2% for JGBs and German bunds, respectively. Inflation expectations, measured by 10-year CPI swap rates, are 2.1% in the U.S., 1.5% in Germany and 0.2% in Japan. Thus, the current wide 10-year Treasury-Bund spread (just under +260ps) can be broken down into a real yield spread of +200bps and an inflation expectations gap of +60bps. In the case of the 10-year Treasury-JGB spread (just under +270bps), that breaks down into a real yield differential of +80bps and an inflation gap of +190bps. Chart 2Big Differentials Here... So while the Treasury-Bund and Treasury-JGB spreads are of similar magnitude, the valuation components driving the spread are much different. The former is more of a real yield gap, while the latter is more of an inflation expectations gap. That is no surprise given the BoJ’s Yield Curve Control policy that maintains a ceiling on the 10-year JGB yield of between 0.1% and 0.2%, limiting how much real yields can move (there are no BoJ restrictions on the level of CPI swap rates). Yet the U.S.-Japan inflation expectations gap is not too far off the spread between realized headline and core inflation measures in both countries - both are 1.4 percentage points higher in the U.S. as of January. Looking at other valuation metrics, the cross-county differentials are less pronounced (Chart 3). Chart 3...But Less So For Other Yield Measures Yield curves are quite flat, with the 2-year/10-year slope a mere +16bps in the U.S., +14bps in Japan and only +66bps in Germany. Our estimates of the term premia on 10-year government debt are negative for all three markets, most notably in the countries that have seen quantitative easing in recent years (-10bps in the U.S., -90bps in Germany and -60bps in Japan). Perhaps most importantly, our preferred measure of the market pricing of the real terminal policy rate – the 5-year OIS rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward – is +0.2% in the U.S., -0.5% in Germany and 0.0% in Japan. That means the market is pricing in only a +70bp differential, in real terms, between the neutral policy rates of the Fed and ECB. That gap is only +20bps between market pricing of the neutral real rates for the Fed and BoJ. That narrower gap between the market-implied pricing of the real neutral rate is consistent with the theoretical macroeconomic drivers of real rate differentials, like growth rates of potential GDP and labor productivity. According to OECD estimates, potential GDP growth is 1.8% in the U.S., 1.5% in the overall euro area and 1.2% in Japan (Chart 4). This implies a long-run real yield gap between the U.S. and Germany of +60bps and the U.S. and Japan of +30bps – very close to the market pricing for the real terminal rate differentials.1 When looking at the 5-year annualized growth rates of labor productivity data from the OECD, there is no difference between the three regions with all growing at a mere 0.5% (suggesting that either a faster growth rate of the labor input, or greater productivity of capital, accounts for the higher potential growth rate in the U.S.). Chart 4No Major Differences In Long-Run Real Growth With the cross-country yield spreads now effectively priced for the long-run real growth differentials between the U.S. and Europe/Japan, this will limit the ability for nominal Treasury-Bund and Treasury-JGB spreads to widen much further. Right now, U.S. inflation expectations are rising faster than those of Europe and Japan, in response to the Fed’s more dovish stance. Yet if those expectations continue to rise, likely in the context of stickier realized U.S. inflation alongside solid U.S. growth, then the Fed will return to a hawkish bias. That ultimately means higher U.S. real yields and, most likely, some pullback in U.S. inflation expectations since the markets would begin to price in the implications of the Fed moving to a restrictive policy stance (including a stronger U.S. dollar that will help dampen U.S. inflation, at the margin). So that means inflation differentials between the U.S. and Germany/Japan can move wider now but will narrow later; and vice versa for real yield differentials (narrower now and wider later). The main investment implication: nominal UST-Bund and UST-JGB spreads are unlikely to move much wider, likely for the remainder of this business cycle/Fed tightening cycle. The main takeaway is that bond yields in core Europe and Japan are effectively anchoring global yields, in general, and U.S. yields, in particular. Treasury yields will not be able to break out of the current narrow trading ranges until there are signs that growth has stabilized in Europe and Japan. Reduced global trade tensions and faster Chinese growth (and import demand) are necessary conditions to reflate the export-heavy economies of Europe and Japan. Yet even if that scenario does unfold in the months ahead (which is BCA’s base case scenario), there is still a case to prefer Bunds and JGBs over U.S. Treasuries on a currency-hedged basis in U.S. dollars. Given the wide short-term interest rate differentials between the U.S. and Europe/Japan, those near-zero 10-year Bund and JGB yields, after hedging into U.S. dollars, are actually higher than 10-year Treasury yields, which benefits the relative hedged performance of the low-yielders versus the U.S. (Chart 5) Chart 5Stay Overweight Bunds & JGBs Vs. USTs (Hedged Into USD) Thus, we continue to recommend an overweight stance on core Europe and Japan, versus an underweight tilt on the U.S., in global U.S. dollar-hedged government bond portfolios. Bottom Line: Weakening non-U.S. growth and a more dovish Fed have crushed global government bond volatility, especially in Europe and Japan where yields are struggling to stay above 0%. Treasury-Bund and Treasury-JGB spreads, which now largely reflect long-run real growth differentials between the U.S and Europe/Japan are likely to stay range bound. Stay overweight Bunds & JGBs versus Treasuries, on a hedged basis in U.S. dollars, given the boost to returns from hedging into higher-yielding dollars. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 We are using the full euro area data for these economic comparisons, even though we are discussing U.S.-German yield differentials in this report. We think this is reasonable given the status of German government bonds as the benchmark for the euro area, and with the ECB setting its monetary policy for the overall euro area. The differences between the data for Germany and the overall euro area are modest, with German potential GDP and 5-year productivity growth both only 0.3 percentage points higher. