Fixed Income
Highlights A weak dollar and low bond yields have pushed up the S&P 500 more than anticipated. Cyclical forces favor loftier stock prices in 12 months. Froth creates short-term vulnerabilities that higher yields could catalyze. The lack of yield curve control along with an improving economic outlook and a decline in deflationary risks indicate that Treasury yields will move toward 1% in the coming months. Long-term investors should begin to add small-cap stocks to their core US holdings. Feature The S&P 500 recent all-time high flies in the face of a long list of tactical indicators that flag an elevated risk of correction. The strength of the US equity market is a testament to the power of policy stimulus, the perceived invincibility of tech titans and the hopes that the powerful economic recovery will continue. Although equities will climb in the coming year, a move up in yields should transfer the leadership from tech and growth stocks to value and traditional cyclicals. While these shifts usually do not spell the end of bull runs, often they generate periods of elevated volatility, especially when the displaced leaders account for 40% of market capitalization. Small-cap stocks look increasingly attractive. A Post Mortem We have been cyclically bullish since late March,1 but on June 25th we warned that the S&P 500 would churn between 2800 and 3200 for the rest of the summer.2 This view did not materialize for several reasons. We underestimated the impact of a weak dollar, which has given a second life to the equity bull market. When expressed in euros, the S&P 500 has been flat since June 5 (Chart I-1). Relative to gold, the S&P 500 is down by 9% since June 8, which further highlights how equities have been supported by a weak US currency and a plentiful money supply. Meanwhile, the S&P 500 has outperformed the EURO STOXX 50 by 7.8% since June 5; however, when we factor in the effect of the strong euro, US equities have steadily underperformed the Eurozone benchmark since early May (Chart I-1, bottom panel). Low bond yields have also buttressed US equities. Near-zero interest rates have allowed the valuation of growth stocks to hit extraordinary levels. The NASDAQ trades at 32-times 2020 earnings and 27-times 2021 EPS. The S&P tech is valued at 29-times 2020 EPS and 25-times next year’s profits. In the most extreme cases, the five tech stocks that have accounted for 31.7% of market gains since March 23 (Apple, Amazon, Microsoft, Alphabet and Facebook) trade on average at 40-times 2020 EPS and 32-times 2021 earnings. Low bond yields have also buttressed US equities. Importantly, COVID-19 has had a positive influence on these same tech stocks. According to our European Investment Strategy colleagues, while spending on restaurant, entertainment and retail collapsed during the pandemic, outlays surged on Amazon, Apple products, Netflix subscriptions, etc.3 At the apex of the crisis, online retail sales expanded by 26.3% annually in the US, while bricks-and-mortar sales contracted by an unprecedented -17.7%. Meanwhile, global shipments of personal computers and servers are expanding by 11.2% and 21.5% annually, respectively (Chart I-2, top panel). Therefore, the largest sector of the S&P 500 is outperforming relative to the rest of the market (Chat I-2, bottom panel). As long as investors continue to expect COVID-19 to affect consumer behavior, they will pay a premium for tech stocks that benefit from the pandemic. Chart I-1The Weak Dollar Is Fueling The Recent Rally Chart I-2Earnings Have Supported Tech Stocks Can Stocks Remain Unscathed? The outlook for stocks is positive, but near-term risks have not dissipated because short-term market conditions remain frothy. Watch for higher bond yields as the force to concretize the tactical risks. The following cyclical forces continue to act as crucial tailwinds for equities: The equity risk premium (ERP) remains low. Computations of ERP must factor in the expected expansion of earnings. To incorporate this alteration, we assume that long-term cash flows will grow in line with potential nominal GDP growth. However, we must also consider the absence of stability of the ERP’s mean. After this adjustment, the ERP is still consistent with significant additional gains for the S&P 500 (Chart I-3). Monetary policy is extraordinarily accommodative. Even when we account for the S&P 500’s elevated multiples, the exceptional jump in the BCA Monetary Indicator is large enough to push up equity prices (Chart I-4). Moreover, the strength of US housing activity indicators confirms that the Federal Reserve has pulled the right levers to boost domestic economic activity. For example, the NAHB Housing Market Index has reached a 22-year record, building permits in July grew at their fastest monthly rate in 30 years, and the Mortgage Applications Index for purchases rocketed to a 11-year high in August. Chart I-3A Low ERP Underpins Equities... Chart I-4...So Does Monetary Policy The US economy continues to heal. For stocks to climb further on a cyclical basis, the market will need more than five tech giants leading the charge. Hence, earnings expectations for the rest of the market must also mount. Practically, the economy must recover its output loss and the pandemic must ebb. For now, the four-week moving average of initial unemployment claims is drifting lower, and the ISM New Orders-to-Inventories spread is consistent with a faster and more solid business cycle upswing. The ERP is still consistent with significant additional gains for the S&P 500. The global industrial sector outlook is brightening. Manufacturing and trade disproportionately contribute to fluctuations in global economic activity, therefore, they exert an outsized influence on the earnings of non-tech multinationals. The strength in Singapore’s electronics shipments indicates that our Global Industrial Activity Nowcast will accelerate (Chart I-5, top panel). Moreover, the rapid expansion in China’s credit flows points to a marked increase in Chinese imports, which will help industrial and commodity exporters around the world (Chart I-5, bottom panel). Core producer prices have bottomed. Core producer prices are a direct input in the corporate sector’s pricing power. A trough in this inflation gauge leads to stronger EPS and widening profit margins for the S&P 500 (Chart I-6). Chart I-5The Global Industrial Cycle Is Turning The Corner Chart I-6Easing Deflationary Pressures Will Help Profits Investors should still wait to allocate new funds to the stock market. The stock market’s near-term outlook remains marked by short-term froth that dampens our cyclical optimism, especially because the market advance has been concentrated in a small group of equities. Chart I-7Tactical Froth The Exposure Index of the National Association of Active Investment Managers has hit 100.1 (Chart I-7). Such a lofty reading indicates that the price of stocks already incorporates optimistic expectations. From a contrarian perspective, this development boosts the probability that swing traders will face disappointments in the near future and will sell their equity holdings. Similarly, the put/call ratio is near a 10-year low, which confirms that traders have bought a lot of upside exposure to stocks without much protection against a pullback. This level of confidence is often a precursor to a significant correction. Finally, our Tactical Strength Indicator is 1.7-sigma above its mean. Historically, when this risk gauge has hit a reading above 1.3, there is a good probability that the S&P 500 will correct or move sideways (Chart I-8). A catalyst must emerge for those aforementioned vulnerabilities to morph into a correction. If Treasury yields move closer to 1%, then stocks will experience a significant pullback of 10% or more as the market rotates away from the leadership of growth stocks. This risk would be especially salient if real yields move up. As Chart I-9 illustrates, falling TIPS yields have been a pillar of the powerful rally of growth stocks. Moreover, low real yields are arithmetically necessary to justify the current level of market multiples exhibited by the S&P 500 (Chart I-9, bottom panel). Chart I-8The S&P 500 Is Vulnerable To A Correction Chart I-9Falling Real Yields Have Helped Growth Stocks Growth and high-P/E ratio stocks are heavily represented in the tech and healthcare sectors, which together account for 42% of the S&P 500. This means that higher yields will likely temporarily drag down the entire market. Ultimately, leadership changes are painful events, but they rarely mark the end of bull markets. Can Yields Move Up? Chart I-10Positive Signs For Inflation It is time to tweak our bond market view because yields should soon move higher. For the past five months, we have written that yields offer minimal downside and that their asymmetric risk profile made government bonds an unappealing investment. We underweighted this asset class relative to stocks and recommended investors bet on higher inflation breakeven rates. However, forces are aligning to expect real rates to rise and thus, nominal yields should move up. The sequencing of the market’s response to QE increasingly favors lower bond prices. Our US Equity Strategy team recently highlighted that in 2009 stocks were the first asset to reflect the implementation of QE1 by the Fed.4 A weaker dollar followed. Bond yields started to perk up only after the USD deteriorated by enough, after stock prices had climbed by enough and after corporate spreads had narrowed by enough to ease financial conditions to stimulate the economy. So far, 2020 echoes the 2009 pattern and our Financial Conditions Index is more stimulatory than it was prior to the COVID-19 outbreak (see Chart III-36 in Section III). Chart I-11Commodities Point To Higher Yields... Inflation momentum confirms the risks to bonds. The apex of the deflationary shock has already passed. In July, core CPI excluding shelter rose by 0.84% month-on-month, which was the highest reading since 1981 when the Fed was combating the most violent inflation outbreak in generations. The upturn in core producer prices also warns that the annual inflation rate of core CPI should accelerate meaningfully by early 2021 (Chart I-10). The dollar’s weakness is another inflationary force. Import prices from China have already bottomed, which points to an escalation in goods inflation in the coming months. Firming commodity prices constitute another risk for yields. Our Commodities Advance/Decline line has recently broken out. This technical development is consistent with higher commodity prices and higher bond yields (Chart I-11). Rallying natural resources are inflationary, but they also indicate that the global economy is strengthening, which should put upward pressure on real interest rates. Strength in the housing sector also confirms that government bond yields have upside. As we highlighted above, a robust housing market is an important validation that monetary policy is very accommodative. By definition, the objective of loose policy is to boost future economic activity and eradicate deflationary pressures. The surge in lumber indicates bond prices are showing downside risk (Chart I-12). Additionally, the upswing in mortgage issuance is occurring as the Treasury and corporations boost their borrowings, which will generate more demand to use savings generated in the economy. The price of those savings will be higher real interest rates. Chart I-12...Especially Lumber The ebbing of COVID-19 also suggests that economic activity has scope to accelerate. Moreover, the House of Representatives reconvened to address the problems plaguing the US Postal Service ahead of the November elections. This early return to work gives Washington another opportunity to negotiate the stimulus bill that it failed to pass earlier this month. We still expect such a bill to ultimately become law because both Democrats and Republicans have too much to lose in November if the economy relapses in response of political paralysis. Declining infections and increased government support will bolster aggregate demand and put upward pressure on rates. The stock market’s near-term outlook remains marked by short-term froth that dampens our cyclical optimism. Market dynamics are also very negative for bonds. Our Valuation Index highlights that Treasurys