Financial Markets
Highlights Dear Client, We will not be publishing next week, as BCA Research's Investment Conference is being held in New York City. We will be back the following week with a Special Report on global agricultural markets, and a recap on the performance of our 3Q17 recommendations. Kind regards, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Our new supply-demand balances indicate OPEC 2.0 will have to extend its production cuts to June 2018 to meaningfully reduce global oil inventories, even with demand growth exceeding 1.60mm b/d this year and 1.70mm b/d next year. This will lift average Brent prices to ~ $59/bbl and WTI to just under $57.50/bbl next year. We continue to expect Brent to trade to $60/bbl by year-end 2017, and for WTI to trade ~ $3.00/bbl under that. Higher prices will incentivize higher production from U.S. shale operators. This is a risk OPEC 2.0 will have to manage, as it develops a modus operandi that allows it to co-exist with shale and still maintain adequate revenues for its member states. Energy: Overweight. We are taking profit on our Brent options positions at today's close, since December options will have only three weeks to trade when we return. These positions, recommended in May and June, were up 116.3% on average by Tuesday's close. We will initiate positions in May and December 2018 Brent call spreads, going long the $55/bbl strike vs. short the $60/bbl strike at tonight's close. Base Metals: Neutral. Our tactical COMEX copper short is up 5.5% since inception on September 7. Precious Metals: Neutral. Our long COMEX Gold hedge is up 6.2% since it was initiated May 4, 2017. We are retaining the position as a strategic portfolio hedge. Ags/Softs: Underweight. Corn is having a tough time holding a bid following last week's USDA's Crop Report, which called for higher production and ending stocks, and lower prices. We will be updating our global ags assessment in a Special Report October 5. Feature OPEC 2.0 will have to extend its 1.8mm b/d production cuts to end-June 2018, in order to bring global inventories closer to levels it considered necessary to clear the market when it embarked on its 1.8mm b/d production-cutting Agreement at the end of last year, based on our most recent supply-demand balances modeling (Chart of the Week). Chart of the WeekOPEC 2.0 Needs To Extend Cuts,##BR##To Reduce Global Inventories As a result, our base case for balances reflects the OPEC 2.0 Agreement being extended to end-June (Chart 2). As we noted in our assessment last week, compliance with the OPEC 2.0 production-cutting Agreement remains high.1 All told, we see global production growing 0.83mm b/d this year, and 2.13mm b/d next year, based on our expectation of the OPEC 2.0 Agreement being extended to end-June. On the demand side, our most recent assessment of global demand leads us to expect growth of 1.62mm b/d this year and 1.72mm b/d in 2018 (Table 1). Chart 2Base Case For BCA Oil Supply-Demand Balances Reflects June 2018 Expiry Of OPEC 2.0 Cuts Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Fundamentals Point To Higher Oil Prices Based on our latest assessment of the global oil market, we believe OPEC 2.0 will fall short of reducing visible inventories back to their 5-year average levels if the coalition's production-cutting agreement expires at end-March 2018 (Chart of the Week, top panel). In fact, we believe that the Agreement will have to be extended to at least June 2018 - assuming no change in OPEC 2.0 country-specific production quotas - in order to draw OECD inventories down to their 5-year average levels (Chart of the Week, middle panel). An extension of the cuts to December 2018 would push OECD commercial inventories closer to levels originally targeted by OPEC 2.0 when its Agreement was reached at the end of last year. There is a higher risk prices will exceed the upper end of the range we assume WTI will trade in - $45/bbl to $65/bbl - with greater frequency next year, given we expect WTI prices will average slightly less than $57.50/bbl and Brent prices will average just under $59.00/bbl. Given the draws we expect in global inventories, the likelihood the WTI forward curve trades in backwardation next year also is elevated. We expect Brent to continue to trade in backwardation next year, which we believe will benefit OPEC 2.0 member states, since it allows them to realize higher spot prices - against which term contracts mostly are written - and will limit the volume of hedging U.S. shale producers can effect. Given our updated balances, we re-estimated our oil fundamentals models, accounting for the higher demand we expect (Chart 3), and continued production restraint by OPEC 2.0 on the supply side (Chart 4). These are markedly different to the EIA's estimates. Chart 3BCA Expecting Stronger Oil Demand Than EIA Chart 4Oil Supply Evolution Under Different Scenarios Using these fundamental inputs, we derived forecasts for the WTI and Brent prices.2 The four scenarios we analyzed are: Expiry of OPEC 2.0 Agreement in March 2018; Expiry of OPEC 2.0 Agreement in June 2018; Expiry of OPEC 2.0 Agreement in December 2018; The U.S. EIA Short-term Energy Outlook (STEO) supply-demand assumptions. The estimated results are presented in Table 2 and Chart 5. Table 2Fundamentally Derived##BR##Price Expectations Chart 5Oil Prices Will Lift As OPEC 2.0##BR##Agreement Restricts Supply Interestingly, the 4Q17 WTI futures curve appears to be priced much closer to Scenario No. 4, the EIA's assumptions. This is something we have observed in the past - i.e., the market has a tendency to price to the EIA's supply-demand balances, in the short term. As far as we can tell, the EIA's estimates assume less steep cuts than we do, and appear to be projecting visible inventories will begin to rise starting next month - (Chart 6). Chart 6EIA Assumes OECD Inventories Will Rise Under the EIA scenario, the average WTI futures price for 4Q17 is $50.40/bbl. Under BCA Base Case Scenario, which assumes the OPEC 2.0 Agreement will be extended to end-June, we estimated WTI prices would average $54.00/bbl over the same period. For 2018, the divergence between the EIA and BCA base cases is even more dramatic: Under the EIA's assumptions, our fundamental model estimates WTI prices will average $45.55/bbl in 2018, while under our new base case scenario, which projects the OPEC 2.0 deal will be extended through June, we estimate WTI prices will average $57.44/bbl next year. In its September Short-Term Energy Outlook (STEO), the EIA substantially lowered its U.S. shale production growth estimates for this year. Our colleagues at BCA's Energy Sector Strategy highlight this revision in this week's report, noting that 3Q17 U.S. onshore production levels will be 540k b/d higher yoy, versus an earlier expectation of a 730k b/d increase. This represents a ~ 25% reduction in the yoy growth rate. In addition, EIA's forecasted 3Q17 quarter-on-quarter oil production growth was cut by 40%, with sequential production growth now estimated at 197k b/d.3 The EIA's estimate now is more in line with BCA's assessment. These revisions will be supportive of prices, once market participants realize the EIA's scaling back on its growth expectations. BCA Lifts Estimate Of Demand Growth In our revised supply-demand balances, we expect 2017 global oil consumption will increase 1.62mm b/d, while 2018 demand will be up 1.72mm b/d. This reflects the strong growth reported by the OECD, which we noted last week, and the IMF.4 Strong growth momentum also can be seen in the continued performance of world trade volumes (Chart 7). The trade expansion is led by EM economies, with EM Asia, Latin America and Central Europe all posting yoy growth of ~ 10% at mid-year. EM