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Portfolio Strategy The ongoing capex upcycle, resurgent credit growth, easy Chinese policy trifecta, upbeat signals from high frequency financial market data and depressed technicals, all suggest that a re-rating phase looms in the S&P industrials sector. Leading indicators of chip end-demand are flashing green, at a time when the chip liquidation phase is clearing excess supplies. It no longer pays to be bearish the S&P semiconductors index. Recent Changes Lift the S&P semiconductors index to neutral today; it is now also on upgrade alert. Table 1 Feature The SPX continued to grind higher last week, and is now within reach of the key 2,800 level. We expect stiff resistance to persist at that mark; 2,800 has served as a barrier on several occasions last year as we highlighted in recent research (please refer to Chart 1 from the January 28 Weekly Report).1 Year-to-date, we have identified three pillars that would propel the market higher – a more dovish Fed alongside a softer U.S. dollar, a year-over-year increase in SPX EPS for calendar 2019 and a positive resolution to the U.S./China trade spat. As the S&P 500 has come full circle and returned to the early December level, this slingshot recovery suggests that there is positive progress on all three pillars. However, our sense is that the bond market now has to remain tamed in order to cement these equity market gains and vault to fresh all-time highs, likely in the back half of the year. Chart 1 highlights this goldilocks macro backdrop. Chart 1Staying Divorced For A While In other words, as U.S. GDP downshifts from last year’s fiscal easing-induced sugar-high back down to trend growth and most importantly avoids recession, equities should excel. Why? Not only will this entice the Fed to stand pat for longer, but the 10-year Treasury yield will also remain on a lower trajectory than previously anticipated. Crudely put, a neither too-hot nor too-cold economic backdrop will allow equities to reflate away. As such, there are high odds that stocks stay divorced from bond yields for a while longer, and we interpret this bond market backdrop as reflationary rather than recessionary. Meanwhile on the Chinese front, following news of the PBoC’s quasi QE that we highlighted in early February as a positive SPX and cyclicals over defensives catalyst,2 it appears that Chinese authorities could not stomach a below 50 print in the Chinese manufacturing PMI for long and are aggressively opening the fiscal taps anew (Chart 2). Chart 2Chinese reflation... This enormous lending/fiscal stimulus complements ongoing monetary easing and the recent PBoC’s quasi QE, and should ensure that the Chinese economy at least steadies. The upshot is that global growth should also stabilize and put an end to its yearlong deceleration (Chart 3). Chart 3... Should Aid Global Growth In addition, as U.S. and Chinese negotiation teams race to the finish line in order to get some sort of a deal done before the March 1st deadline, it is clear that a positive outcome is already discounted by the stock market as the SPX enjoys one of the best starts to the year in recent memory. Once this trade policy uncertainty permanently dies down, then last year’s worst performing sectors that were hit hard by the trade dispute will turn into this year’s stock market champions (Chart 4). Chart 4Trade War Hit Deep Cyclicals The Most In that light, we reiterate our cyclical over defensive portfolio bent and this week we highlight that a deep cyclical sector stands to benefit greatly from China’s reflation and the apparent resolution of the U.S./China trade spat; another tech subsector weighed down by the trade tussle is also going to enjoy a reversal of fortune and it no longer pays to be bearish. Don’t Write Off Mighty Industrials Year-to-date, industrials stocks are the best performing GICS1 sector, outperforming the SPX by a massive 650bps (Chart 5). While such a breakneck pace is unsustainable and a short term breather is likely, from a cyclical perspective more gains are in store in this still underowned sector. In this report we highlight the top five reasons it still pays to be overweight this deep cyclical sector. Capex upcycle. The capex upcycle theme remains intact and while there has been some softness recently in the national accounts reported investment outlays, it is highly unlikely that spending plans will grind to a halt similar to the late-2015/early-2016 episode (third panel, Chart 6). Capital goods producers have since replenished their cash coffers and remain committed to develop their capital expenditure projects. Importantly, leading indicators of capex corroborate this backdrop; regional Fed surveys suggest that capital outlays will remain firm for the rest of the year (second panel, Chart 6). Chart 6Capex Upcycle Supports Industrials Resurgent credit growth. Loan growth is on fire in the U.S. and commercial and industrial loan growth is leading the pack, galloping higher and breaching the 10%/annum mark. Bankers are providing the needed fuel to bring to fruition industrials capex plans and, given that historically loan growth and relative profit growth have been positively correlated, the current message is upbeat (Chart 7). Chart 7Loan Growth Fueling The Fire Chinese easy policy trifecta: credit, fiscal & monetary. Beyond the positive resolution in the U.S./China trade dispute, China has opened up its central bank liquidity tap to complement ongoing easy monetary policy. Tack on the recent monster loan origination and reaccelerating infrastructure spending and factors are falling into place for a pick up in end demand, which is a boon for U.S. capitals goods producers (Chart 8). Chart 8Heed The Chinese Reflation Message... Upbeat signal from high frequency EM related financial market data. Emerging market stocks have been outperforming the MSCI ACW Index since early-October and even in absolute terms have troughed in late-October. The ultimate leading EM indicator, EM FX, put in a bottom in early September, sniffing out some sort of reflationary impulse. Meanwhile, momentum in the CRB raw industrials commodity index has also troughed, confirming the high-frequency EM data points. As a reminder, industrials stocks and the global commodity complex move in lockstep, and we heed the positive message all these financial market indicators are emitting (Chart 9). Chart 9...EM Financial Variables Concur Downtrodden sector sentiment and compelling valuations. Despite this year’s rebound in industrial equities, sour investor sentiment appears deeply ingrained. Relative EPS breadth and oversold technical conditions are contrarily positive. Relative valuations are also beaten down and still offer a compelling entry point (Chart 10). Even on a forward P/E basis industrials are trading at a 4% discount to the broad market and below the historical average. Finally, industrials profit and revenue expectations for the coming 12-months are forecast to trail the broad market according to the sell-side community. Were our thesis to pan out, these would represent low hurdles for capital goods producers to surpass. Chart 10Underowned And Unloved Nevertheless, there is a key macro variable, the U.S. dollar, that is a risk to our sanguine S&P industrials sector view. Chart 11 shows that the greenback and industrials sector fortunes are tightly inversely correlated. Not only is an appreciating U.S. dollar deflationary for global commodities that are priced in the reserve currency, but it also weighs on industrials P&Ls via negative translation effects. As a reminder, roughly 40% of industrials sales are international. Chart 11Rising Greenback Is A Risk Netting it all out, the ongoing capex upcycle, resurgent credit growth, easy Chinese policy trifecta, upbeat signals from high frequency EM related financial markets and depressed technicals, all suggest that a re-rating phase looms in the S&P industrials sector. Bottom Line: Stay overweight the S&P industrials sector. The Chip Cycle Is Turning It no longer pays to be bearish chip stocks; lift the S&P semiconductors index to neutral from underweight today. There are high odds that the chip cycle will soon take a turn for the better. Global chip sales have been decelerating for 17 months and are now on the cusp of contraction (Chart 12). Over the past two decades, steep contractions have been associated with recession. Given that BCA’s view does not call for recession this year, it is highly unlikely for global semi sales to suffer a major