are incredibly expensive (Chart I-13, top panel). Moreover, our Composite Technical Indicator remains overbought, though it has lost momentum. In this context, the lack of appetite for yield curve control or more QE demonstrated by the Federal Open Market Committee creates a genuine danger for bonds. Without these policies, bond yields will have trouble resisting the upward push created by our rising US Pipeline Inflation Pressures Index, our rebounding Nominal Cyclical Spending proxy (which is an average of the ISM Manufacturing headline index and Prices Paid component), and the uptick in the amount of liquidity sitting on commercial banks’ balance sheets (Chart I-14). Chart I-13Treasurys Are Expensive And Losing Momentum Chart I-14Building Cyclical Risks For Bonds Thus, equities are at risk on a tactical basis because we anticipate that 10-year Treasury yields may climb towards 1%, including a rise in TIPS yields. The US election creates an additional near-term hurdle for stocks. As we wrote last month, President Trump will likely become more belligerent toward the US’s trading partners in the coming months. Moreover, Vice-President Joe Biden, who has a comfortable lead in the polls including in key swing states such as Florida, Michigan, Pennsylvania, and Wisconsin wants to cancel half of the 2017 tax cuts.5 Small Over Big Long-term investors should expect stocks to beat bonds on a 5- to 10-year horizon, but equities will generate paltry real returns compared with the past 40 years. Elevated valuations for US equities are consistent with long-term annualized real rates of return of only 0.5% (Chart I-15). Moreover, the long-term outlook for profit margins is poor. As we wrote three months ago, mounting populism will result in redistributive policies that will lift the share of wages relative to GDP.6 Moreover, the shift of the US population to the left on economic matters will push up corporate tax rates. Increased labor costs and corporate taxes are negative for profit margins. If profit margins normalize, then equities will probably underperform the uninspiring expected returns implied by current market multiples. The surge in lumber indicates bond prices are showing downside risk. Investors can still generate generous returns through geographical and sectoral selection. We have highlighted how value stocks, industrials and materials, and EM and European equities will likely beat US equities.7 This month we will explore how US small-cap equities are also well placed to best the dismal projected real returns offered by their large-cap counterparts. Our BCA Relative Technical Indicator shows that small-cap stocks are 1.8-sigma oversold when compared with the S&P 500, which indicates a capitulation among investors toward these equities. The bifurcation is even greater if we compare small-cap equities with the S&P 100’s mega-caps that have driven up the US market in recent years. Incorporating these influences, our Cyclical Capitalization Indicator has moved in favor of small-cap stocks, which suggests that small-cap stocks will be rerated if the yield curve can steepen further (Chart I-16). Equities are at risk on a tactical basis because we anticipate that 10-year Treasury yields may climb towards 1%. Chart I-15Valuations And Profit Margins Threaten Long-Term Stock Returns Chart I-16Indicators Favor Small Cap Stocks Chart I-17A Debt Turnaround Would Help Small Cap Stocks Debt dynamics could also increasingly beneficial to small-cap equities. In the past few years, the heavy debt-to-EBITDA of smaller firms created a major headwind for small-cap investors. The indebtedness of small-cap stocks often decreases relative to large-caps when an economic recovery begins. This shift in leverage portends an increase in small-caps’ relative future returns (Chart I-17). Our negative bias toward the dollar and our positive view on commodities also benefit small-cap stocks. Since the early 1990s, increasing real commodity prices and a falling Dollar Index have coexisted with a robust performance of small-cap firms (Chart I-18). The negative US balance-of-payment dynamics, coupled with escalating inflation risks, will continue to weigh on the dollar, especially as various large EM nations try to diversify their reserves and payment systems away from the dollar.8 Meanwhile, a declining dollar, expanding global growth, monetary debasement, populism, inflation and a lack of investment in supply, all will accentuate the appeal of natural resources. The sectoral bias of small-cap indices will capitalize on these trends. Chart I-18Small Is Beautiful Chart I-19Small Cap Stocks Like Higher Yields Finally, cyclical timing is also moving in favor of small-cap firms. Since 2014, the Russell 2000 has outperformed the S&P 500 when real yields moved higher (Chart I-19). Small-cap firms display a more marked pro-cyclicality than large firms. Additionally, the S&P 500 growth bias implies that the US large-cap benchmark underperforms the small cap indices when real yields increase. Mathieu Savary Vice President The Bank Credit Analyst August 27, 2020 Next Report: September 24, 2020 II. Global Semiconductor Stocks: A Hiatus Is Overdue In A Structural Bull Market The strength in global semiconductor sales in recent months has been due to one-off factors stemming from pandemic-related lockdowns. As the one-off demand surge subsides, global semiconductor sales will decline modestly toward the end of this year. In the near term, global semiconductor stock prices are vulnerable due to overbought conditions, excessive valuations and demand disappointment. The global semiconductor industry is at the epicenter of the US-China confrontation, and more US restrictions on chips sales to China are probable. This is another risk for this sector's share prices. Nevertheless, the structural outlook for global semiconductor demand is constructive. Its CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024. Investor euphoria has taken hold of semiconductor stocks. Global semiconductor stock prices have skyrocketed by 68% from March lows and 96% from December 2018 lows. Meanwhile, global semiconductor sales during March-June rose only by 5% from a year ago. As a result, the ratio of market cap for global semiconductor stocks relative to global semiconductor sales has reached its highest level since at least the inception of data in 2003 (Chart II-1). Chart II-1Global Semi Sector: Market Cap-To-Sales Ratio Has Surged With semi equity multiples very elevated, their share prices have become even more sensitive to global semiconductor demand growth. Hence, the focus of this report is to try to gauge the strength of global semiconductor demand, both in the near term and structurally. The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. Near-term semiconductor stock prices could disappoint due to weak chip demand from the smartphone sector and diminishing purchases of personal computers (PCs) and servers. However, structurally, we are positive on global semiconductor demand, which is underpinned by the continuing rollout of 5G networks and phones, a wider adoption of data centers, and further technological advancements in artificial intelligence (AI), cloud computing, edge computing and smaller nodes for chip manufacturing (Box II-1). Box II-1 Key Technologies Underpinning Potential Global Semiconductor Demand AI refers to the simulation of human intelligence in machines, for example, computers that play chess and self-driving cars. The goals of AI include learning, reasoning and perception. Cloud computing is the delivery of computing services – including servers, storage, databases, networking, software, analytics and intelligence – over the Internet (“the cloud”) to offer faster innovation, flexible resources and economies of scale. Edge computing is a form of distributed computing, which brings computation and data storage closer to where it is needed, to improve response times and save bandwidth. Technology node refers to the width of line that can be processed with a minimum width in the semiconductor manufacturing industry, such as technology nodes of 10 nanometers (nm), 7nm, 5nm and 3nm. The smaller the nodes are, the more advanced they are. Near-Term Headwinds Semiconductor demand worldwide grew by 6% year-on-year in the first half of this year. There has been a remarkable divergence between world semiconductor sales and the global business cycle (Chart II-2). The divergence between semiconductor sales and economic activity was most striking in the US and China. Semiconductor sales in China rose by 5% year-on-year in Q12020, and in the US they grew by 29% year-on-year in Q22020, despite a contraction in their aggregate demand during the same period. By contrast, Q2 annual growth of semiconductors sales was -2.2% for Japan, -17% for Europe and 1.8% for Asia ex. China and Japan (Chart II-3). Chart II-2World Semi Sales Diverged From The Global Business Cycle Chart II-3Strong Semi Sales In The US And China, But Not Elsewhere The reasons why the US and China posted a surge in semiconductor demand while Europe and Japan experienced a contraction in domestic semiconductor sales are as follows: Most data center investment is occurring in the US and China. Chart II-4 shows that 40% of global hyperscale data centers are operating in the US, much larger than any other countries/regions. China, in turn, ranked second, with a global share of 8%. Chart II-4The US Has The Most Global Hyperscale Data Centers Demand contraction in Europe and Japan is due to semiconductor demand in these regions mainly originating from the automobile sector, where production was severely hit by the global pandemic. About 37% of European semiconductor sales were from last year’s automotive market. We believe the divergence between global economic activity and semiconductor sales, as demonstrated by Chart II-2 on page 3, has been due to one-off factors, as the global pandemic lockdowns have spurred semiconductor demand. Such a one-off demand boost will likely dissipate in the coming months. Traditional PCs and tablets: There has been a surge in demand for traditional PCs9 and tablets in the past six months. This was due to the significant increase in online activities, such as working from home, education, e-commerce, gaming and entertainment. Data from the International Data Corporation (IDC) has revealed that shipments of traditional PCs and tablets in volume terms had a strong year-on-year growth of 11.2% and 18.6%, respectively, in the period of April-June (Chart II-5). Looking forward, even renewed lockdowns will not lead to a similar rush to buy these products. Many households are already equipped to work from home and for other online activities. With many countries gradually opening their economies, such demand will diminish. The traditional PC and tablet sectors together account for about 13% of global chip demand (Chart II-6). Chart II-5Personal Computers Sales Have Surged Amid Lockdowns Server demand: Another major semiconductor demand contribution in Q2020 was from the server sector, which spiked by 21% year-on-year (Chart II-7). The surge in online activities triggered a strong demand for cloud services and remote work applications, both of which require computer servers to run on. Chart II-6The Breakdown Of Global Semiconductor Sales By Type Of Usage However, demand from the server sector is also set to diminish in 2H2020 and Q1 2021. Provided the inventories at major data center operators, including Microsoft, Google and Amazon, remain at high levels,10 global cloud service providers will likely reduce their orders of servers next quarter.11 Enterprises will also likely cut their investment in computer servers in 2H2020, as many of them had already increased their purchases of servers to prepare employees and business processes for remote working. We expect global server demand growth to soften in 2H2020. The Digitimes Research forecasted a 5.6% quarter-on-quarter contraction in 3Q2020 and a further cut in global sever shipment in the 4Q2020.10 The global server sector accounts for about 10% of global chip demand and, together with PCs and tablets, they make for 23% (please refer to Chart II-6 on page 5). Further, the smartphone sector – accounting for 27% of global semiconductor demand – will continue struggling in H2 this year. Chart II-7Server Sales Have Surged Amid