also drives most of global oil-demand growth (Chart 8).5 Chart 7Global Growth Reflected##BR##In Increased Trade Volumes Chart 8EM Import Volumes##BR##Remain Strong Our expectation is EM oil demand will grow 1.20mm b/d this year and 1.30mm next year, accounting for the bulk of the 1.62mm and 1.72mm of overall demand growth we expect in 2017 and 2018, respectively. We will continue to follow demand trends in EM closely, particularly China and India, given its importance to overall global oil demand growth. Backwardation Will Persist In Brent, Arrive Sooner In WTI The direct implication of our results is backwardation will become more pronounced going forward. In the Brent market, the forward curve is backwardated to the end of 1Q18 then pretty much flattens out, based on mid-week settlements. In the WTI curve forwards, WTI futures carry to June 2018 then backwardate slightly to the beginning of 4Q19. We expect both to backwardate next year as storage draws and markets tighten. We have maintained OPEC 2.0 member states would benefit from a strategy under which they manage production and storage in such a way as to backwardate Brent and WTI curves. This would allow member states to realize higher revenues from spot prices, which are referenced in long-term supply contracts and are received on outright spot sales, and limit the amount of hedging U.S. shale producers can do: Lower deferred prices are not as profitable for producers, since they result in less revenue per barrel hedge in the future. Upward-sloping forward curves - i.e., contango market structures - allow producers to hedged at higher prices in the future, providing higher revenues, assuming the starting point is the same as in a backwardated market. We expect that as 2017 winds down and we approach the end of 1Q18, it will become apparent to OPEC 2.0's leadership their production-cutting agreement needs to be extended in order to drain global storage and get prices to lift. This is particularly true for the Kingdom of Saudi Arabia (KSA), which most likely will IPO Saudi Aramco, the state-owned oil company toward the end of next year. If OPEC 2.0's production-management agreement is not extended and inventories do not draw sufficiently to lift prices and backwardate the Brent forward curve, KSA most likely will have to push its IPO into 2019. Given the country's keen desire to raise funds to support its diversification away from its oil dependency, we believe its leaders would prefer to get the funds raised by the IPO in the door and begin allocating them. Bottom Line: OPEC 2.0 will extend the expiry of its production-cutting agreement from end-March to end-June 2018. This will force global inventories to fall to levels closer to those expected when the coalition agreed to jointly manage production at the end of last year. Demand growth will exceed 1.60mm b/d this year and 1.70mm b/d next year. This, along with the extension of the OPEC 2.0 cuts to end-June, will lift average Brent prices to ~ $59/bbl and WTI to just under $57.50/bbl next year. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance," published September 14, 2017. It is available at ces.bcaresearch.com. 2 We estimate WTI and Brent prices for the balance of 2017 and 2018 with respect to their fundamentals. The adjusted R2 for the WTI and the Brent regressions are 0.89 and 0.92, respectively. 3 Please see BCA Research's Energy Sector Strategy Weekly Report "A Funny Thing Happened On The Way To The "Shalepocalypse," published September 20, 2017. It is available at nrg.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Hurricane Recovery obscures OPEC 2.0's Forward Guidance," published September 14, 2017. It is available at ces.bcaresearch.com. See also "A Firming Recovery," in the IMF's World Economic Outlook Update published July 24, 2017. We use IMF global GDP growth estimates as an input to our oil-demand modelling. 5 We have found EM imports to be a good explanatory variable for oil and base metals demand, as well as inflation in the U.S. and EU. Please see, e.g., BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published July 27, 2017. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights EM EPS growth is set to decelerate significantly and will likely turn negative in 2018 based on the China/EM money/credit indicators. All measures of Chinese broad money growth have fallen to a record low signifying a major growth slump. The two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields- are set to reverse. EM equities and credit markets relative performance versus their DM peers is about to relapse. A new fixed-income trade: receive 2-year swap rates in Mexico / pay 2-year swap rates in the U.S. Feature Last week we were on the road, meeting with some of our U.S. East Coast clients. This week we address some of the common questions we received. Q: Why do you think EM profits will relapse in the next six-to-nine months, given both global and EM growth continue to show strength? A: Our reluctance to change our view on EM risk assets in general and equities in particular has to do with EM/China business cycle/corporate profit indicators. Several indicators for EM profits - which have exhibited very good track records - presently forecast a material slowdown and possibly a contraction in EM EPS starting late this year and well into next year. In particular, China's broad and narrow money impulses lead EM EPS by about nine months, and are currently signaling that EPS growth is set to peak and begin to decline in the next nine months (Chart I-1). What's more, a few business cycle indicators from Korea and Taiwan, such as nominal manufacturing production and manufacturing shipments-to-inventory ratios, corroborate a peak in EM EPS growth (Chart I-2). Chart I-1EM EPS Is Set to Decelerate ##br##And Probably Contract Chart I-2More Signs Of Relapse##br## In EM EPS Growth Importantly, the EM corporate earnings slowdown will not occur in a vacuum. It will transpire amid a slowdown in Asian trade and lower commodities prices. In particular: China's broad money M3 impulse leads domestic industrial orders, nominal manufacturing production and imports (Chart I-3). Even though Asian export data were strong in August, China's container freight index signals a slowdown in Asian trade lies ahead (Chart I-4). Chart I-3China: M3 Impulse And Domestic Demand Chart I-4Asian Export Growth To Slow The Chinese broad money impulse also points to a rollover in Korean, Taiwanese, other EM as well as DM countries' shipments to the mainland (Chart I-5). This is how the slowdown in China's money/credit will hurt corporate profits in EM as well as in DM sectors with substantial exposure to Chinese growth. Besides, China's broad money impulse leads industrial metals prices in general and iron ore prices in particular (Chart I-6). This signifies downside risks to commodities producers. Finally, China's yield curve suggests that mainland manufacturing PMI will roll over after its recent ascent (Chart I-7). Chart I-5Shipments To China Are At Risk Chart I-6Industrial Metals Prices Have Peaked Chart I-7China: The Yield Curve And Manufacturing PMI In short, China has been gradually tightening monetary policy, which has already manifested in record-low broad money growth. The next phase is evidence of a material deterioration in sales and profits among China-exposed plays. The EM stock markets are unlikely to ignore it. Q: It seems you are putting a lot of emphasis on China's broad money M3 measure. Why do you look at your version of Chinese broad money M3 and not at official M2 and total social financing (TSF)? A: Over the past several months we have done a lot of research and analysis on China's money and credit, and believe that our broad