setback. While we do not rule out a brief and shallow dip below zero similar to the 2011/12 and 2015/16 parallels, leading indicators of global semi sales suggest that a trough is near. Chart 12Global Semi Cycle... Namely, BCA’s Global Leading Economic Indicator (GLEI) diffusion index is in a V-shaped recovery signaling that global growth is close to a nadir (middle panel, Chart 12). Similarly the U.S. dollar is decelerating which is a boon to global growth and conducive to higher global chip sales (trade-weighted U.S. dollar shown inverted, bottom panel, Chart 12). With regard to U.S. domiciled semi producers, a depreciating currency provides tremendous leverage to profits as foreign sourced revenues are roughly 80% of the total or twice as high compared with the SPX. Table 2, shows the one year trailing internationally- and China-derived revenues of the ten largest firms in the S&P semiconductors index, representing over 95% of the index. On a weighted basis, 80% of sales are sourced from overseas, including 36% of total sales coming from China. Clearly, global growth in general and Chinese growth in particular are key drivers of semi top line growth. Thus, any positive U.S./China trade dispute resolution would provide more relief for the S&P semi index. Table 2Semi Sales Geographical Exposure Moreover, electronics activity is an excellent gauge for semi end-demand. The all-important Chinese electronics imports have ticked up recently. In the U.S., consumer outlays on electronics are firing on all cylinders. Taken together, there is tentative evidence that global semi demand will soon bottom (Chart 13). Chart 13...Is Turning Importantly, the global semi inventory liquidation is ongoing and this supply backdrop should help balance the market. Already Asian DRAM prices, our pricing power gauge for the semi industry, are contracting, underscoring that the semi market is clearing (second & third panels, Chart 14). Importantly, global semi billings that tend to lead global semi sales by a few months have also ticked higher of late (top panel, Chart 14). Chart 14Improving Supply/Demand Dynamics Unfortunately, none of these positive catalysts are picked up by sell-side analysts. In fact, despite the recent rebound in relative share prices, 12-month forward EPS and revenue expectations remain in free fall. Net EPS revisions are as bad as they get, and have sunk near previous troughs that have coincided with durable relative share price rallies (second panel, Chart 15). Chart 15Analysts Have Thrown In The Towel On the relative technical and valuation fronts, pessimism reigns supreme. Our Technical Indicator hovers near one standard deviation below the historical mean and our Valuation Indicator is probing all-time lows. Interestingly, the S&P semi index sports a higher dividend yield than the SPX currently, underscoring that semi stocks are cheap (Chart 16). Chart 16Compelling Valuations And Technicals Our Chip Stock Timing Model (CSTM) does an excellent job in capturing all these moving parts and is currently sending a bullish signal (Chart 17). We heed the signal from our CSTM and are compelled to lift exposure to neutral. Chart 17Prepare To Deploy Capital Bottom Line: Lift the S&P semiconductors index to neutral and it is now also on our upgrade watch list; we are looking for an opportunity to boost to overweight on a pullback, stay tuned. Finally, from a risk management perspective we are enticed to increase our trailing stop to 15% in our tactical overweight in the S&P semi equipment index, in order to protect gains. The ticker symbols for the stocks in the S&P semiconductors index are: BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Don’t Fight The PBoC” dated February 4, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights A sooner-than-anticipated end to the Federal Reserve’s balance-sheet runoff should give a welcome boost to international liquidity conditions. Moreover, reflationary efforts in China, cautious global central banks, and easing global financial conditions all point to a rebound in economic surprises. This will support pro-cyclical versus defensive currencies and argues against a strong USD. At this point, it is too early to tell how long a pro-cyclical FX stance will be warranted. Sell NZD/CAD. Feature Since the turn of the year, this publication has argued that a correction in the dollar was increasingly likely, and that the main beneficiaries of this move should be the more pro-cyclical currencies. Because U.S. domestic fundamentals remain much stronger than the rest of the G10’s, our preference has been to favor commodity currencies versus the yen instead of playing dollar weakness outright. This theme remains in place for now. However, we are increasingly concerned about the dollar and think the outperformance of commodity currencies could last longer than originally expected. Essentially, an end to the Federal Reserve’s balance-sheet runoff, more cautious central banks, and easier global financial conditions could set the stage for a significant rebound in commodity currencies. U.S. Excess Reserves Vs. Commodity Currencies Whether it is from Governor Lael Brainard, Cleveland Fed President Loretta Mester, or the FOMC minutes, the message is clear: The days of the Fed’s balance sheet runoff are numbered. Ryan Swift, BCA’s Chief U.S. Bond Strategist, has written at length that the Fed’s balance sheet attrition has had a limited direct impact on U.S. growth. However, Ryan and the FOMC members both agree that a smaller balance sheet impacts the ability of the Fed to control the level of the fed funds rate.1 With less excess reserves in the banking system, the New York Fed has to intervene more often to keep the policy rate below its ceiling. This might seem like a very technical point, but it is an important one for many FX markets. Prior to the financial crisis, expanding excess reserves on U.S. commercial banks would coincide with improving dollar-based liquidity. Moreover, since 2011, reserves even lead our financial liquidity index (Chart I-1). Since there is 14 trillion of USD-denominated foreign-currency debt around the world, these fluctuations in U.S. excess reserves, and thus global liquidity, can have an impact on the price of assets most levered to global growth conditions. Chart I-1U.S. Excess Reserves Contribute To The Global Liquidity Backdrop Chart I-2 illustrates that commodity currencies are indeed very responsive to changes in U.S. excess reserves, particularly when these pro-cyclical currencies are compared to counter-cyclical ones like the JPY. Meanwhile, the trade-weighted dollar tends to move in the opposite direction of excess reserves, reflecting the dollar’s countercyclical nature (Chart I-3). This relationship, however, is not as tight as the one between commodity currencies and the reserves. Chart I-2Improving Growth In Excess Reserves Leads To Stronger Commodity Currencies... Chart I-3...And To A Weaker Greenback A corollary to the growing consensus within the FOMC to end the balance-sheet runoff sooner than later is that the contraction in excess reserves will end. A bottoming in the rate of change of the reserves is consistent with a rebound in commodity currencies, especially against the yen, and with a correction in the dollar. Gold prices are very sensitive to global liquidity conditions. Today, not only is the yellow metal moving closer to the US$1350-US$1370 zone that marked its previous highs in 2016, 2017, and 2018, but also, the gold rally is broadening, as exemplified by the advance / decline line