Lockdowns Chart II-8Global Smartphone Shipments Will Likely Remain Weak In 2020H2 The global total smartphone demand has been hit severely, as households delayed their new smartphone purchases. According to Canalys’ data, global smartphone shipments dropped by 13% and 14% year-on-year in Q1 and Q2, respectively. We expect smartphone shipments to continue contracting over the next three-to-six months (Chart II-8). We believe global consumers will remain cautious in their spending on discretionary goods, such as smartphones, due to lowered incomes and increased job uncertainty. The IDC also forecasted that global smartphone shipments would not grow until 1Q2021.12 The Chinese smartphone sales showed a considerable weakness in July, with a 35% year-on-year contraction, which is much deeper than the 20% decline in H1 this year. 5G smartphone shipments also slowed last month, with a 21% drop from the previous month. The global semiconductor industry is at the epicenter of the US-China confrontation. Bottom Line: The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. As this one-off demand subsides, global semiconductor sales will decline modestly toward the end of this year. Given the overbought conditions and the elevated equity valuations, global semiconductor stocks are currently vulnerable to near-term disappointments in semiconductor demand. At The Epicenter Of The US-China Rivalry Semiconductors are at the epicenter of the US-China confrontation. Ultimately, the US-China contention is about future technological dominance. That is access to technology and the capability to develop new technologies. China currently accounts for about 35% of the global semiconductor demand. US restrictions on semi producers worldwide to supply semiconductors to Chinese buyers constitute a major risk to semiconductor stock prices. On August 17, the US announced fresh sanctions that restrict all US and foreign semiconductor companies from selling chips developed or produced using US software or technology to Huawei, without first obtaining a license. In May, the US had already limited companies, such as the Taiwan Semiconductor Manufacturing Company (TSMC), from making and supplying Huawei with its self-designed chips. In addition, the US recently threatened bans on Chinese-owned apps TikTok and WeChat, and signaled that it could soon restrict Alibaba’s operations in the US. Chart II-9Global Semi Companies' Sales To China Are Substantial The global semiconductor sector is highly vulnerable to further escalation in the tension between these two superpowers. Major global semiconductor companies’ sales are heavily exposed to China, and their revenue from China ranges from 16% to 50% of total (Chart II-9). We have been puzzled why global semi share prices have been rallying in spite of US limitations on semiconductor shipments to Huawei and its affiliated entities. One explanation could be that the Chinese companies that are not affiliated with Huawei are able to import semiconductors and then supply them to Huawei. If this is true, the US will have no other choice but to limit all semiconductor sales to China. This will be devastating for global semi producers given their large exposure to China. In anticipation of US punitive policies limiting its access to semiconductors, China had boosted its semiconductor imports over the past 12 months (Chart II-10, top panel). Chinese imports of integrated circuits rose by 12% year-on-year in 1H2020, which is much higher than the 5% year-on-year increase in Chinese semiconductor demand during the same period (Chart II-10, bottom panel). This gap suggests the country had restocked its semiconductor inventories. China has particularly restocked its imports of non-memory chips with imports of processor & controller and other non-memory chips in H1, surging by 30% and 20%, respectively, in US dollar terms (Chart II-11). For memory chips, the contraction in Chinese imports was mainly due to a decline in global memory chip prices. Chart II-10China Had Likely Restocked Its Semi Inventories Chart II-11Strong Chinese Imports In Non-Memory Chips Bottom Line: The global semiconductor industry is at the epicenter of the US-China confrontation, and more restrictions on sales to China are probable. In turn, the restocked semiconductor inventory in China raises the odds of weakening mainland semiconductor import demand in H2 of this year. Structural Tailwinds Table II-1Global Semiconductor Demand CAGR Forecast Over 2020-2024 By Device We are optimistic on structural global semiconductor demand. Its nominal CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024 in US dollar terms. Table II-1 shows our demand growth forecasts for global chips in the main consuming sectors over the next five years. The major contributing sectors during 2020-2024 will be 5G smartphones, servers, industrials, electronics and automotive manufacturing. The underlying driving forces are the continuing rollout of 5G networks and phones, the development of data centers, and further technological advancements in AI, cloud computing and edge computing. Currently, the world is still in the early stages of 5G network development. AI, cloud computing and edge computing are constantly evolving. With increasing adoption of 5G smartphones, computer servers and IoT devices, global semiconductor demand is in a structural uptrend (Box II-2). Box II-2 Key Components For The Virtual World In Development Data centers and cloud computing allow data to be stored and applications to be running off-premises and to be accessed remotely through the internet. Edge computing allows data from Internet of things (IoT) devices to be analyzed at the edge of the network before being sent to a data center or cloud. IoT devices contain sensors and mini-computer processors that act on the data collected by the sensors via machine learning. The IoT is a growing system of billions of devices — or things — worldwide that connect to the internet and to each other through wireless networks. AI technology empowers cloud computing, edge computing and IoT devices. 5G is at the heart of the IoT industry transformation, making a world of everything connected possible. Chart II-125G Phone Shipments In China Will Continue To Rise 5G Smartphone Currently, China is the world’s largest 5G-smartphone consumer and the leading 5G-adopter in the world. According to Digitimes Research, global 5G smartphone shipments will reach over 250 million units in 2020, with 170 million (68%) in China and only 80 million units in the world ex. China. Looking forward, 5G smartphone shipments are set to accelerate worldwide over the coming years. The 5G phone shipments in China will continue to rise. The 5G phone sales penetration rate in China is likely to rise from 60% in July to 95% by the end of 2022. In such a case, we estimate that the monthly Chinese 5G phone shipments will increase from the current 16 million units to about 25-30 million units in 2022 (Chart II-12). In the rest of the world, the 5G smartphone adoption pace will also likely speed up over the next five years. The 5G phone selling prices in the world outside China will drop, as more models are introduced and become more affordable. 5G smartphone prices have already fallen in China and will inevitably fall elsewhere. Chinese 5G smartphone producers will ship their low-priced 5G phones overseas, putting pressure on other producers to lower their prices. The 5G infrastructure development is accelerating in China and will accelerate in the rest of the world. Both China and South Korea have been very aggressive in their respective 5G network development. As of the end of June, China's top three carriers: China Mobile, China Unicom, and China Telecom – which together serve more than 1.6 billion mobile users in the country – had installed 400,000 5G base stations against an annual target of 500,000. In comparison, as of April 2020, American carriers had only put up about 10,000 5G base stations.13 As the US is competing with China on the 5G front, the country will likely boost its investment in 5G network development aggressively over the next five years in order to catch up to, or even exceed, China. Importantly, the 5G smartphone has more silicon content than 4G smartphones. More silicon content means higher semiconductor value. Rising 5G smartphone sales and higher silicon content together will more than offset the loss in semiconductor sales due to falling global 4G smartphone shipments. Overall, global semiconductor stock prices have diverged from their sales and profits. Based on our analysis, we expect a CAGR growth of 4% in semiconductor demand from the global smartphone sector over the next five years, slightly lower than the 5% in previous five years (Table II-1 on page 10). This also takes into consideration that the 5G network will be more difficult and more expensive to develop than the 4G network. Servers Global server shipment growth will be highly dependent on both the pace and the scale of data center development (Box II-3). Data centers account for over 60% of global server demand. Box II-3 Data Centers There are four main types of data centers – enterprise data centers, managed services data centers, colocation data centers, and cloud data centers. Data centers can have a wide range of number of servers. Corporate data centers tend to have either 200 (small companies), or 1000 servers (large companies). In comparison, a hyperscale data center usually has a minimum of 5,000 servers linked with an ultra-high speed, high fiber count network. Outsourcing and a move towards the cloud are driving the growth of the hyperscale data center. Instead of companies investing in physical hardware, they can rent server space from a cloud provider to both save their data and reduce costs. Amazon, Microsoft, Google, Apple and Alibaba are all top global cloud service providers. The more hyperscales to be built up, the higher the demand for servers. In 2019, about 13% of the total number of data centers in China were of the hyperscale and large-scale varieties. The plan of new infrastructure development announced earlier this year by Beijing was aiming to increase the number of hyperscale and large-scale data centers in China. Among current data centers either under construction or to be developed in the near future, 36% of them are hyperscale and large-scale data centers. The future growth of data centers is promising. The global trend of data localization14 due to the concerns of data privacy and national security will also bolster a boom of data centers over the next five years. A growing number of countries are adopting data localization requirements, such as China, Russia, Indonesia, Nigeria, Vietnam and some EU countries. While the Chinese data center market is expected to expand by a CAGR of about 28% over 2020-2022,15 a report recently released by Technavio forecasted the global data center industry’s CAGR at over 17% during 2019-2023. We forecast that the global semiconductor demand from servers will grow at a CAGR of 12% over 2020-2024. IoTs Technological advancements in AI, cloud computing and edge computing, in combination with 5G network development, will facilitate the IoTs adoption. According to the GSMA,16 46 operators in 24 markets had launched commercially available 5G networks by 30 January 2020. It forecasted that global IoT connections will be increased from 12 billion mobile devices in 2019 to 25 billion in 2025 with a CAGR at 13%.17 IoTs chips include the Artificial Intelligence of Things (AIoT) – a powerful convergence of AI and the IoT. IoTs is an interconnected network of physical devices. Every device in the IoT is capable of collecting and transferring data through the network. Looking forward, global demand of AI chips and IoT chips will have significant potential to grow with creation of “smarter manufacturing”, “smarter buildings”, “smarter cities”, etc. AI applications can be used in manufacturing processes to render them smarter and more automated. Productivity will be enhanced as machines achieve significantly improved uptime while also reducing labor costs. There are plenty of upsides in industrial semiconductor demand (Chart II-13). We expect the CAGR of industrial electronics to increase from 3.4% during 2014-2019 to 8% during 2020-2024. AI applications can create smart buildings by