money M3 measure and private and public credit aggregate calculated by BIS are presently better measures of money and credit than official broad money M2 and TSF: First, the TSF data have become distorted because of the local government financing vehicles (LGFV) debt swap program. Specifically, according to the LGFV debt swap mechanics, starting in 2015 provincial governments began issuing bonds that have been purchased by banks. The amount of bonds issued was RMB 3.2 trillion in 2015, RMB 4.9 trillion in 2016 and expected to be RMB 4.8 trillion in 2017. This amounts to total issuance of RMB 12.9 trillion since the commencement of the program. As the next step, local governments were supposed to transfer the proceeds from these bond issuances to their LGFVs, with the latter using the money to pay down their debt. The ultimate goal of the program is to shift the debt from LGFVs to provincial governments, as the latter's creditworthiness is much better than the former. This has also reduced interest rates on the debt as provincial governments borrow at lower interest rates than LGFVs. All that said, it is unclear how much of their debt LGFVs have repaid. The main problem with using TSF data is knowing the amount of proceeds from the issued debt swap bonds that were used to pay down LGFV debt. If the entire amount of these bonds issued by provincial governments was used to pay down LGFV debt, there would not be an impact on economic activity, and only a very short-term impact on money supply. When banks buy bonds from non-banks (including governments), they create new money. When debtors (including governments and their entities) pay down debt to banks, money is destroyed. Nevertheless, both official M1 growth and our measure of broad money (M3) were too strong in 2015 and 2016 – i.e., they remained strong much longer than would have been justified by the LGFV debt swap. Furthermore, private and public credit, M2 and M3 money measures have decoupled from TSF since the middle of 2015 (Chart I-8A). TSF adjusted for the LGFV debt swap – the latter is added to TSF – has also diverged from official M2, our broad money M3 and BIS’s private and public credit measures (Chart I-8B). This corroborates that TSF data can no longer serve as a reliable measure of credit/money origination. Chart I-8AChina: TSF Has Diverged From ##br##Other Money/Credit Measures Chart I-8BChina: TSF Adjusted For LGFV Debt Swap Has Also Decoupled From Money/Credit Measures Markedly, paying down debt by LGFVs should have reduced corporate debt outstanding by RMB 12.9 trillion, which would represent a 12% drop from the RMB 112 trillion outstanding at the end of 2015. However, corporate debt has continued to expand rapidly, even as government debt has surged. Given all of the above, we doubt all of the proceeds from bonds issued within the LGFV debt swap program were immediately used to repay LGFV debt. Instead, we suspect the proceeds from the bond issuance might have been at least partially invested into the economy in 2016, in defiance of the rules of LGFV debt swap operation. We played down the rise in M1 in late 2015 and early 2016 because we regarded it as temporary, reflecting the LGFV debt swap program. In retrospect, it was a mistake - this was one of the main reasons we did not heed the message from recovering money growth in early 2016 to turn cyclically positive on China's growth, and consequently on commodities and broader EM. Provided we do not know what portion of LGFV debt was repaid and when, corporate credit and total social financing data have become difficult to interpret. Chart I-8A and Chart I-8B demonstrate that TSF with and without the LGFV debt swap has diverged from private and public debt since the middle of 2015 when the LGFV debt swap program commenced. Apparently, one no longer can rely on TSF or adjust it by the amount of LGFV debt swap to gauge money and credit creation in China. In this context, the aggregate of private and public credit is a much more appropriate measure of credit provision and debt creation than TSF. The basis is because it includes both private and public debt. Indeed, the reshuffling of debt between local governments and LGFVs (the latter are treated as enterprises in China's banking statistics), does not affect either aggregate borrowing or amount of debt held in the economy. Second, when credit numbers are distorted, one needs to resort to money supply measures to judge credit dynamics. The reason is because financial engineering and, in the case of China, the LGFV debt swap program, can obscure the amount of outstanding credit, but they cannot conceal the amount of money banks create when they lend or purchase bonds or any other asset. Money is created when a bank originates claims on non-banks, and money is destroyed when a debt is paid back to the bank. Accordingly, money traces debt creation by banks. Banks can disguise their assets, and corporations and governments can conceal their liabilities, but none of them can camouflage the amount of money in circulation. In short, we trace money to gauge the amount of private and public sector borrowing from banks. This is why we have calculated various measures of money in China to overcome the shortcomings of the TSF. Specifically, we have calculated broad money M3 (see details of our calculation below) and credit-money. The latter is the sum of commercial banks' assets such as claims on non-financial institutions, claims on other financial institutions, claims on government and claim on other resident sectors and commerical banks' as well as the central bank's foreign currency assets. Chart I-9 demonstrates various measures of broad money and outstanding credit: official M2, our measure of broad money M3, our credit-money measure, and private and public debt (source BIS). Importantly, all measures of money and private and public credit suggest that credit origination/money creation was very strong in 2015 and 2016, and that it has slowed substantially in 2017. In brief, the message from various measures of money/credit is consistent. Chart I-9China: Money/Credit Growth Has Decelerated To New Lows Interestingly, broad money M3 rose by RMB 21 trillion in 2015, RMB 20 trillion in 2016 and by only RMB 16.5 trillion in the past 12 months through end of August. This is why the M3 impulse - a change in money flows - has turned negative since early this year. Third, we prefer our broad money measure M3 to official M2 because it is more consistent with the BIS's measure of private and public credit. It has also served as a better tool in forecasting the 2016-2017 recovery in Chinese growth. As can be seen in Chart 1, 3, 4, 5 and 6 on previous pages, the M3 impulse - its second derivative - has a great track record in forecasting China's business cycle dynamics. The acceleration in M2 growth in 2015-16 was milder than one would expect in order to achieve meaningful acceleration in nominal economic activity. M2 growth was more subdued than a rise in both private and public debt (Chart I-9). We suspect that M2 is no longer an encompassing measure of broad money in China, and therefore we have calculated other measures of broad money to gauge true money/credit creation. Chart I-10China: Consumer Price Inflation Is Rising Broad money consists of various liabilities of commercial banks. While the official M2 includes many of their liabilities such as corporate demand deposits, corporate time deposits and personal deposits. It does not include some others. We have added the following commercial banks' liabilities - transferable deposits and other deposits which are not included in M2, liabilities to other financial corporations and other liabilities - to M2 to produce a more all-inclusive