of gold prices versus nine currencies, which is making new highs (Chart I-4, top panel). This indicates that the precious metal could punch above this resistance level. Gold is probably sniffing out an improvement in global liquidity conditions. Since rising gold prices tend to lead EM high-yield bond prices higher (Chart I-4, bottom panel), investors need to monitor this move closely. Chart I-4A Broadening Gold Rally Is Consistent With Easing Liquidity Conditions Bottom Line: The growing chorus among FOMC members singing the praises of the end of the Fed’s balance-sheet runoff points toward a significant slowdown in U.S. excess reserves attrition. While this may not be a significant development for U.S. domestic economic variables, it should help liquidity conditions outside the U.S. While this could weigh on the greenback, the probability is higher that it will help commodity currencies in the short run, especially against the yen. Global Policy And Commodity Currencies In China, new total social financing hit CNY 4.6 trillion in January, well above the normal seasonal strength. Accordingly, the Chinese fiscal and credit impulse is starting to improve (Chart I-5). While this rebound is currently embryonic, our Geopolitical Strategy team has argued that a massive increase in Chinese credit this January would indicate a change in Beijing’s economic priorities.2 The Chinese government may be trying to limit the downside to growth, and reflation may expand. This would result in a further pick-up in the credit impulse. Chart I-5The Chinese Credit Impulse May Be Bottoming Easing EM financial conditions – courtesy of rebounding EM high-yield bond prices – and rising Chinese credit flows should ultimately lead to improving growth conditions across EM. As a result, our diffusion index of EM economic activity – which tallies improvements across 23 EM economic variables – should bounce from currently very depressed levels. Such a recovery is normally associated with a weaker trade-weighted dollar, a stronger euro, rising commodity prices and rising commodity currencies – both against the USD and the JPY (Chart I-6). Chart I-6IF EM Growth Conditions Improve, This Will Have A Profound Impact On the FX Market We can expand this line of thinking to the global economy. Our Leading Economic Indicator Diffusion Index, which compares the number of countries with a rising LEI versus those with a falling LEI, already rebounded five months ago. Historically, this signals an upcoming rebound in the BCA global LEI. Additionally, other major central banks are also sounding an increasingly cautious tone. This should accentuate the easing in global financial conditions that began in late December, creating another support for global growth. However, global investors remain very pessimistic on global growth, as exemplified by this week’s very poor global growth expectations computed from the German ZEW survey (Chart I-7). This dichotomy between depressed growth expectations and burgeoning green shoots suggests that risk asset prices have room to rally further in the coming quarter or two. Chart I-7Investors Remain Pessimistic About Growth, Yet Green Shoots Are Popping Up These dynamics are positive for commodity currencies and negative for the dollar. This cycle, the pattern has been for the trade-weighted dollar to correct and hypersensitive pro-cyclical currencies like the AUD and the NZD to perk up only after our Global LEI diffusion index has trough, and around the same time as risk asset prices rebound (Chart I-8). Chart I-8Thinking About Growth, Asset Prices, The Dollar, And Commodity Currencies Treasury yields will most likely also be forced higher by improving risk asset prices and economic activity, especially as bond market flows suggest T-notes currently are a coiled spring. The U.S. Treasury International Capital System data released at the end of last week was very revealing. The press emphasized the large-scale selling of Treasurys from the Cayman Islands – interpreted as selling by hedge funds. Missing from the picture was the enormous buying from these same players over the past 12 months, which corresponded with falling yields and a rallying trade-weighted dollar (Chart I-9). It was a sign of growing fear that pushed up the price of bonds. Chart I-9Hedge Funds Have Room To Liquidate Their Treasury Holdings If, as we expect, global growth beats dismal expectations and risk assets rebound further, the countercyclical dollar should correct. This will further ease global financial conditions and justifying even more a wholesale liquidation of stale bond holdings by hedge funds and further pushing the Fed toward resuming its hiking campaign faster than the market is currently anticipating. This combination is highly bond bearish. Unsurprisingly, this means that the yen, which normally trades closely in line with U.S. Treasury yields, is likely to weaken. Hence, USD/JPY and EUR/JPY could experience significant upside over the coming months (Chart I-10). Chart I-10A Bond Bearish Backdrop Is Also Bad For The Yen Bottom Line: Global growth conditions are evolving away from a dollar-bullish, commodity currency-bearish backdrop. Not only is the dollar-based liquidity set to improve, but China is also releasing the proverbial brake. Additionally, a generally more cautious tone among global central banks will contribute to easing global financial conditions. These developments are likely to result in a period of positive global economic surprises – and an environment where the greenback weakens and where pro-cyclical currencies outperform. But For How Long? It remains a question mark as to how long this pro-growth cycle will last. Parts of the dynamics described above are very self-defeating. If global growth conditions and asset prices rebound strongly, the Fed will be in a better position to increase rates once again. This could quickly curtail the improvement in global financial conditions and favor a strong dollar. Additionally, it is not clear how far Beijing will go in terms of pushing reflation through the Chinese economy. Chinese policymakers are worried about too-pronounced a slowdown but are equally worried about too much debt in their economy, and do not want to repeat the debt binge witnessed in 2010 and 2016. Therefore, they may be much quicker to lift their foot off the gas pedal. This conflicting attitude is best illustrated by recent opposing remarks made by Chinese policymakers. On the one hand, Premier Li-Keqiang expressed concerns regarding the January credit surge, suggesting that some Chinese policymakers are already trying to dampen expectations that stimulus will be substantial. On the other hand, the PBoC sounded utterly unconcerned. Moreover, as our Emerging Markets Strategy service highlights, EM earnings are likely to continue to suffer from the lagged effect of China’s previous tightening. This creates the risk that even if global growth rebounds, EM stock prices, EM FX and all related plays do not follow. This would maintain the dollar-bullish environment and hurt pro-cyclical commodity currencies while supporting the yen. Despite these risks, it is nonetheless too early to tell how short-lived this period of dollar softness and commodity currency strength will be. After all, the dollar is a momentum currency. If the dollar weakness gathers steam, a virtuous cycle could emerge: improving global growth begets a weaker dollar, a weaker dollar begets easier global financial conditions, easier global financial conditions beget stronger growth, and so on. Gold prices