increasing connectivity across enterprise assets, enabling home network infrastructure (e.g., routers and extenders) and employing home-security devices (e.g., cameras, alarms and locks). AI applications can be used to create smart cities. A smart city is an urban area that uses different types of IoT electronic sensors to collect data. Insights gained from that data are used to manage assets, resources and services efficiently; in return, that data is used improve operations across the city. China has already developed about 750 trial sites of smart cities with different degrees of smartness in the past decade. As AI and 5G technology advances, the existing smart cities’ “smartness” will be upgraded and new trial smart cities will be implemented. Based on IDC data, China’s investment in smart cities will rise at a CAGR of 13.5% over 2020-2023 (Chart II-14). Globally, the U.S., Japan, European countries and other nations are also actively developing smart cities. According to a new study conducted by Grand View Research, the global smart cities market size is expected to grow at a CAGR of 24.7% from 2020 to 2027.18 Chart II-13Plenty Of Upside In Industrial Semi Demand Chart II-14China’s Investment In Smart Cities Will Continue To Grow Automotive We expect the global automotive chip market to grow at a CAGR of 9% during 2020-2024, as in 2014-2019. The increase in consumption of semiconductors by the auto industry will continue to be driven by the market evolution toward autonomous, connected, electric and shared mobility. Most new vehicles now include some level of advanced driver assist systems (ADAS), such as adaptive cruise control, automatic brakes, blind spot monitoring, and parallel parking. The whole industry is progressing toward fully autonomous vehicles in the coming years. Increasing adoption of automotive chips and recovering car sales will revive automotive chip sales. In addition, rising penetration of new energy vehicles (NEVs) is beneficial to semiconductor sales, as NEVs contain higher semiconductor content than conventional vehicles. Conventional vehicles contain an average of a $330 value of semiconductor content while hybrid electric vehicles can contain up to $1,000 and $3,500 worth of semiconductors.19 Regarding other sectors, we are also positive on structural demand of storage and consumer electronics. AI applications generate vast volumes of data — about 80 exabytes per year, which is expected to increase by about tenfold to 845 exabytes by 2025.20 In addition, developers are now using more data in AI and deep learning (DL) training, which also increases storage requirements. With massive potential demand for storage, we estimate a CAGR of 7% over 2020-2024 (Table II-1 on page 10). A recent report from ABI Research predicts that the COVID-19 pandemic will increase global sales of wearables (such as a Fitbit or Apple Watch) by 29% to 30 million shipments of the devices this year. With contribution from wearables, we expect global semiconductor demand from the consumer sector to grow at a CAGR of 3% over 2020-2024, the same rate as in the previous five years. Bottom Line: Continuing rollout of 5G networks and phones, development of data centers, and further technological advancements in AI and cloud computing will provide tailwinds to structural global semiconductor demand, accelerating its CAGR growth from 3% during 2014-2019 to 5% during 2020-2024. Valuations And Investment Conclusions Most global semiconductor stocks are currently over-hyped. Critically, both DRAM and NAND prices have been deflating since January, reflecting weak demand for memory chips. Yet, share prices of memory producers have rallied (Chart II-15). Overall, global semiconductor stock prices have diverged from their sales and profits (Chart II-16). Chart II-15Falling Memory Prices Pose Risk To Memory Stocks Chart II-16Global Semiconductor Stocks Have Deviated From Profits Consequently, the multiples of semiconductor stocks have spiked to multi-year highs (Chart II-17). Even after adjusting for negative US real bond yields, valuations of semiconductor stocks are not cheap. Chart II-18 illustrates the equity risk premium for global semiconductor stocks is at the lower end of its range of the past 10 years. The ERP is calculated as forward earnings yield minus 10-year US TIPS yields. Chart II-17Global Semi Stocks: Elevated Valuations Chart II-18Equity Risk Premium For Global Semi Stocks Is Historically Low It is impossible to time a correction or know what the trigger would be (US-China tensions have been our best guess). Nevertheless, we do not recommend chasing semiconductor stocks higher due to their overstretched technicals and valuations on the one hand and potential weakening demand in H2 on the other. In addition, the ratio of global semi equipment stock prices relative to the semi equity index correlates with absolute share prices of global semi companies. This is because equipment producers are higher-beta as they outperform during growth accelerations and underperform during growth slumps. The basis is that semi manufacturers have to purchase equipment if there is actual strong demand coming up and vice versa. The recent underperformance by global semi equipment stocks relative to the semi equity index might be an early sign of a potential reversal in semi share prices in absolute terms (Chart II-19). Chart II-19A Signal Of A Potential Reversal In Semi Share Prices Meanwhile, we believe the subsector- memory chip stocks - will outperform the overall semiconductor index amidst the potential correction, because they have lagged and are less over-extended. Finally, we remain neutral on Taiwanese and Korean bourses within the EM equity space for now. Escalation in US-China confrontation, as well as their exposure to semiconductors, put these bourses at near-term risk. That said, we are reluctant to underweight these markets because fundamentals in EM outside North Asia remain challenging. Ellen JingYuan He Associate Vice President Emerging Markets Strategy III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, but equities are increasingly vulnerable because short-term sentiment and positioning measures are growing increasingly stretched. Three forces can prompt a correction. First, a rebound in yields toward 1% would cause turbulence for the S&P 500, because the index is dominated by growth stocks that are highly sensitive to fluctuations in the risk-free rate. Second, a dollar bounce would hurt the S&P 500 because a depreciating USD has fueled the US stock market rally since June. Finally, the US presidential election is drawing nearer; hence, the risk of potentially damaging political headlines is growing. Despite these short-term risks, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative and the chance of inflation moving high enough to spook central bankers is minimal in the near future. Additionally, the fiscal spigots are open and governments around the world will ultimately continue to support their economies. Hence, any correction in the S&P 500 is unlikely to move beyond 15% or a level of 2900. Our cyclical indicators confirm the positive backdrop for stocks. While our Valuation Indicator has reached overvalued territory, our Monetary Indicator remains extremely accommodative. Moreover, our Technical Indicator is now flashing a clear buy signal. Putting all those forces together, our Intermediate-Term Indicator continues to support equities. Finally, our Revealed Preference Indicator strongly argues in favor of staying invested in equities. That being said, our Speculation Indicator has surged back up, thus the volatility of the rally should increase. Bonds remain extremely unappealing. Our Bond Valuation Index shows Treasurys as prohibitively expensive and our Composite Technical Indicator continues to lose momentum. So far, government bond yields have managed to remain stable at very low levels even if they have not declined further. Nonetheless, bonds have underperformed equities, which is a trend that will remain in place for many more quarters. Moreover, the pick-up in commodity prices and in various gauges of the business cycle suggests that bond yields should soon move higher, especially because the Fed is far from enthused at the concept of yield curve control. Our Cyclical Bond Indicator has turned higher and will soon flash an outright sell signal. The dollar continues to weaken after its recent breakdown. For now, the USD’s weakness has been concentrated among DM currencies. For the dollar to weaken further, EM currencies must begin to rally more markedly than they have until now, especially in Latin America. The firmness of the CNY is a good sign for the EM complex, but another clear up-leg in global growth must emerge before EM currencies can fully blossom. As a result, we are likely to have entered a temporary period of consolidation for the US dollar. The extremely oversold nature of our Dollar Composite Technical Indicator supports the idea that the dollar needs to digest its recent losses before its poor fundamentals force it lower once again. Finally, commodities have been a prime beneficiary of the weakness in the dollar and the combination of stable yields and improving economic activity. Our Composite Technical Indicator is now well into overbought territory which makes natural resource prices vulnerable to a pullback. A move up in yields as well as a short-term rebound in the dollar will likely catalyze any underlying technical risks to commodities. Gold will be particularly vulnerable to any such pullback, especially if higher real yields are the cause of the correction in natural resource prices. Despite these short-term worries, the outlook for commodities remains bright. As a result, we would use any correction to add exposure to the commodity complex. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst "April 2020," dated March 26, 2020, available at bca.bcaresearch.com 2 Please see The Bank Credit Analyst "July 2020," dated June 25, 2020, available at bca.bcaresearch.com 3 Please see European Investment Strategy "An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs," dated July 30, 2020, available at eis.bcaresearch.com 4 Please see US Equity Strategy "Inversely Correlated," dated August 25, 2020, available at uses.bcaresearch.com 5 Please see The Bank Credit Analyst "August 2020," dated July 30, 2020, available at bca.bcaresearch.com 6 Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 7 Please see The Bank Credit Analyst "August 2020," dated July 30, 2020, available at bca.bcaresearch.com 8 Diversifying away from the dollar does not mean that the USD will lose its reserve status. However, a return to the share of FX reserves that prevailed in the first half of the 1990s will hurt the dollar, especially because the US net international investment position has fallen from -4.6% of GDP in 1992 to -57% today. 9 Traditional PCs are comprised of desktops, notebooks, and workstations. 10 Global server shipments to contract 5.6% sequentially in 3Q2020, says Digitimes Research 11 Global server shipments forecast to increase by 5% this year: TrendForce 12 IDC Expects Worldwide Smartphone Shipments to Plummet 11.9% in 2020 Fueled by Ongoing COVID-19 Challenges 13 America does not want China to dominate 5G mobile networks 14 “Data localization” can be defined as the act of storing data on a device that is physically located within the country where the data was created. Data localization requirements are governmental obligations that explicitly mandate local storage of personal information or strongly encourage local storage through data protection laws that erect stringent legal compliance obligations on cross-border data transfers. 15 The big data center industry ushered in another outbreak 16 The GSMA represents the interests of mobile operators worldwide, uniting more than 750 operators with almost 400 companies in the broader mobile ecosystem, including handset and device makers, software companies, equipment providers and internet companies, as well as organizations in adjacent industry sectors. 17 GSMA: 5G Moves from Hype to Reality – but 4G Still King 18 Smart Cities Market Size Worth $463.9 billion By 2027 19 The Automotive Semiconductor Market – Key Determinants of U.S. Firm Competitiveness 20 AI is data Pac-Man. Winning requires a flashy new storage strategy.