measure of broad money M3. Q: Why can't the Chinese authorities stimulate and revive growth again, like they have done many times in the past? A: Of course, they can. However, if the authorities begin easing monetary/credit and fiscal policies now, it will affect growth six to nine months down the road. Based on money and credit indicators shown in the charts above, growth is set to slow over the next nine months because of the time lag that money/credit has on the economy. In the next six to nine months, economic activity and corporate profits are likely to decelerate considerably, based on the monetary/credit tightening that has already occurred in China. Provided China-related financial markets in general and EM risk assets in particular have so far not discounted the slowdown suggested by China's money/credit indicators, they are very vulnerable. Finally, the magnitude of the impending growth slump is likely to be large, as evidenced by the substantial decline in these money and credit indicators that has already occurred. In brief, policymakers have been tightening credit/money creation, and it has not yet impacted financial markets. Furthermore, inflation is rising in China (Chart I-10) and policymakers are unlikely to start easing before they witness a major growth slump. Until the latter becomes visible in economic data and on the ground, financial markets leveraged to mainland growth will sell off notably. Q: There is no indication that the Federal Reserve will turn hawkish. This will be especially true if global growth slows - as you argue it will because of China. Why do you expect the EM currency rally to peter out amid a dovish Fed? Historical empirical evidence suggests that EM currencies are often driven by commodities prices, not the interest rate differential over U.S. rates. Let's take the BRL and the ZAR as examples. Charts I-11A and Chart I-11B illustrate that the BRL and ZAR exchange rates versus the U.S. dollar have historically been closely correlated with commodities prices, not the level of or change in their interest rate differential over the U.S. Chart I-11ABrazil: What Drives The Currency? Chart I-11BSouth Africa: What Drives The Currency? This has also been true over the past 18 months. The rally in EM currencies since early 2016 can be largely attributed to the rise in commodities prices. As and when commodities prices roll over - as we expect to occur - the trade balances of commodities-producing nations will deteriorate, as will their currencies. Remarkably, there are tentative signs that the drop in U.S. bond yields and the greenback's depreciation are late and overdone. Two-year U.S. bond yields have bounced from their 200-day moving average (please refer to the middle panel of Chart II-1 in the Mexican section). Typically, such a technical profile leads to new highs. Our sense is that U.S. bond yields will rebound in the coming months, which will also weigh on EM currencies. Importantly, one of the drivers behind the U.S. dollar selloff since early this year has been the rise in banks' excess reserves at the Fed (Chart I-12). The latter was due to the debt ceiling, as the U.S. Treasury was running down its account at the Fed by issuing less paper. In short, since the beginning of this year the U.S. Treasury did not issue bonds/bills and deposit them at its Treasury General Account (TGA) at the Fed - meaning it was not destroying banking system reserves as it typically does. This boosted the supply of U.S. dollars - banks' excess reserves at the Fed rose by US$ 300 billion. More dollar supply depressed both the exchange rate and U.S. interest rates. Chart I-12 demonstrates that in the post-QE era, banks' excess reserves at the Fed have correlated with the U.S. dollar's exchange rate. The debt ceiling has been resolved for now, and the Treasury will now begin accumulating dollars in its TGA account again. It has already announced that its TGA will rise from $73 billion now to $400 billion at the end of this year. The Treasury will issue more paper, and deposit U.S. dollars in the TGA. This will shrink banks' excesses reserves. This, in tandem with the reduction in the Fed's balance sheet, will diminish banks' excess reserves. The latter will reduce U.S. dollar supply in off-shore markets and will likely trigger a U.S. dollar rebound. On the whole, the two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields - are set to reverse. In turn, a potential EM currency selloff along with deteriorating EM corporate profits will likely weigh on EM equities and EM sovereign and corporate debt. Q: Does this mean EM stocks will relapse in absolute terms, or simply underperform the DM equity markets? Our strongest conviction at the moment is on EM relative equity performance versus DM equity markets. Odds are that a relapse in relative performance is imminent as and if U.S. bond yields rise (Chart I-13). Chart I-12U.S. Banks' Excess Reserves ##br##And The U.S. Dollar Chart I-13U.S. Stocks Outperform EM Ones When ##br##U.S. Bond Yields Are Rising In addition, U.S. stocks' underperformance versus the global equity index in common currency terms is at a technical support (Chart I-14, top panel), and will likely reverse as the dollar firms up. Historically, when U.S. stocks outperform the global benchmark in common currency terms - denoted by shaded periods in Chart I-14, EM stocks typically underperform the global equity index. The dynamics of EM equity absolute performance depends on investor's risk appetite. It will be hard for EM share prices to drop meaningfully as the DM rally persists. Global stocks are still trading well, and it is very difficult to pinpoint any trigger that will lead to a reversal. As our readers well know, we do not forecast triggers for the simple reason that the chances of getting it right are much lower than a coin toss. That said, in the medium term, the reason for a correction in DM stocks could well be EM/China growth, as it was in 2015. In such a scenario, EM risk assets will sell off first. As to timing, it is hard to find indicators that lead share prices, but aggregate EM narrow (M1) money growth has historically been coincident or leading with EM share prices - and it presently points to a considerable drop in EM equity prices (Chart I-15). This EM M1 aggregate is equity market-cap weighted making it relevant to investors. Chart I-14EM And U.S. Equites Typically Do Not Outperform Global Stocks Simultaneously Chart I-15EM M1 Growth And EM Share Prices Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com A New Trade: Receive Mexican / Pay U.S. 2-Year Swap Rates Mexico's 2-year bond yield has recently fallen through a technical support line while the U.S. 2-year bond yield has recently bounced off a major support level (Chart II-1). Our bias is that the 2-year yield in Mexico will fall relative to 2-year U.S. yield (Chart II-1, bottom panel). We recommend a new trade: receive 2-year swap rates in Mexico and pay U.S. 2-year swap rates. Historically, the domestic demand cycle in Mexico was synchronized with the business cycle in the U.S., mainly due to the fact these two economies are heavily integrated. However, the two economies have recently become desynchronized. This is evident by the fact that the Mexican export sector - which is leveraged to U.S. - is booming while the domestic demand in Mexico is slowing down (Chart II-2). Chart II-12-Year Bond Yields: Mexico And U.S. Chart II-2Divergence Within Mexican Economy The culprit behind this desynchronization is the previous collapse in the peso. Falling oil prices and excessive money/credit expansion in Mexico led to a major peso depreciation in 2014 and 2015. The election of Trump pushed it off the cliff in 2016. Inflation in Mexico