may hold the key to cut this Gordian knot. If gold cannot maintain its recent gains, then the pro-cyclical positioning will not be valid for more than three months. However, if gold prices can remain at elevated levels or even rally further, then this pro-cyclical positioning will stay appropriate for at least six to nine months. What is clear is that for now, buying risk in the FX space makes sense. Bottom Line: At this point, too many crosscurrents are at play to evaluate confidently the length of any rally in pro-cyclical currencies relative to defensive ones. Since easier financial conditions ultimately force the Fed to resume hiking and since it is far from clear how committed to reflation Chinese policymakers are, our base case remains that this move will last a quarter or so. However, the fact that a falling dollar further eases global financial conditions, fomenting greater global growth in the process, suggests that a virtuous circle that create additional dollar downside can also emerge. Gold may provide early signals as to when investors should once again adopt a defensive posture. Sell NZD/CAD Something exceptional happened three months ago. For the second time in 25 years, Canadian policy rates fell in line with New Zealand’s. As Chart I-11 shows, this last happened from 1998 to 1999, when NZD/CAD subsequently depreciated 26%. However, today Canada’s and New Zealand’s current accounts are roughly in line while back then New Zealand had a substantially larger deficit, such a decline is unlikely to repeat itself. Nonetheless, we posit that NZD/CAD possesses ample downside. Chart I-11Bad News For NZD/CAD First, like in 1998-‘99, the real trade-weighted NZD exhibits a larger premium to its fair value than the real trade-weighted CAD (Chart I-12). In fact, the relative premium of the NZD to the CAD is roughly comparable as it was back then. Moreover, our Intermediate-Term Timing Model for NZD/CAD reinforces this message as it suggests that short-term valuations are also stretched (Chart I-13). Chart I-12NZD/CAD Is Pricey... Chart I-13...And Our Short-Term Valuation Metric Agrees Second, the New Zealand economy is currently weaker than that of Canada. Relative consumer confidence and business confidence have been in a downward trend for three years. Historically, while NZD/CAD can deviate from such dynamics, ultimately this cross tends to revert toward relative growth trends. The recent collapse in New Zealand’s economic surprises relative to Canada’s suggests that the timing for such a reversion is increasingly ripe, as there is currently scope for investors to discount a more hawkish Bank of Canada than Reserve Bank of New Zealand. Indeed, 1-year/1-year forward yields in Canada have fallen much more relative to the BoC overnight rate than similar forwards have fallen relative to the RBNZ policy rate. Third, New Zealand real bond yields have collapsed relative to Canada’s. As Chart I-14 illustrates, NZD/CAD tends to follow real yield differentials. So far, NZD/CAD has been less-weak than the real-yield gap would imply, but from late 2003 to early 2005 this cross also managed to defy gravity for an extended time, only to ultimately succumb to the inevitable. Chart I-14Falling Real Yield Spreads Will Weigh On NZD/CAD Fourth, as the top panel of Chart I-15 illustrates, the performance of kiwi stocks relative to Canadian equities tend to lead NZD/CAD, especially at tops. While tentative, the ratio of New Zealand to Canadian stocks seems to have peaked in early 2016. Supporting this judgment, kiwi profits have fallen relative to their Canadian counterparts and relative net earnings revisions are following a similar path – a move normally associated with a weaker NZD/CAD (Chart I-15, bottom panel). Chart I-15Relative Stock Market Dynamics Look Poor Fifth, terms of trades are becoming a growing headwind for NZD/CAD (Chart I-16). The price of agricultural commodities relative to energy products drives this pair, reflecting the comparative advantages of the two countries. BCA’s Commodity & Energy service is currently much more positive on the outlook for the energy complex than the agricultural complex. NZD/CAD is a perfect instrument to implement this view, especially now that the NZD suffers from a very rare negative carry against the CAD. Chart I-16A Negative Tems-Of-Trade Shock For NZD/CAD Bottom Line: NZD/CAD is set to experience an important fall. The NZD currently suffers from a very rare negative carry against the CAD. The last time this happened, a large depreciation ensued. Moreover, valuations and economic trends argue in favor of shorting this pair. Finally, relative bond yields, equity dynamics and term-of-trade outlooks also point to a lower NZD/CAD. Sell at 0.900, with a stop at 0.927 for a target of 0.800. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, titled “Caught Offside”, dated February 12, 2019, and the U.S. Bond Strategy Weekly Report, titled “The Great Unwind”, dated September 19, 2017, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Special Report titled “China: Stimulating Amid The Trade Talks,” dated February 20, 2019 available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Capacity Utilization underperformed expectations, coming in at 78.2%. However, Michigan Consumer Sentiment outperformed expectations, coming in at 95.5. Finally, the NAHB Housing Market Index also surprised to the upside, coming in at 62. The DXY has fallen by 0.2% this week. We remain bullish on the U.S. dollar on a cyclical basis, given that the Fed will end up hiking rates more than expected. However, the current easing of monetary conditions by Chinese authorities should tactically hurt the dollar and help commodity currencies. Moreover, the fact that the Fed announced that it might bring about an end to the balance sheet runoff sooner than expected will further help global liquidity conditions. The real question now is how long the coming dollar correction will last? Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: The annual growth in construction output underperformed expectations, coming in at 0.7%. The current account balance also surprised to the downside, coming in at 33 billion euros. However, the Zew Survey – Economic sentiment, though negative, surprised to the upside, coming in at -16.6. EUR/USD has risen by 0.4% this week. We remain bearish on EUR/USD on a cyclical basis; given that, we expect real rates to rise much faster in the U.S. than in the euro area. This is because we think that the U.S. economy will remain stronger than Europe’s, a consequence of the fact that the former has experienced a significant private sector deleveraging since 2008 while the latter has not. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth outperformed to the upside, coming in at 0.9%. Hurt by a very sharp contraction in shipments to China, the yearly growth of Japanese exports also surprised to the downside, coming in at -8.4%. However, imports yearly growth outperformed to the upside, coming in at -0.6%. USD/JPY has risen by 0.2% this week. We are bearish towards the yen on a tactical basis as the current upturn in liquidity conditions should hurt safe haven currencies. Moreover, reflationary efforts by Chinese Authorities should provide a boon to risk assets and make low yield currencies like the yen even less attractive. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been strong: Retail sales and retail sales ex-fuel yearly growth both outperformed expectations, coming in at 4.2% and 4.1%. Moreover, the yearly growth of average hourly earnings excluding bonus also surprised positively, coming in at 3.4%. GBP/USD has risen by 0.9% this week. We expect that a soft Brexit deal remains the most probable outcome out of Westminster. Thus, this factor, along with how cheap the pound is, make us bullish on the pound on a long-term basis. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: The wage price index yearly growth underperformed expectations, coming in at 0.5%. However, the employment change surprised to the upside, coming in at 39.1 thousand in January. The participation rate also surprised positively, coming in at 65.7%. AUD/USD has fallen 0.7% this week. We are positive on the AUD on a tactical basis. Global monetary conditions have eased thanks to the rising Chinese credit and more cautious global central banks. Moreover, the announcement that the Fed is looking to halt its balance sheet reduction sooner than expected has provided further relief. However, the fundamentals of Australia remain poor, and thus long-term investors should continue to avoid this currency, Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The recent data in New Zealand has been mixed: The business PMI in January fell to 53.1. However, the input of the producer price index on a quarter-over-quarter basis surprised to the upside, coming in at 1.6%. NZD/USD depreciated by 0.7% this week. While NZD/USD might have some upside in the short term, we remain bearish on the NZD/USD on a cyclical basis. Both the short-term and long-term interest rates in New Zealand are lower than in the U.S., while the real trade-weighted NZD is trading at 7% premium to its fair value. Thus, the kiwi is relatively overvalued which means that any tactical upside of NZD won’t have legs. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data in Canada has been neutral: The December new housing price index stays unchanged at 0%, on both month-over-month and year-over-year basis. The CAD has risen by 0.2% against USD this week. As BCA anticipates oil prices to strengthen more, we also expect the CAD to outperform the AUD and the NZD over the next few months. However, we remain bearish on CAD/USD on a structural basis. The unhealthy housing market in Canada could be a potential risk to the Canadian financial industry and the economy as a whole. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The recent data in Switzerland has been positive: The December exports increased to 19,682 million, while the imports increased to 16,639 million. The trade balance in December thus increased to 3,043 million, surprised to the upside. EUR/CHF has been flat this week. We are bullish on EUR/CHF on a cyclical basis. Easy global financial conditions should hurt safe haven currencies like the franc. Moreover, we believe that the SNB will continue to play a heavily dovish bias in order to counteract the fall in inflation caused by the surge in the franc last year. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: January trade balance increased to 28.8 million, from previous 25 billion. USD/NOK was flat this week. In general, we are overweight the krone, since we believe the pickup in oil prices will help the Norwegian economy, ultimately boosting the performance of NOK against the EUR, the SEK, the AUD and the NZD. Moreover, the NOK is undervalued and currently trading at a large discount to its fair value, which could further lift the performance of the NOK on a cyclical basis. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: January unemployment rate has increased to 6.5%. Moreover, the monthly inflation rate comes in at -1%, surprising to the downside. USD/SEK rallied by more than 1% this week. We remain bearish on EUR/SEK since the SEK is currently trading at a discount to its long-term fair value. Moreover, there are many signs pointing to a Swedish economy rebound. The negative rate in the country and easy financial conditions could stimulate the domestic demand and if global growth perks up, the weak inflation readings will prove transitory. The Riksbank has already abandoned it pledge to suppress the krona and it will move this year to lift rates again. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Please note that analysis on India is published below. Even if the recent upturn in the Chinese credit impulse is sustained, there will likely still be a six- to nine-month lag between the impulse’s trough and the bottom in the mainland’s business cycle. EM corporate earnings cycles typically lag Chinese stimulus efforts by about nine months. Therefore, EM profits will be contracting in the first three quarters of 2019. This will short-circuit the current rebound in EM share prices. EM equity valuations are not cheap enough to shield stocks from profit contraction. Feature China’s credit growth was very strong in January. We contend that even if the upturn in the credit impulse proves to be persistent, there will likely be a six- to nine-month lag between its low point and the bottom in the mainland’s business cycle. Chart I-1 demonstrates that the credit impulse leads both nominal manufacturing output growth and the manufacturing PMI’s import subcomponent by roughly nine months. Chinese imports are the most pertinent variable to gauge China’s economic impact on the rest of the world. Chart I-1China: Credit Impulse Leads Business Cycle By Nine Months In the meantime, will financial markets exposed to Chinese growth look through the valley of the ongoing growth deceleration and continue to rally? Or will they experience a major relapse in the coming months? In our opinion, corporate profits will be the key to broader financial market performance. So long as corporate profits do not shrink, investors will likely look beyond weak macro data, and any weakness in stocks will be minor. However, if corporate profits contract in the next nine months, then share prices will plummet anew. EM Profits Are Heading Into Contraction Chart I-2 illustrates that China’s credit impulse leads both EM and Chinese corporate earnings per share (EPS) by at least nine months and that it currently foreshadows EPS contraction in the first three quarters of 2019. Even if the recent upturn in the credit impulse is sustained, EM and Chinese EPS growth will likely bottom only in August – while they are in negative territory. Chart I-2EM EPS Is Beginning To Contract EM corporate earnings growth has already dropped to zero and will turn negative in 2019. Chart I-3A reveals that EPS in U.S. dollar terms are already contracting in six out of 10 sectors – industrials, consumer staples, consumer discretionary, telecom, utilities and health care. Chart I-3AEM EPS By Sector Chart I-3BEM EPS By Sector EPS growth has not yet turned negative for financials, technology, energy and materials (Chart I-3B). Notably, corporate earnings within these four sectors collectively account for 70% of EM total corporate earnings, as shown in Table I-1. Over the course of 2019, these sectors’ EPS are also set to shrink: Technology (accounts for 20% of MSCI EM corporate earnings): NAND semiconductor prices have been plunging for some time, and DRAM prices are also beginning to drop (Chart I-4). This reflects broad-based weakness in global trade – global auto sales are shrinking for the first time since the 2008 global financial crisis, global semiconductor sales are relapsing and global mobile phones shipments are falling (Chart I-5). Chart I-4Semiconductor Prices Are Falling Chart I-5Broad-Based Weakness In Global Trade Semiconductors accounted for 77% of Samsung’s operating profits in the first