Highlights Negative Rates: The persistence of the COVID-19 pandemic is intensifying pressure on policymakers in many countries to provide more stimulus. The odds that a new central bank will join the negative policy interest rate club are increasing. UK vs. New Zealand: Recent comments from Bank of England and Reserve Bank of New Zealand officials have hinted at the possibility of a shift to negative policy rates, should conditions warrant. The odds are greater for such a move in New Zealand. Go long 10-year New Zealand government bonds versus 10-year UK Gilts (currency-hedged into GBP) on tactical (0-6 months) basis. Feature Policymakers around the world are, once again, under increasing pressure to contemplate new responses to the COVID-19 pandemic, which continues to rage through much of the US and emerging world and is flaring up again across Europe. Additional fiscal policy measures will likely be necessary, but it is increasingly politically difficult in many countries to ramp up government support measures – or even extend existing programs - after the massive increase in deficits and debt undertaken this past spring. Chart of the WeekA Bull Market In Negative-Yielding Debt An inadequate fiscal response will put even more pressure on monetary policy to give a boost to virus-stricken economies. Yet fresh options there are even more limited. Policy rates are already near 0% in all developed nations, with central banks promising to keep them there for at least the next couple of years. Central banks are also rapidly expanding their balance sheets to buy up assets via quantitative easing programs. A move to sub-0% policy rates may be the next option for central banks not already there like the ECB and the Bank of Japan. Although it remains questionable how much more stimulus monetary policy could hope to deliver. Government bond yields are at or near historic lows in most countries, while equity and credit markets continue to enjoy a spectacular recovery from the rout in February and March. The stock of global negative-yielding debt has risen to $16 trillion, according to Bloomberg, which remains close to the highs seen over the past few years (Chart of the Week). So who will be the next central bank to cross that bridge into negative rate territory? US Federal Reserve Chairman Jerome Powell, Bank of Canada Governor Tiff Macklem and Reserve Bank of Australia Governor Philip Lowe have all publicly dismissed the need for negative rates in their economies. Recent comments from Bank of England (BoE) Governor Andrew Bailey and Reserve Bank of New Zealand (RBNZ) Governor Adrian Orr, however, have suggested that negative rates could be a future policy choice, if needed. New Zealand looks like the more likely candidate to go to negative rates sometime in the next 3-6 months. Markets are increasingly discounting those outcomes. The UK Gilt yield curve is trading below 0% out to the 6-year maturity, while New Zealand nominal government bond yields are trading at or below a mere 0.3% out to 7-years (and where real yields on inflation-linked bonds have recently turned negative). Of the two, New Zealand looks like the more likely candidate to go to negative rates sometime in the next 3-6 months. A Negative Rates Checklist For The UK & New Zealand In a Special Report we published back in May, we looked back at the decisions that drove the move to negative policy rates by the ECB, Bank of Japan, Swiss National Bank and the Riksbank, with a goal of determining if such an outcome could happen elsewhere.1 We were motivated by the growing market chatter suggesting that the Fed would eventually be forced to cut the fed funds rate to sub-0% territory to fight the deep COVID-19 recession. Chart 2The Fundamental Case For Negative Rates We concluded in that report that such a move was unlikely, but could occur if there was a contraction in US credit growth and/or a spike in the US dollar to new cyclical highs, both outcomes that would result in a major drop in US inflation expectations. Such moves preceded the shift to negative rates in those other countries during 2014-16, as a way to lower borrowing costs and weaken currencies. Since that May report, the US dollar has depreciated and US credit growth has continued to expand amid very stimulative financial conditions, thus the odds of the Fed having to cut the funds rate below 0% are very low. The Fed is far more likely to dovishly alter its forward guidance, or even institute yield curve control to cap US Treasury yields, to deliver additional monetary easing, if necessary. (NOTE: next week, we will be discussing the Fed’s next possible policy moves, and the potential impact on financial markets, in a Special Report jointly published with our colleagues at BCA Research US Bond Strategy). The pressure to consider negative interest rates in the non-negative rate developed market countries remains strong, however, after the major increase in unemployment rates and sharp falls in inflation seen earlier this year (Chart 2). Putting current levels of both into a simple Taylor Rule formula suggests that the “appropriate” level of nominal policy rates is currently negative in the US and Canada, mainly because of the double-digit unemployment rates in those countries. Taylor Rules for the UK and New Zealand remain slightly positive, however, at 0.2% and 0.9%, respectively. Yet the forecasts for inflation and unemployment from the BoE and RBNZ suggest a diverging dynamic between the two over the next couple of years. The BoE is forecasting a very sharp recovery from the 2020 recession, with the UK unemployment rate projected to fall back to 4.7% by 2022 from the surge to 7.5% this year. At the same time, the RBNZ’s forecasts are more cautious, with the New Zealand unemployment rate expected to fall to only 6.1% in 2022 from the projected 8.1% peak at the end of this year. Thus, the implied Taylor Rules using those forecasts suggest a need for negative rates in New Zealand, but a rising path for UK policy rates over the next two years (Chart 3). Clearly, markets are taking the RBNZ’s open talk about negative interest rates to heart, while remaining skeptical that the BoE’s optimistic path for the post-virus UK economy will come to fruition. Despite the diverging trajectory in policy rates implied by the two central banks’ forecasts, markets are pricing in a more similar path for rates. Forward overnight index swap (OIS) rates are discounting slightly negative rates in the UK and New Zealand to the end of 2022 (Chart 4). Clearly, markets are taking the RBNZ’s open talk about negative interest rates to heart, while remaining skeptical that the BoE’s optimistic path for the post-virus UK economy will come to fruition. Chart 3Mapping Central Bank Projections Into The Taylor Rule Chart 4Markets Pricing Slightly Negative Rates In The UK & NZ The individual cases of the UK and New Zealand as current candidates for negative interest rates can help derive a list of factors to monitor to determine if negative rates would be a more likely policy outcome for any central bank. Based on our read of recent comments from BoE and RBNZ officials, combined with our assessment of what took place in other countries that moved to negative rates in the past, we would include the following in any Negative Rates Checklist: Policymaker perceptions on the effective lower bound (ELB) on policy rates For central bankers, the ELB (or “reversal rate”) is defined as the policy rate below which additional rate cuts are deemed counterproductive to stimulating the economy. For example, cutting rates too low could limit the ability of the banking system to earn interest income, thus hindering banks’ appetite to make new loans. Chart 5Could The Effective Lower Bound Be Negative In the UK & NZ? For most central banks, the belief is that the ELB is at or just above 0%. It is possible that because of a structural shift, a central bank could deem the ELB to be negative in that particular economy. That could be because of a sharp deterioration in trend economic growth or a rapid rise in debt or a belief that the banking system was strong enough to handle the income shock of negative rates. Currently, potential GDP growth rate estimates have been marked down in both the UK and New Zealand because of the 2020 COVID-19 recession (Chart 5). In New Zealand, taking the average of the RBNZ’s real GDP growth forecasts for the next three years as a proxy for trend growth suggests that trend growth is now around 1.2%, similar to the reduced estimates of UK potential GDP growth. In terms of debt levels, the ratio of total public and private non-financial debt to GDP is close to 400% in the UK, which is far greater than the 126% level of that same ratio in New Zealand. In terms of banking system health, banks in both countries are well capitalized. The Tier 1 capital ratio of the major UK banks is 14.5%, while the similar figure in New Zealand is 13.5%; both figures are provided by the BoE and RBNZ, respectively. Stress tests run by the central banks in recent months indicate that capital levels will remain adequate even after the likely hit from loan losses due to the severity of the 2020 economic downturn. Our assessment is that both the BoE and RBNZ can claim that the ELB is in fact below zero, based on the slow pace of trend economic growth in both. In the case of the UK, high debt levels also suggest that policy rates may have to go below 0% to generate any stimulus to growth via new borrowing activity. In both countries, the central banks can claim that the banking system can handle a period of negative rates, if policymakers go down that road to boost economic growth. Economic confidence is depressed An extended period of weak economic activity and depressed confidence can trigger a need to move to negative policy rates if rates were already at 0%. Currently, UK economic confidence is in tatters after the -20% decline in real GDP seen in the second quarter of 2020. The GfK consumer confidence index remains at recessionary low levels, while the BoE Agents’ survey of UK firms shows a collapse in plans for investment and hiring over the next year (Chart 6). Chart 6A Severe Hit To UK Growth & Confidence New Zealand, the economy contracted -1.6% in the first quarter of the year with consensus forecasts calling for a -20% collapse in the second quarter. Yet economic confidence is surprisingly resilient. The Westpac survey of consumer confidence is falling, but the July reading was still above typical recessionary lows (Chart 7). The ANZ survey of business investing and hiring intentions has been surprisingly upbeat of late, rebounding from the April trough but still below pre-virus levels. Our assessment here is that the BoE has a stronger case for moving to negative rates, based on the deeper collapse in confidence in the UK compared to New Zealand. Inflation expectations are too low If inflation expectations remain too low once rates have hit 0%, then inflation-targeting central banks must consider more extraordinary options to revive inflation expectations. That could take the form of extended forward guidance on future interest rate moves, expanding the size and scope of quantitative easing programs, or cutting policy rates into negative territory. Currently, inflation expectations remain elevated in the UK. 5-year CPI swaps, 5-years forward, are