spiked due to the massive currency depreciation. Consequently, the Mexican central bank has hiked interest rates by 400 basis points since the end of 2015. This, along with fiscal tightening, has choked domestic demand growth in Mexico. At this point, our bias is that the short-term interest rate differential between Mexico and the U.S. is unjustifiably wide and is about to narrow. Going forward, we expect inflation to fall in Mexico and interest rate expectations will at minimum not rise. Inflation in Mexico will roll over soon and moderate because of the following: A large part of the rise in inflation was caused by the depreciation in the peso. The peso's material appreciation this year will reduce the inflation rate (Chart II-3). Consumer spending and capital expenditure are set to continue slumping as the impact of higher interest rates continues filtering through the economy (Chart II-4, top and bottom panel). Chart II-3Mexico: Exchange Rate And Core Inflation Chart II-4Mexico: Domestic Demand To Disappoint Further Domestic vehicle sales are shrinking signifying no revival in interest rate-dependent sectors. Fiscal policy has been tightening and this will continue to be a headwind on economic growth (Chart II-5). Hence, despite flourishing exports to the U.S., very weak domestic demand will dampen inflation in Mexico. Finally, there were several one-off effects to inflation such as the gasoline subsidy removal that took place at the end of last year, and the minimum wage hike that was implemented at the beginning of the year. As the base effect of these fade, the inflation rate will moderate. In the U.S., our bias is that interest rate expectations are too low given the tight labor market, reasonably strong growth, and the U.S. dollar depreciation this year. Odds are that the U.S. interest rate expectations will rise as core inflation moves up (Chart II-6). Chart II-5Mexico: A Major Improvement In Fiscal Position Chart II-6U.S. Core Inflation To Rise Investment Recommendations We recommend fixed-income traders to receive Mexican / pay U.S. 2-year swap rates. The main risk to this trade lies in the event of an abrupt sell-off in the peso against the U.S dollar that could push up the 2-year swap rate differential. While we expect EM currencies, including the peso, to depreciate, this trade is still favorable in terms of risk-reward because of the starting point in interest rate differential and peso valuations: Despite the rally this year, the peso is still cheap (Chart II-7). Furthermore, its current account and fiscal balances have improved dramatically. So, the peso should depreciate less than many other EM currencies. Chart II-7The MXN Is Still Cheap In fact, the interest rate spread between Mexico and the U.S. is already historically high, and the peso depreciation might not push it much higher. We would not be recommending this trade if the peso was fairly or overvalued, or if interest rates in Mexico were not this high. Entering this position under these current circumstances reduces the downside risk and, therefore, makes the risk-reward attractive. As to Mexican financial markets in general, we remain constructive on the peso versus other EM currencies. More specifically, we continue to recommend long positions in MXN versus ZAR and BRL. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Finally, the outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Within an EM equity portfolio we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Portfolio Strategy The S&P hotels, resorts and cruise lines index will suffer from a profit margin squeeze, which should weigh on valuations. Cut exposure to underweight. A cyclical capex recovery is a boon for software outlays and coupled with reviving animal spirits, signal that it no longer pays to underweight the S&P software index. Augment positions to a benchmark allocation. Recent Changes Downgrade the defensive/cyclical portfolio bias to neutral. Downgrade the S&P hotels, resorts and cruise lines index to underweight today. Lift the S&P software index to neutral. Table 1 Feature Chart 1Weak Dollar Positive Contributor##br## To EPS Growth Equities broke out in a bullish fashion last week, as geopolitical fears subsided and the backlash from hurricane Irma was less severe than initially feared. Beneath the surface, non-inflationary synchronized global growth remains the dominant macro theme. While the latest U.S. CPI print was better than anticipated the Fed would have to see a couple more perky inflation reports before an uptrend is established, cementing the December hike. Until then, the path of least resistance is higher for equities. In our last Weekly Report, we noted that our four-factor S&P 500 operating EPS model has recently accelerated.1 This week, Chart 1 isolates the U.S. dollar as the sole regression variable on SPX earnings and the fitted value suggests that profits will likely surprise to the upside in the back half of the year despite difficult comparisons. Importantly, as we posited earlier this summer, irrespective of where the trade-weighted U.S. dollar ends the year, delayed FX translation effects will act as a tonic for S&P 500 profits. Since late-December's peak, the broad trade-weighted dollar has deflated by 9%. Regression analysis shows that a 1% fall in the U.S. dollar boosts operating EPS by 0.98%, with our dataset going back to the early 1970s. If, however, we narrow the interval of estimation starting in 1994 when NAFTA come into effect then the greenback's sensitivity on SPX EPS increases to 1.6%. While every cycle is different, a fresh all-time high in quarterly EPS - driven by a weak dollar - would not surprise us in Q3 and Q4. At some point, the deflating currency should show up in selling price inflation, again as a lagged effect (middle panel, Chart 2). This is encouraging for our firming operating leverage thesis, as a modest inflationary backdrop would reinforce top line growth (bottom panel, Chart 2). The implication of a sustainable revenue growth outlook is a profit margin-led flow through to EPS, especially for high fixed cost businesses. Already, sell side analysts' overall S&P 500 net earnings revisions are benefitting from the U.S. dollar's decline, and so is sector EPS breadth (trade-weighted dollar shown inverted, Chart 3). Chart 2Will The Dollar's Fall Show Up In Inflation? Chart 3EPS Breadth Improvement Moreover, U.S. dollar-based liquidity (defined as the sum of the Fed's balance sheet and foreign central bank U.S. Treasury holdings) has finally arrested its fall and has recently ticked higher above the zero line. This even mild increase in U.S. dollar-based liquidity represents a de facto easing in global monetary conditions, and historically has been synonymous with S&P 500 EPS acceleration (Chart 4). The upshot is that profits are on a solid upward trajectory. Chart 4Dollar Based Liquidity Also On The Rise The equity market's sensitivity to the greenback has been increasing as the percentage of foreign sourced earnings has been rising over the decades. Globally-exposed goods-producers are in the driver's seat. This raises the question: what to do with our long held preference for defensives versus cyclicals? We are taking our cue from the U.S. dollar-induced shifting macro backdrop, and locking in gains of 11% since the mid-2014 inception in our defensive over cyclical sector tilt, and moving to the sidelines. As a reminder, since the beginning of the spring we have been tweaking our portfolio adding cyclical exposure and, at the margin, removing defensive protection.2 Thus, a defensive over cyclical sector preference is no longer in place. Synchronized global growth, reviving emerging markets, a stable China, and a deflating U.S. dollar