three quarters of 2018, suggesting the potential drop in DRAM prices will be devastating for its profits. Next week we will publish a Special Report on Korea and discuss the outlook for both semiconductors and Korean profits in more detail. In addition, the ongoing contraction in Taiwanese exports of electronics parts confirms downside risks to EM tech earnings (please refer to top panel of Chart I-3B). In brief, the ongoing decline in semiconductor prices will bring about EPS contraction in the EM technology sector. Financials/Banks (financials make up 31% of EM corporate earnings): Banks’ profits often correlate with fluctuations in economic activity, because the latter drive non-performing loan (NPL) cycles (Chart I-6). NPL cycles outside Brazil, Russia and India – where the banking systems have already gone through substantial NPL recognition and provisioning – will deteriorate, and push banks to increase their provisions. The latter will be a major drag on EM banks’ profits. Chart I-6EM Banks EPS And Economic Activity Regarding Chinese banks in particular, if the credit revival in January is sustained, it would strongly suggest that the government is resorting to its old, credit-driven growth playbook. Following 10 years of an enormous credit frenzy and a 20-year capital spending boom, it is currently difficult to find many financially viable projects. Hence, a renewed credit binge will once again be associated with further capital misallocation and more NPLs. Many of these projects will fail to generate sufficient cash flow to service debt. NPLs will thus rise considerably and the need to raise capital will dilute the banks’ existing shareholders. Of course, this will happen with a time lag. Chart I-7 shows that the gap between Chinese banks’ EPS and non-diluted profits has once again widened, and that EPS are beginning to contract. Chart I-7Chinese Banks: Earnings Dilution Chinese banks could issue perpetual bonds – discussed in great detail in last week’s report – to recapitalize themselves. Nevertheless, this will be negative for existing shareholders. In a nutshell, despite low multiples, share prices of Chinese banks will drop because more credit expansion amid the lingering credit bubble is negative for existing shareholders. The basis is that it will ultimately lead to their dilution. Chinese banks make up 4.5% of the MSCI’s EM equity market cap and 10% of aggregate EM profits. Hence, their EPS contraction will have a non-trivial impact on overall EM EPS. Resource sectors (energy and materials together make 20% of EM corporate earnings): The ongoing slowdown in China will exert renewed selling pressure in commodities markets. As shown in Chart I-9 on page 8, base metals prices lag the turning points in the Chinese credit impulse by several months and are still at risk of renewed price decline. Hence, profits of firms in the materials sector are at risk. Energy companies’ trailing EPS growth is still positive because the late-2018 carnage in oil prices has not yet filtered through to corporate earnings announcements (Chart I-3B on page 3). More importantly, the recent oil price rebound can be attributed to both Saudi Arabia’s output cuts as well as stronger demand – in the form of a surge in Chinese imports of oil and petroleum products. Chart I-8 illustrates that growth rates of China’s intake of oil and related products approached zero when crude prices were rising but has dramatically accelerated following their plunge. This is consistent with China’s pattern of buying commodities on dips. The point is that the upside in oil prices will be capped by China, which will likely moderate its oil purchases going forward, as crude prices have recently rallied. Chart I-8China And Oil Bottom Line: EM profit cycles lag Chinese’s stimulus by about nine months. EM profits will be contracting in the first three quarters of 2019. This will short-circuit the current rebound in EM share prices. China’s Credit Cycles And Financial Markets What has been the relationship between China’s credit cycle and related financial markets over the past 10 years? The time lag between turning points in China’s credit impulse and relevant financial markets can be anywhere from zero to 18 months. Chart I-9 illustrates historical time lags between the Chinese credit impulse on the one hand and EM share prices, base metals prices and the global manufacturing PMI on the other. The time lag has not been consistent over time. Chart I-9Chinese Credit Impulse And Financial Markets: Understanding Time Lags In late 2015-early 2016, the rebound in China’s credit impulse led financial markets by six months. At the recent market peak in January 2018, the credit impulse led financial markets and the global manufacturing PMI by about 18 months. In the meantime, in the 2012-13 mini cycle, EM share prices and commodities markets did not rally much, despite the meaningful upturn in China’s credit impulse. Finally, at the 2010-2011 peak, the credit impulse led EM stocks and base metals prices by 12 months. In short, the credit impulse led those financial markets by a few months to as much as a year and a half. Further, not only do time lags to the stimulus vary, but the impact on both economic activity and financial markets varies as well. This is because both economic activity and financial markets are driven by human psychology and behavior; iterations in stimulus, economic activity and financial markets are chaotic and complex in nature and do not follow well-defined patterns. Given the poor state of sentiment among Chinese consumers, business managers and entrepreneurs, more stimulus and more time may be required to turn the mainland’s business cycle this time around. Besides, unlike in previous episodes, there has not been any stimulus for the property market and no tax reductions on auto sales. Finally, although China and the U.S. may strike a deal on trade, it is unlikely to be a comprehensive agreement that is sustainable in the long run. This would be consistent with our Geopolitical Strategy team’s view that China and the U.S. are in a long-term and broad geopolitical confrontation – not a trade war. The trade war and tariffs are just one dimension of this. Hence, Chinese consumers and businesses, as well as the global business community may well look through this potential deal and not significantly alter their cautious behavior, at least for some time. In other words, the genie of geopolitical confrontation is out of the bottle, and the presidents of the U.S. and China are unlikely to succeed in putting it back. Bottom Line: Turning points in China’s credit impulse generally lead financial markets exposed to Chinese growth by several months. Given that the improvement in the credit impulse is both very recent and modest, odds are that China-related plays including EM risk assets will go through a major selloff before putting in a durable bottom.1 EM Equity Valuations In terms of the ability of EM stocks to withstand profit contraction, would cheap valuations not shield share prices from a considerable drop? We do not think EM equities are cheap; their valuations are neutral. Hence, there is no real valuation cushion in EM stocks to help them endure a period of negative EPS growth. We have written frequently about valuations and will touch on the topic only briefly here. Market cap-based multiples indeed appear very low. However, some segments of the EM universe such as Chinese banks and state-owned companies in Russia, Brazil, China and India have had low multiples for years. In other words, they