now at 3.6%, while the Citigroup/YouGov survey of household inflation expectations 5-10 years out sits at 3.3% (Chart 8). In New Zealand, the RBNZ inflation survey shows inflation expectations have fallen into the bottom half of the central bank’s 1-3% target band. Chart 7Only A Very Modest Downturn In NZ Chart 8Inflation Expectations Are Much Lower In NZ Our assessment here is that only the RBNZ can argue for a move to negative rates because of weak inflation expectations. Our assessment here is that only the RBNZ can argue for a move to negative rates because of weak inflation expectations. Financial conditions turning more restrictive Chart 9The News Is Mixed On UK & NZ Financial Conditions Another reason why a central bank could try negative rates is if asset prices were trading at depressed levels even after policy rates were at 0%. The current signals on financial conditions in the UK and New Zealand are generally stimulative, but more so in the latter. Currently, the MSCI equity index for New Zealand is nearing the all-time high reached in 1987, while the equivalent UK equity index is languishing near the lows of the past decade (Chart 9). The New Zealand dollar and British pound have both bounced off the cyclical lows seen earlier this year (more on that later). The annual growth rates of nominal house prices have started to pick up in both countries, but with a faster pace in New Zealand. Finally, corporate credit spreads have narrowed sharply since the end of the first quarter in both countries, with New Zealand spreads actually falling below the pre-virus levels seen this year. Our assessment here is that financial conditions in both countries remain generally stimulative, but more so in New Zealand. Neither central bank can point to restrictive financial conditions as a reason to move to negative rates. Signs of impairment of the transmission of policy interest rates to actual borrowing costs If bank lending growth was weakening and/or borrowing rates remained high relative to policy rates, this could be a sign that negative policy rates are necessary to induce greater loan demand by lowering borrowing costs. Chart 10NZ Lenders Are Not Passing On RBNZ Rate Cuts Currently, the annual growth rate of bank lending is slowing in New Zealand, but remains positive at 4.5% (Chart 10). Loan growth in the UK is now a much more robust 7.4%, but some of that growth is due to UK companies drawing down lines of credit with their banks to survive during the COVID-19 lockdowns. A bigger issue is the lack of the full pass-through of the RBNZ’s recent cuts into borrowing rates, especially for home loans. The spread between 5-year fixed mortgage rates and the RBNZ cash rate is now an elevated 387bps, while the equivalent spread in the UK is much lower at 160bps. Our assessment here is that only the RBNZ can argue that an impaired transmission of policy rate cuts to actual borrowing rates could justify a move to negative rates. Scope For Currency Depreciation For any central bank, a benefit of a negative interest rate policy is that it can trigger more stimulus via a weaker currency. This can help boost economic growth by making exports more competitive, while also helping lift inflation by raising the cost of imports. On the growth side, a weaker currency would be somewhat more helpful for New Zealand where exports are 19% of GDP, compared to 16% in the UK. (Chart 11). That is an important distinction, as there is greater scope for the New Zealand dollar (NZD) to depreciate if the RBNZ went to negative rates than for the British pound (GBP) to weaken if the BoE did the same. Chart 11A New Experiment? Negative Rates With A Current Account Deficit Chart 12BoE Does Not Need To Go Negative To Weaken The Pound Perhaps the most interesting feature of this entire negative rates discussion is that, for the first time in the “negative rates era”, central banks of countries with current account deficits are considering pushing policy rates below 0%. For the first time in the “negative rates era”, central banks of countries with current account deficits are considering pushing policy rates below 0%. The UK and New Zealand both have similarly sized current account deficits, equal to -3.3% and -2.7% of GDP, respectively (middle panel). At the same time, both countries have net foreign direct investment surpluses roughly equal to those current account deficits, leaving their basic balances around 0 (bottom panel). In other words, both countries currently attract enough long-term foreign direct investment inflows to “fund” their current account deficits. Foreign investors may be less willing to continue buying as many New Zealand or UK financial assets if either country went to a negative interest rate to intentionally weaken the currency, as the RBNZ has publicly stated would be a desired outcome of such a move. Chart 13RBNZ Could Go Negative To Weaken The Kiwi Our colleagues at BCA Foreign Exchange Strategy estimate that, on purchasing power parity (PPP) basis, the GBP/USD exchange rate is now -20% below its long-run fair value (Chart 12). The level of the currency is also broadly in line with the current level of interest rate differentials between the UK and the US (bottom panel). In other words, the GBP is already cheap and additional rate cuts would have limited impact in driving the currency lower. It is a different story for NZD/USD, which is fairly valued on a PPP basis but remains elevated relative to New Zealand-US interest rate differentials (Chart 13). Therefore, our assessment is that only the RBNZ can credibly generate meaningful currency weakness from a move to negative rates. Summing it all up Based on the elements of our Negative Rates Checklist, we deem it more likely for the RBNZ to go negative than the BoE. In the UK, there is less evidence pointing to a significantly impaired credit channel that could be remedied by negative rates, inflation expectations are elevated, and the pound is already at undervalued levels. In New Zealand, previous RBNZ rate cuts have not fully flowed through into bank lending rates, inflation expectations are low, and the New Zealand dollar is at fair value (and, therefore, has room to become cheaper via negative rates). Based on the elements of our Negative Rates Checklist, we deem it more likely for the RBNZ to go negative than the BoE. Bottom Line: The persistence of the COVID-19 pandemic is intensifying pressure on policymakers in many countries to provide more stimulus. The odds that a new central bank will join the negative policy interest rate club are increasing. Recent comments from Bank of England and Reserve Bank of New Zealand officials have hinted at the possibility of a shift to negative policy rates, should conditions warrant. The odds are greater for such a move in New Zealand. A Negative Rates Trade Idea: Go Long New Zealand Government Bonds Vs. UK Gilts Chart 14Go Long 10yr NZ Govt. Bonds Vs 10yr UK Gilts Based on our analysis above, we are adding a new cross-country spread trade to our Tactical Overlay Trades list on page 18: going long 10-year New Zealand government bonds versus 10-year UK Gilts on a currency-hedged basis (i.e. hedging the NZD exposure into GBP). The trade is to be implemented using on-the-run cash bonds. The current unhedged NZ-UK 10-year yield spread is +36bps, but even on a hedged basis (using 3-month currency forwards) the yield differential is still positive at +23bps (Chart 14). We are targeting zero for the unhedged spread, to be realized sometime within the six months. We like this trade because it can win not only from a decline in New Zealand bond yields if the RBNZ goes to negative rates (as we think is increasingly likely), but also from a potential rise in Gilt yields if the BoE defies market pricing and does not go to negative rates. If both countries keep rates on hold, then the trade will earn a small positive spread over the current meagre level of Gilt yields. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Special Report, "Negative Rates: Coming Soon To A Bond Market Near You?", dated May 20, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
BCA Research's Global Fixed Income Strategy service argues that the persistence of the COVID-19 pandemic intensifies pressure on policymakers around the world to provide more economic stimulus. The odds that more central banks will join the negative policy…
Highlights Portfolio Strategy Softening operating metrics, the falling US dollar, the reopening of the economy, all suggest that investors should avoid hypermarket stocks. A firming macro backdrop, the USD’s recent drop, along with the bearish signals from financial variables, all concur that investors should start a program of modestly shedding consumer staples exposure. Recent Changes Downgrade the S&P hypermarkets index to underweight, today. This move also pushes our S&P consumer staples sector to a modest below benchmark allocation. Table 1 Feature In our March 23 Weekly Report, when we identified 20 reasons to start buying equities, we published a cycle-on-cycle profile (Chart 1, top panel) of how the SPX performs following a greater than 20% drawdown. History suggested that, on average, new all-time highs would emerge sometime in early 2022! Unfortunately, this assessment proved offside as the S&P 500 made fresh all-time closing highs last week, less than five months from the March 23 trough. Chart 1Overstretched Nevertheless, comparing the current unprecedented SPX rebound with the historical recessionary profile remains instructive as it highlights how excessively stretched equities currently appear. The bottom panel of Chart 1 warns that the SPX is vulnerable to a snapback, were the SPX to return to the historical mean or median recovery profile. Likely rising (geo)political risks could serve as a near-term catalyst for a healthy pullback. Importantly, all of the SPX’s return since the March lows is due to the multiple expansion and then some, as forward EPS have taken a beating (not shown). Equities are long duration assets and given the drubbing in the discount rate, the forward P/E multiple has done all the heavy lifting. Chart 2 puts some historical context to the S&P 500 forward P/E going back to 1979 using I/B/E/S data. Empirical data supports finance theory and shows that the 40-year bull market in bond prices has caused a structural upshift to the SPX forward P/E. Chart 2Moving In Opposite Directions While low rates explain the near all-time highs in the SPX forward P/E, looking ahead we doubt that the SPX multiple can expand much further if we assume that the easy assist from ZIRP is behind us and will not repeat; i.e. the Fed will refrain from wrecking the US banking system by exploring NIRP. In contrast, our analysis suggests that a selloff in the bond market is the missing ingredient that will ignite a massive rotation out of growth stocks and into value and propel deep cyclicals versus defensives to uncharted territory. More specifically, the rallies in copper prices, crude oil and the CRB Raw Industrials index need confirmation from the bond market that they are demand, rather than supply driven. This backdrop will also shift equity returns within deep cyclicals away from a handful of tech stocks and toward other beaten down high operating leverage sectors (i.e. energy, industrials and materials) as we