are all giving us confidence that it no longer pays to play defense (Chart 5). Finally, following a sling shot recovery, relative valuations are on a more even keel, as is our relative Technical Indicator which is hovering in the neutral zone (Chart 6). Chart 5Book Gains And Move##br## To Neutral Chart 6Valuations And Technicals##br## In The Neutral Zone This week we are making an early cyclical downshift and deep cyclical upshift to our portfolio. Hotels Update: Check Out Time This year has been a good one to be overweight the S&P hotels, resorts and cruise lines index which has outperformed the S&P 500 by a wide margin. However, earnings expectations have moved broadly in line with the market in 2017, meaning that the index's outperformance has been entirely valuation multiple driven. Normalizing earnings to smooth out profit volatility reveals a more severe picture with valuation multiples at decade highs, above the historical mean and at a 40% premium to the broad market (Chart 7). The index's strength has been most pronounced since the beginning of the summer and, unsurprisingly given the cyclical rotation into highly discretionary stocks, has been exclusive to the cruise line operator segment of the index. The two relevant stocks (RCL and CCL) now represent nearly half of the S&P hotels, resorts and cruise lines index's market capitalization. Cruise line operators' margins have climbed to 10-year highs (top panel, Chart 8), justifying soaring stock prices. Profit gains have come on the back of healthy unit revenue as unit costs have remained mostly unchanged (third panel, Chart 8). Chart 7Very Expensive Beneath The Surface Chart 8Cruise Lines Leading The Pack Cruise line occupancy rates corroborate this firm demand backdrop. They have risen in line with margin gains (second panel, Chart 8), a result of improving passenger growth and constrained capacity (bottom panel, Chart 8). This has been the industry's largest margin lever, i.e.: incremental passengers per room come with much higher incremental margin. As cruise lines cannot increase their occupancy ad infinitum (occupancy rates above 100% already imply more than two occupants of a double-occupancy berth), further margin gains of this magnitude seem doubtful. In fact, if cruise operators are to continue growing profits, a capacity growth cycle will eventually have to begin anew, meaning margin contraction rather than expansion. Thus, extrapolating profit growth far into the future is fraught with danger, warning that sky-high valuation multiples are vulnerable to even a modest de-rating. The outlook is even less bright for hotels, an industry that has been losing its share of the consumer's wallet for some time (Chart 9, second panel). Specifically, the low/non-corporate end of the market seems increasingly exposed to competition from Airbnb and other room share competitors; cutthroat competition is pricing power negative with industry selling prices sinking into outright deflation (Chart 9, third panel). Hoteliers are trying to compensate for low prices with huge capacity additions, adding a sense of permanence to recent pricing power declines. However, just as pricing has fallen, the accommodation related employment cost index has gone vertical (bottom panel, Chart 9). The implication of soft pricing power and a rising wage bill is a profit letdown. Our newly introduced S&P hotels, resorts and cruise lines EPS model (comprising the U.S. dollar, employment, PCE and confidence measures) does an excellent job encompassing all these moving parts and confirms our bearish industry profit stance. In fact, it is pointing to significant relative declines vis-à-vis the S&P 500 (Chart 10). Chart 9Mind The Deflationary Impulse Chart 10EPS Model Says Rush For The Exits Putting it together, shrinking margins and increased capital deployment mean lower return on capital and hence lower valuation multiples. This implies that the index's relative gains are in the past. Bottom Line: Take some chips off the table and reduce exposure to underweight in the S&P hotels, resorts and cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, HLT, WYN. Software: A Capex Upcycle Winner? Software stock relative performance has returned to its long-term uptrend, but remains far from the two standard deviations above-the-mean peak reached during the tech bubble (top panel, Chart 11). The structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Traditional hardware tech sectors, like communications equipment, are also suffering from the "virtualization" threat as software is making inroads into hardware and blurring the lines between the two. Beyond this constructive backdrop, cyclical forces are also painting a brighter picture for software equities. Importantly, there is tentative evidence that a fresh capex upcycle has commenced (see Chart 3 from last Monday's Weekly Report 3), and if software commands a larger slice of the overall spending pie, industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (third & fourth panels, Chart 11). Reviving animal spirits also suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments (second panel, Chart 12). It has also rekindled software M&A activity, with the number of industry deals jumping in recent months (bottom panel, Chart 13). Chart 11Back To Trend Chart 12Capex Upcycle... Chart 13... And Reviving Animal Spirits Are Key Drivers Supply reduction presents a bullish backdrop for software selling prices that have exited deflation at a time when overall corporate sector inflation is decelerating. The upshot is that revenue growth will likely reaccelerate (middle panel, Chart 14). But before getting too carried away, there is some cause for concern. The S&P software index is priced to perfection fully reflecting most, if not all, of the positive drivers (bottom panel, Chart 14), warning that any sales/profit mishaps will likely knock relative performance over. Moreover, productivity dynamics are waving a yellow flag. Business sector productivity growth troughed in early 2017. Historically, this output per hour worked metric has been inversely correlated with software outlays (productivity shown inverted, third panel Chart 15). Importantly, even shown as a deviation from the long-term trend, productivity gains have troughed, suggesting that relative profit growth will likely remain muted (productivity shown inverted, bottom panel Chart 15). Keep in mind that, historically, software spending has been countercyclical (second panel, Chart 15) and given that we are not at the end of the line yet, relative outlays on software may not rebound to the same extent as our other aforementioned indicators suggest. Chart 14Impressive Pricing Power, ##br##But Fully Priced Chart 15Productivity Dynamics##br## Are A Sizable Offset Adding it up, enticing structural software forces aside, a cyclical capex recovery is a boon for software outlays and, coupled with reviving animal spirits, signal that it no longer pays to underweight this tech sub-sector. Bottom Line: The S&P software index does not deserve an underweight. Lift exposure to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, EA, INTU, ADSK, SYMC, RHT, SNPS, CTXS, ANSS, CA. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see Chart 5 of the U.S. Equity Strategy Report titled "Still Goldilocks", on September 11, 2017, available at uses.bcaresearch.com. 2 Please see the August 14, 2017 U.S. Equity Strategy Report titled "Three Risks" for a quick recap of most of our portfolio moves, available at uses.bcaresearch.com. 3 Please see the September 11, 2017 U.S. Equity Strategy Report titled "Still Goldilocks", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights The law of the vital few states that a small number of causes have a disproportionate impact on your overall investment performance. Get the bond yield direction right and your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. Expect the euro area versus U.S. bond yield spread to continue compressing. This means euro area banks will outperform U.S. banks and EUR/USD has cyclical upside. But within a European equity portfolio, banks should be at neutral weight. This implies upgrading Italy's MIB and Spain's IBEX to neutral and downgrading Germany's DAX to underweight. Feature "Less is more, and usually more effective" - Nassim Taleb The law of the vital few states that a small number of causes usually have a disproportionate impact on any overall result. Familiar examples of the law - also known as the Pareto principle or the 80/20 rule - are that a minority of bugs cause a majority of software problems; and that the top few salespeople in any company tend to be responsible for most of its sales. With investment research costs now coming under intense scrutiny, the law of the vital few has become highly significant for the investment management industry too. Every day, investors are bombarded with a seemingly endless stream of research, email alerts and newsfeeds. Yet most of the hundreds of choices that investors have to make reduce to getting just a handful of fundamental decisions right. We call this investment reductionism. The message from investment reductionism is to identify the few decisions that really matter, and to focus your time, effort and resources on these vital few rather than the trivial many. Because the vital few will have a disproportionate impact on hundreds of positions across different asset-classes in your investment portfolio. Bond Yields Are One Of The Vital Few Right now, one of the vital few decisions is the direction of high-quality government bond yields. Get bond yields right absolutely and relatively and you will get at least four investment decisions for the price of one. Not only will you get fixed income right, but your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. In the most recent mini-cycle, the bond yield has driven the bank equity sector's relative performance almost tick for tick both in Europe (Chart I-2) and globally (Chart of the Week). There are two reasons. Higher bond yields fatten banks' net interest margins. They also signal an improving growth outlook and thereby a reduction in bad debts. Lower bond yields imply the exact opposite. Chart of the WeekGet Bond Yields Right And You"ll ##br##Get Banks Right Too Chart I-2Get Bond Yields Right And You"ll ##br##Get Banks Right Too In turn, the bank sector's relative performance has a major influence on equity country allocation. Investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-3 and Chart I-4) Which itself reduces to: will bond yields head higher? The bond yield - relative to those in other economies - is also a major driver of the exchange rate (Chart I-5). As we detailed in Who's Afraid Of A Stronger Euro?1 the transmission mechanism is the so-called fixed income portfolio channel. In a nutshell, a higher bond yield in one jurisdiction relative to others attracts international fixed income portfolio flows into that jurisdiction, pushing up its currency - until a new higher level of the currency repels any further bond inflows. Chart I-3Get Banks Right And You"ll ##br##Get Italy Right Too Chart I-4Get Banks Right And You"ll ##br##Get Spain Right Too Chart I-5Get Bond Relative Performance Right And##br## You"ll Get EUR/USD Right Too Follow Your High Convictions Still, it is impossible to have a high-conviction view on a macro call at all times. A golden rule of investing is to have a big position only where and when you have a high-conviction view. Chart I-6When Unemployment Is Plunging, Real Wage ##br##Inflation Should Be Rising, But It Isn"t At the moment, our high-conviction view on bond yields is a relative view. Specifically, the euro area versus U.S. yield shortfall will continue to compress one way or another. This is because the polarisation of monetary policy expectations in the euro area relative to the U.S. remains at odds with growth and inflation data that have been, are, and will continue to be near-identical. Using investment reductionism, a high-conviction view that the euro area versus U.S. yield spread will compress necessarily means overweighting European banks versus U.S. banks. And it means staying cyclically long EUR/USD. On the absolute direction of bond yields we have less conviction. On the one hand, major economies are growing well and unemployment rates are coming down. Yet as we explained in Why Robots Will Kill Middle Incomes,2 the current wave of technological progress is especially disinflationary for wages, and one of the reasons why the Phillips curve relationship between unemployment and wage inflation isn't working (Chart I-6). Even the Federal Reserve Bank of Philadelphia, in a recent research paper,3 "finds no evidence for relying on the Phillips curve". The upshot is that we are cyclically neutral on bonds, but structurally positive. Using investment reductionism again, a cyclically neutral stance on bonds necessarily means a cyclically neutral weighting to European banks versus other European sectors. In turn, this means a cyclically neutral weighting to Italy's MIB and Spain's IBEX versus the Eurostoxx600. Sector Skews Are One Of The Vital Few To reiterate, the key consideration for European equity country allocation is always: how to allocate to the vital few sectors that feature most often in the skews: in addition to Banks, this means Healthcare, Energy and Materials (Box I-1 and Appendix). Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Within a European equity portfolio, our cyclical stance to Banks is neutral. Healthcare's cyclical relative performance reduces to its defensiveness and low beta. This means that Healthcare tends to underperform in a strongly advancing market. But it tends to outperform when the market is doing no better than advancing weakly (Chart I-7). As this is our central expectation, our cyclical stance is to remain overweight Healthcare. Chart I-7Healthcare"s Cyclical Relative Performance Reduces To Its Defensiveness And Low Beta Regarding Energy, Materials (and Industrials), euro area equity markets with a large exposure to these export-heavy sectors will be under pressure, given our cyclical view on the euro. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. Hence, underweight these sectors. Finally, to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown above. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Italy, Spain, and Netherlands. Underweight: Germany, Sweden and Norway. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3, 2017 and available at eis.bcaresearch.com 2 Published on August 10 and available at eis.bcaresearch.com 3 https://www.philadelphiafed.org/-/media/research-and-data/publications/… Chart Appendix Chart I-8Germany (DAX) Is Overweight Chemicals, ##br##Underweight Banks Chart I-9France (CAC) Is Underweight Banks ##br##And Basic Materials Chart I-10Italy (MIB) Is Overweight Banks Chart I-11Spain (IBEX) Is Overweight Banks Chart I-12Netherlands (AEX) Is Overweight Technology, ##br##Underweight Banks Chart I-13Ireland (ISEQ) Is Overweight Airlines (Ryanair)##br## Which Is, In Effect, Underweight Energy Chart I-14The U.K. (FTSE100) Is Effectively##br## Underweight The Pound Chart I-15Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Chart I-16Sweden (OMX) Is Overweight ##br##Industrials Chart I-17Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Chart I-18Norway (OBX) Is##br## Overweight Energy Chart I-19The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks Fractal Trading Model* Our model successfully captured the early August technical bounce in USD/CAD, and is signalling another opportunity now. The profit target / stop loss is 2.5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-20 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##Br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Feature The Brazilian economy is finally improving following a devastating depression of about 3 years, where real GDP dropped by a whopping 7.4%. Does the current economic revival warrant a bullish stance on its financial markets? If the global risk-on trade persists among EM risk assets and commodities and there are no domestic political blunders in Brazil, the country's financial markets will continue to rally as economic growth improves. If the EM and commodities rallies wane and an EM risk-off cycle develops, Brazilian risk assets will sell off, regardless of domestic economic recovery. Provided economies around the world have become interconnected, it is often difficult to separate global economic and financial market impact from domestic economic dynamics. Yet, it is possible to do so in Brazil in the latest cycle. Chart I-1 demonstrates that the Brazilian real bottomed with iron ore prices on December 21, 2015 - not with the bottom in the Brazilian economy in early Q1 2017 (Chart I-1, bottom panel). In turn, the currency's rally amid the collapse in domestic demand has led to a material drop in inflation and allowed the central bank to cut interest rates aggressively. The exchange rate is the main variable driving financial markets in many developing countries, including Brazil. In these countries, it is the exchange rate that causes swings in interest rate expectations, not the other way around. Furthermore, other important variables that led to the bottom in iron ore prices and the BRL were the Chinese manufacturing PMI and money growth, both of which bottomed in the second half of 2015 (Chart I-2). Chart 1BRL Correlates With Commodities ##br##Not Domestic Demand Chart 2Chinese Data Led##br## The Bottom In BRL In short, economic recovery arrived much later in Brazil, and so far it has been exceptionally tame and tentative (Chart I-3). Brazil's domestic demand performance has in no way justified the rally in its financial markets since January 2016. If anything, it is the opposite: the domestic economic recovery emerged too late, and has been extremely subdued compared with the sizable gains in share prices. For example, banks' EPS bottomed only in May 2017, while their share prices troughed in January 2016 (Chart I-4). Similarly, Brazil's fiscal outlook and debt profile has continued to deteriorate, even though the country's sovereign spreads have tightened substantially (Chart I-5). Chart 3Brazil: Economic Recovery Is Exceptionally Tame Chart 4Brazil: Bank Share Prices And EPS Chart 5Brazil's Fiscal And Debt Profiles Have Deteriorated Hence, one can safely argue that economic growth and domestic fundamentals were not the basis behind why Brazilian financial markets found a bottom and rallied starting January 2016. Rather, the critical driving force has been commodities prices, China, the U.S. dollar and global risk appetite. This is consistent with the defining features of bull and bear markets: In a bull market, liquidity lifts all boats, and all flaws are overlooked or discharged while minor positives are magnified by the market. In a bear market, even marginal negatives are overblown, and the market punishes severely for minor missteps. In short, global risk assets have been in a genuine bull market since early 2016, and that has overridden Brazil's poor domestic fundamentals. Going forward, we recommend avoiding Brazilian risk assets - not because we do not expect an economic recovery in Brazil to progress, but because our view on China's impact on commodities and the potential U.S. dollar rebound will curb overall risk appetite toward EM. We discussed this EM/China/commodities outlook at length in last week's report.1 Timing a shift in financial market regimes is always a difficult task, but our sense is that a top in EM risk assets will likely occur between now and the end of October, as China's Communist party Congress reiterates its focus on containing financial risk and leverage, as well as the authorities' marginal tolerance for slightly slower growth. Furthermore, our broad money (M3) impulse for China suggests an imminent relapse in Goldman Sach's current economic activity indicator for the mainland economy (Chart I-6). Our assumption is that commodities prices will drop due to potential weakness in China, and that the U.S. dollar and U.S. bond yields are oversold and will recover, respectively. Altogether, these views warrant a cautious stance on EM currencies. The real has historically been correlated with commodities prices, and this positive correlation will likely continue. As and when the Brazilian currency resumes its depreciation, the risk-on trade in Brazilian equities and credit markets will end. As for Brazilian financial markets, a few relationships are worth highlighting: Since early this year, iron ore prices have been inversely correlated with Chinese money market rates (Chart I-7). A possible explanation is that iron ore and other commodities prices trading on Chinese exchanges have been driven by meaningful speculative buying that negatively correlates with borrowing costs on the mainland. Chart 6China's Growth Is Set To Slow Chart 7Iron Ore Prices Are Vulnerable Given the latest relapse in Brazil's nominal GDP growth, the pace of amelioration in private banks' NPL and NPL provisions could stall (Chart I-8). In turn, Brazilian banks' share prices seem to move inversely with the rate of change in private banks' NPL and NPL provisions (Chart I-9A & Chart I-9B). If these relationships hold, we might be close to a peak in Brazilian bank share prices. Chart 8Brazil: Is The Improvement In NPL Cycle Over? Chart 9ABrazil: NPL Cycles and Bank Stocks Chart 9BBrazil: Provisions Cycles And Bank Stocks Finally, the pace of economic recovery will likely disappoint because the Brazilian economy is facing numerous headwinds: High borrowing costs - the real prime lending rate is 12.5% and the policy rate in the real terms is 6.8%, while public banks' lending rates are set to rise due to the TJLP reform that will remove the government budget's subsidy for borrowers. With 50% of outstanding credit being earmarked credit (previously subsidized by the government and provided by public banks), the impact on economic activity will be non-trivial; Lower government spending, as 2018 government expenditure growth cannot exceed the 2017 June headline inflation rate of 3%. Besides, the fiscal balance is so disastrous that risks to taxes are to the upside, not downside. Furthermore, the recently augmented 2017 year-end fiscal primary deficit target of BRL 159 billion is smaller than the deficit of BRL 182 billion for the past 12 months. This entails government spending cuts are likely this year, which will weigh on growth. The Brazilian exchange rate is not cheap. The nation needs a cheaper currency to reflate its economy. Lingering political uncertainty amid the corruption scandals and upcoming presidential elections in fall 2018 will continue to weigh on capital spending and employment, which have not yet recovered. Bottom Line: Our overarching negative view on EM, China and commodities heralds staying cautious on Brazil's financial markets despite the early signs of domestic economic recovery. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Copper Versus Money/Credit In China - Which One Is Right?", dated September 6,. Equity Recommendations Fixed-Income, Credit And Currency Recommendations