are a value trap and their multiples are low for a reason. We elaborated above why Chinese banks are chronically “cheap”. For many other companies, low multiples are due to structural issues such as the lack of focus on profitability and shareholder value, or the high cyclicality of profits. Many of these stocks have large market caps, which pull down the EM index’s aggregate multiple. To remove market-cap bias, we have calculated 20% trimmed-mean multiples by ranking 50 MSCI EM industry groups (sub-sectors) and cutting off the top and bottom 10%. Then, we calculate the equal-weighted average of the remaining 80% of the sub-sectors. We did this calculation for the following five ratios: trailing P/E, forward P/E, price-to-cash earnings, price-to-book value and price-to-dividend. Then, we combined them into a composite valuation indicator (Chart I-10, top panel). This indicator shows that EM equity valuations are neutral. Chart I-10EM Equity Valuations In Absolute Terms In addition, we calculated the median and equal-weighted composite valuation indicators (Chart I-10, middle and bottom panels). They also remove market cap bias and tell the same message: EM stocks are trading close to their fair value. EM equities are also close to their historical average relative to developed markets (DM). Chart I-11 illustrates relative EM versus DM valuation indicators based on 20%-trimmed mean, median and equal-weighted metrics. Chart I-11EM Equity Valuations Versus DM In sum, EM valuations are not cheap neither in absolute terms, nor relative to DM. According to both measures, valuations are neutral. Hence, valuations will not prevent share prices from falling as profits begin to contract. This is why we continue to recommend a defensive strategy for absolute-return investors, and we continue to underweight EM versus DM within a global equity portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Beware Of Rural Growth Lapse Indian share prices are weak and are underperforming the emerging markets benchmark in U.S. dollar terms (Chart II-1, top panel). Small cap stocks are in a full-fledged bear market (Chart II-1, bottom panel). Chart II-1Indian Stocks Are Weak The latest earnings season turned out to be disappointing. Many companies missed their earnings estimates. Chart II-2 shows that net profit margins of listed non-financial companies have turned down and overall EPS growth is weakening. Chart II-2Indian Corporate Profits Are Sluggish Disappointing corporate earnings are confirmed by macro data as well. Chart II-3A shows that manufacturing production is decelerating and intermediate goods production is contracting. Further, sales of two-wheelers, three-wheelers, passenger and commercial vehicles, as well as tractors, are either slowing or contracting (Chart II-3B). Chart II-3ACyclical Spending Is Decelerating Chart II-3BCyclical Spending Is Decelerating This weakness emanates from rural areas. The basis is that food prices have been falling since the summer of 2018 – and are deflating for the first time since the early 2000s. This is hurting rural incomes. Several indicators confirm considerable weakness in rural income growth and the latter’s underperformance versus urban income and spending: The top panel of Chart II-4 illustrates that our proxy for spending in rural areas relative to urban areas has deteriorated massively along with the decline in Indian food prices. Chart II-4Rural Spending Is Weaker Than Urban One This measure is calculated as revenue growth of four rural-exposed listed companies minus the revenue growth of four urban-exposed listed companies. In both cases, the companies largely operate in the consumer goods space. Credit growth in rural areas has lagged that of urban areas, explaining the underperformance of rural spending (Chart II-4, bottom panel). Corroborating this, stock prices of these urban-exposed companies have outperformed their rural peers substantially (Chart II-5). Chart II-5Urban-Exposed Stocks Have Outperformed Rural Ones Such a slump in rural income is posing a challenge to Modi’s re-election in May. His government – which lost three key state elections in late 2018 – is aware of these ominous trends and is acting boldly to revive income growth in rural areas. The government announced an expansionary budget that appeases rural voters. In particular, the budget aims to strengthen farmers’ support schemes, cut taxes for low- and middle-income earners and introduce a pension scheme for social security coverage of unorganized labor. However, there is a significant risk that the authorities’ fiscal and monetary stimulus are too late to lift growth before May’s elections. According to the past relationship between fiscal spending and India’s business cycle, higher government expenditure growth will only begin to have an effect on the economy in the second half of this year – i.e. after the elections are held (Chart II-6). Hence, the BJP could lose its majority, meaning it would either rule in a minority government or be forced to turn over power to the Congress Party and its allies. Chart II-6Government Expenditures To Lift Growth In H2 2019 Beyond the elections, food prices might be approaching their lows. Well-below average rain will likely result in weak agricultural production and, hence, higher food prices in the second half of 2019 (Chart II-7). Chart II-7Below Trend Monsoon = Food Prices Will Likely Rise Therefore, in the second half of 2019, both fiscal easing and higher food prices will revive rural incomes and spending. In the meantime, monetary easing and credit growth acceleration will support demand in urban areas. Overall, Indian financial markets will likely remain in a risk zone until the elections as economic growth and corporate profits will continue to disappoint. If the opposition Congress Party’s alliance wins the election, Indian stocks and the currency will initially sell off. After this point, Indian assets could offer a buying opportunity because growth will likely revive in the second half of 2019. Bottom Line: For now, we continue to recommend an underweight position in Indian equities relative to the EM equity benchmark. Weakening growth, the very low interest rate differential versus U.S. rates and political uncertainty ahead of the general elections, pose risks of renewed rupee depreciation. A weaker rupee will continue to benefit India’s export-oriented software companies. Therefore, we also reiterate our long Indian software / short EM stocks recommendation. Finally, fixed-income investors should stay with the yield curve steepening trade. The central bank could further cut rates in the near term. However, long-term bond yields will not fall substantially and will likely start drifting higher sooner than later. The widening fiscal deficit, expectations of growth revival in the second half of 2019, and eventually higher food prices and inflation expectations, will all lead to a continuous steepening in the local yield curve. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1 This is the view of BCA’s Emerging Markets Strategy team and it is different from BCA’s house view on China-related assets and the global business cycle. The primary source of the difference is the outlook for China’s growth. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
The above chart highlights this reflationary backdrop for U.S. stocks. Our U.S. equity team’s Reflation Gauge (RG, comprising oil prices, interest rates and the U.S. dollar) is probing levels last hit in 2012. Historically, our RG and equity momentum have…