posited in our recent August 3 Special Report “Top 10 Reasons To Start Nibbling On Cyclicals At The Expense Of Defensives”. Zooming out and observing how investors have moved capital from one asset class to the next in the aftermath of QE5 is in order (Chart 3). First, the SPX enjoyed a V-shaped recovery from the March 23 lows. Then in early-May, as we first posited in our May 11 Weekly Report, the big EURUSD up-move was set in motion and investors started piling into short USD positions taking cue from the Fed’s QE5 that was directly targeting the US dollar with liquidity swaps. The debasing of the dollar served as a global reflator. Now the final piece of the QE5 puzzle is the bond market. Chart 3 highlights that in order for QE to work, counterintuitively a selloff in the bond market would confirm that the economy is healing and is ready to start standing on its own two feet. The jury is still out. With regard to the Fed’s remaining bullets, yield curve control (YCC) is one unorthodox tool that the FOMC could choose to deploy in the coming years. On that front, turning back in time and drawing parallels with the 1940s is instructive. In 1942 the Fed, at the behest of the Treasury, pegged long-term interest rates at 2.5% and ballooned its balance sheet in order to finance the government’s expenditures during WWII. The Fed surrendered its independence, and this YCC unwarrantedly stayed in place until 1951 when in the midst of the Korean War, the Treasury-Federal Reserve Accord finally ended the peg of government long-dated bond interest rates.1 Chart 3Bonds Yields Are Left To Rally Chart 4WWII-Like Starting Point Chart 4 shows the ebbs and flows of the US government’s total debt-to-GDP ratio and fiscal deficit as a percentage of output since 1940. While the debt-to-GDP profile fell from 1945 onward owing partially to a tight fiscal ship that the US subsequently ran, it troughed when the US floated the greenback. Since then, the US has been fiscally irresponsible running large budget deficits and the debt-to-GDP ratio has never looked back and very recently went parabolic (top panel, Chart 4). Charts 5 & 6 take a closer look at some macro variables in the 1940s and Charts 7 & 8 compare them to today. Chart 5The… Chart 6…1940s… First, YCC did not prevent the late-1948 recession (Chart 5, shaded areas). Crudely put, monetary stimulus is not a panacea for boom/bust cycles. Second, M2 growth was climbing at a 30%/annum rate, the money multiplier was on a secular advance and money velocity was surging especially in the first half of the 1940s (Chart 6). As a result and as expected, YCC caused three significant inflationary jumps (bottom panel, Chart 6) that aided the US government in bringing down the massive debt-to-GDP ratio (i.e. inflating its way out of a debt trap) that it had accumulated via large deficits in the front half of the 1940s (top panel, Chart 5). Third, interest rates were a coiled spring and once the Treasury-Fed Accord was signed, they exploded higher (fourth panel, Chart 5). Finally, equities fared well during the first three years of YCC until the end of WWII, but then suffered an outsized setback until mid-1949, before recovering and taking out the 1945 highs in 1951 (bottom panel, Chart 5). Chart 7...Compared With… Chart 8…Today Were the Fed to embark on YCC in the near-future in order to monetize the US government’s deficits, there are a few parallels to draw with the 1940s especially given that the starting point of debt-to-GDP is similar to the WWII figure (top panel, Chart 4). The Fed would likely lose its independence. This would be a paradigm shift. The Fed would crowd out fixed income investors, and flood the market with US dollars. M2 money stock would continue to surge. Few investors will be chasing US dollar assets including equities. The path of least resistance would be significantly lower for the US dollar as foreign investors would flee. This debt monetization along with a depreciating currency and swelling money supply would result in inflation rearing its ugly head, especially given that import prices would soar. What is difficult to envision is how the economy would perform during an inflationary impulse. Our sense is that the risk of stagflation would rise significantly, especially given the current inverse correlation between M2 growth and the velocity of money.2 In the stagflationary 1970s, any liquidity injections via higher M2 growth failed to translate into rising money velocity. Importantly, the “Nixon shock” effectively ended the Bretton Woods system and floated the US dollar causing a 40% devaluation from peak-to-trough (Chart 9). Tack on the oil related supply shock and stagflation reigned supreme in the 1970s, owing to cost-push inflation. Chart 9Dollar The Reflator In contrast during the 1940s, demand-pull inflation hit the economy rather hard, as the US was retooling its industrial base to win WWII alongside its allies. Also the US dollar was linked to gold since the Gold Reserve Act of 1934 and ten years later the Bretton Woods international monetary agreement ushered in the era of fixed exchange rates, which is a big difference from the 1970s.3 As a reminder, from a political perspective venturing down the inflation avenue is the least painful way of dealing with a debt burden, rather than pursuing tight fiscal policy which is synonymous with political suicide. From an equity perspective, owning commodity-levered sectors and other hard asset-linked equities including REITs would make sense as we highlighted in our recent inflation Special Report. Health care stocks would also shine in case of an inflationary spurt according to empirical evidence that we highlighted in the same Special Report. On the flip side, our inflation Special Report also revealed that shedding telecom services and utilities would be wise and most importantly avoiding technology stocks. Tech stocks are disinflationary beneficiaries as they are mired in constant deflation and have built business models not only to withstand, but also to thrive in deflation. Inflation is a tech killer as these growth stocks suffer when the discount rate spikes and causes valuations to move from a premium to a discount. Nevertheless, deflation/disinflation is more likely in the coming 12-to-18 months, whereas inflation is at least two-to-three years away as we mentioned in our recent inflation Special Report. This week we continue to augment our cyclicals versus defensives portfolio bent and take our defensive exposure down a notch by downgrading consumer staples to a modest below benchmark allocation via a downgrade in the S&P hypermarkets index. Downgrade Hypermarkets To Underweight… Last summer we upgraded the S&P hypermarkets index to overweight as we were preparing the portfolio to withstand a recessionary shock given that the yield curve had inverted. Fast forward to the March carnage in the equity markets and this defensive move served our portfolio well. However, we did not want to overstay our welcome and set a stop in order to exit this position that was triggered in late-March netting our portfolio 26% in relative gains. More recently, we have been adding cyclical exposure to the portfolio and lightening up on defensives and as a continuation of this shift we are now compelled to downgrade the S&P hypermarkets to underweight. The economy is reopening and thus it no longer pays to seek refuge in safe haven hypermarket equities. In fact most of the macro indicators we track suggest the recession is over that will sustain severe downward pressure on relative share prices. Chart 10 shows that the ISM manufacturing new orders subcomponent has slingshot from below 30 to north of 60, junk spreads are probing all-time lows, consumer confidence has troughed and small and medium enterprises hiring intentions are on the mend. Moreover, the extraordinary fiscal expansion has brought spending forward and PCE is all but certain to skyrocket when the Q3 GDP figures get released in late-October, signaling that the easy money has been made in Big Box retailers (top panel, Chart 11). Similarly, discretionary spending should pick up the slack from staple-related purchases, further dampening the need to own hypermarket shares (middle & bottom panels, Chart 11). Chart 10Rebounding Macro Chart 11Returning to Normality On the operating front, while WMT is making strides in its online presence and offering mix, non-store retail sales are on a tear dominated by King AMZN (as a reminder we are overweight the S&P internet retail index). This is a secular trend and should continue unabated and in a relative sense continue to weigh on hypermarket profitability (bottom panel, Chart 12). Finally, a significant tailwind is turning into a severe headwind for this industry: import price inflation. The US dollar has reversed course and it is in a freefall. Historically, the greenback has been an excellent leading indicator of import price inflation and the current message is grim for hypermarket razor thin profit margins (import prices shown inverted, Chart 13). Chart 12Amazonification Is On Track Chart 13Currency Headwinds Adding it all up, softening operating metrics, the falling US dollar, the reopening of the economy, all suggest that investors should avoid hypermarket stocks. Bottom Line: Trim the S&P hypermarkets index to underweight. The ticker symbols for the stocks in this index are: BLBG S5HYPC – WMT, COST. …Which Pushes Consumer Staples To A Below Benchmark Allocation The downgrade in the S&P hypermarkets index tilts our S&P consumer staples sector to a modest below benchmark allocation. Countercyclical consumer staples stocks served their purpose and provided the support to our portfolio in the front half of the year when we needed them most. Now that the economic reopening is gaining steam and the government, the health care system and society are all ready to effectively deal with a flare up in the pandemic, the allure of defensive positioning has diminished. In other words, COVID-19 is currently a known known risk versus an unknown unknown risk early in the year, and defending against it now is more successful. Moreover, according to our mid-April research on what sectors investors should avoid during recessionary recoveries, consumer staples stocks trail the SPX on average by 660bps one year following the SPX trough. The current macro backdrop corroborates this analysis and underscores that the path of least resistance is lower for relative share prices. Not only is the ISM manufacturing survey on fire, but also consumer confidence is making an effort to trough (ISM manufacturing and consumer confidence shown inverted, Chart 14). Meanwhile, financial market variables emit a similarly bearish signal for safe haven staples stocks. Following a brief spike in the bond-to-stock ratio (BSR), the BSR has recently resumed its downdraft (top panel, Chart 15). Volatility has all but collapsed since soaring to over 80 in March, as the Fed has orchestrated a quashing of all asset class volatilities (middle panel, Chart 15). Lastly, the pairwise correlation between stocks in the S&P 500 has also nosedived bringing some semblance of normality back into equity markets (bottom panel, Chart 15). All three of these financial market variables will continue to exert downward pressure on relative share prices. Chart 14V-shaped Recovery… Chart 15...Across The Board On the US dollar front, while consumer goods manufacturers get a P&L translation gain from a depreciating currency, their export exposure is on par with the SPX and does not provide a relative advantage. In marked contrast, empirical evidence shows that relative profitability moves in tandem with the greenback and the USD recent weakness will undercut consumer staples profitability (bottom panel, Chart 16), especially via climbing input cost inflation. In sum, a firming macro backdrop, the US dollar’s recent drop, along with the bearish signals from financial variables, all concur that investors should start a program of modestly shedding consumer staples exposure. Bottom Line: Downgrade the S&P consumer staples index to underweight. Chart 16Mind the Gap Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 https://www.richmondfed.org/publications/research/special_reports/treasury_fed_accord/background 2 The velocity of money “is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.” Source: Federal Reserve Bank of St. Louis. 3 Our colleagues from The Bank Credit Analyst recently illustrated how a strong dollar is good for the US economy on a medium term basis. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020 Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth
The lumber rally this year has been spectacular. We have been positive on this asset since February and sadly, cut our exposure too early relative to other commodities, five weeks ago. Nonetheless, we cannot ignore what the surge in lumber prices means. At…
BCA Research's US Bond Strategy service concludes that nominal Treasury yields will move modestly higher during the next 6-12 months with the increase concentrated at the long-end of the curve. Investors should keep portfolio duration close to benchmark and…
BCA Research's Global Fixed Income Strategy service concludes the easy part of the liquidity-driven rally in credit is over. More gains are to come but investors will need to be more selective. We have described the Fed’s corporate bond-buying programs as…
Highlights Global Credit Spreads: The relentless rally in global credit markets since the rout in February and March has driven corporate spreads to near pre-pandemic lows in the US, Europe and even emerging markets. Central bank liquidity is dominating uncertainties over the coronavirus and US politics. Credit Strategy: Valuations now look far less compelling in US investment grade corporates, even with the Fed backstop. EM USD-denominated corporates offer better value versus US equivalents. High-yield spreads offer mixed signals in both the US and Europe: historically attractive breakeven spreads that offer no compensation for likely default losses over the next 6-12 months. Remain neutral US junk and underweight euro area junk, favoring Ba-rated names in both. Feature Chart of the WeekA Pandemic? Credit Markets Are Not Concerned Global credit markets have enjoyed a spectacular recovery from the carnage seen just five months ago when investors realized the magnitude of the COVID-19 shock. The option-adjusted spread (OAS) on the Bloomberg Barclays Global Investment Grade Corporate index has tightened from the 2020 high of 326bps to 130bps, while the OAS on the Global High-Yield index has narrowed from the 2020 high of 1192bps to 556bps. Unsurprisingly, those spread peaks both occurred on the same day: March 23, the day the US Federal Reserve announced their corporate bond buying programs. We have described the Fed’s actions as effectively removing the “left tail risk” of investing in credit, and not just in the US, by introducing a central bank liquidity backstop to the US corporate bond market. The backdrop for global credit markets, on the surface, seems typical for sustained spread compression (Chart of the Week). Economic optimism is buoyant, with the global ZEW expectations index now at the highest level since 2014. Monetary conditions are highly supportive, with near-0% policy rates across all developed economies and the balance sheets of the Fed, ECB, Bank of Japan and Bank of England growing at a combined year-over-year pace of 46%. Credit markets seem to be signaling boom times ahead, ignoring the pesky details of an ongoing global pandemic and election-year political uncertainty in the US. Credit markets seem to be signaling boom times ahead, ignoring the pesky details of an ongoing global pandemic and election-year political uncertainty in the US. The next moves in credit will be more challenging and less rewarding than the past five months. Investment grade corporate credit spreads no longer offer compelling value in most developed economies, while high-yield spreads are tightening in the face of rising default rates in the US and Europe. While additional spread tightening is not out of the question in these markets, investors should consider rotating into credit sectors that still offer some relative value – like emerging market (EM) hard currency corporates. A World Tour Of Our Spread Valuation Indicators The sharp fall in global bond yields over the past several months has not just been confined to government debt. Yields have fallen toward, and even below, pre-virus lows for a variety of sectors ranging from US mortgage-backed securities (MBS) to EM USD-denominated sovereign debt (Chart 2). Investors are clearly reaching for yield in the current environment of tiny risk-free government bond yields, with no greater sign of this than the recent new issue by a US sub-investment grade borrower of a 10-year bond with a coupon below 3%.1 The drop in credit yields has also occurred alongside tightening credit risk premiums, although spreads remain above the pre-virus lows for most sectors in the US, Europe and EM (Chart 3). The degree of correlation across global credit markets has been intense, with very little differentiation between countries. Investment grade corporate spreads in the US, UK and euro area are all closing in on 100bps; high-yield spreads in those same regions are all around 500bps. Chart 2Global Credit Yields Are Low Chart 3Global Credit Spreads Are Getting Tight Last week, we introduced the concept of “yield chasing” to describe how the ranking of returns in developed market government bonds was becoming increasingly correlated to the ranking of outright yield levels.2 We have seen a similar dynamic unfold in global credit markets, especially since that peak in spreads in late March. In Chart 4 and Chart 5, we present the relationship between starting benchmark index yields, and the subsequent excess returns over risk-free government bonds, for a variety of developed market and EM credit products. The first chart covers the time from start of 2020 to the March 23 peak in spreads, while the second chart shows the relationship since then. The two charts are mirror images of each other. Chart 4Starting Yields & Subsequent Global Credit Excess Returns In 2020 (January 1 To March 20) Chart 5Starting Yields & Subsequent Global Credit Excess Returns In 2020 (Since March 23) The worst performing markets in the first three months of the year were those with the highest yield to begin 2020: high-yield corporates in the US and Europe along with EM credit, which have been the best performing markets since late March. The opposite is true for lower yielders like investment grade credit in Japan, the euro area and Australia, which were among the top performers before March 23 and have lagged sharply since then. While there appears to be “yield chasing” going on in credit markets, much of the spread tightening over the past five months has been a reflection of reduced market volatility that justify lower risk premiums. Chart 6Lower Vol = Lower Credit Risk Premia While there appears to be “yield chasing” going on in credit markets, much of the spread tightening over the past five months has been a reflection of reduced market volatility that justify lower risk premiums. Measures of bond volatility like the MOVE index of US Treasury options prices have declined to pre-pandemic lows, while the VIX index of US equity volatility is now down to 22 from the 2020 peak around 80 (Chart 6). The excess return volatility of US corporate bond markets has followed suit, thus allowing for lower US credit spreads. Even allowing for the lower levels of overall market volatility, corporate credit spreads do look relatively tight in the US and Europe. The ratio of the US investment grade index OAS to the VIX is now one standard deviation below the median since 2000 (Chart 7). A similar reading exists for the ratio of the US high-yield index OAS to the VIX, which is also one standard deviation below the long-run average (bottom panel). In the euro area, the ratios of investment grade and high-yield OAS to European equity volatility, the VStoxx index, are not as stretched as in the US, but remain below long-run median levels (Chart 8). Chart 7Very Tight US Corporate Credit Spreads Relative To Equity Vol Chart 8Tight Euro Area Corporate Credit Spreads Relative To Equity Vol While these simple comparisons of spread to market volatility suggest that corporate credit spreads are tight in most major markets, other indicators paint a more nuanced picture of cross-market valuations. Our preferred measure of the attractiveness of credit spreads is the 12-month breakeven spread. That measures the amount of spread widening that must occur over a one-year horizon for a credit product to have the same return as government bonds. In other words, how much must spreads increase to eliminate the carry advantage of a credit product over a risk-free bond, after accounting for the volatility of that product. We compare those 12-month breakeven spreads with their own history in a percentile ranking, which determines the attractiveness of spreads. While the valuations for US investment grade credit look the least compelling among those three main regions, the power of the Fed liquidity backstop will continue to put downward pressure on spreads. A look at breakeven spread percentile rankings for the major credit groupings in the US (Chart 9), euro area (Chart 10) and EM (Chart 11) shows more diverging spread valuations. Chart 9US Corporate Bond Breakeven Spread Percentile Rankings Chart 10Euro Area Corporate Bond Breakeven Spread Percentile Rankings Chart 11EM USD Credit Breakeven Spread Percentile Rankings The US investment grade breakeven spread is just below the 25th percentile of their long-run history, although the high-yield breakeven spread remains in the top quartile of its history. Euro area breakeven spreads are “fairly” valued, both sitting around the 50th percentile. The EM USD-denominated sovereign breakeven spread is in the third quartile below the 50th percentile, while the EM USD-denominated corporate breakeven spread looks better, sitting just at the 75th percentile. While the valuations for US investment grade credit look the least compelling among those three main regions, the power of the Fed liquidity backstop will continue to put downward pressure on spreads. We would not be surprised to see US investment grade spreads tighten back to the previous cyclical low at some point in the next 6-12 months. There are more compelling opportunities in other global credit markets, however, especially on a risk-adjusted basis. The only investment grade sectors that have attractive breakeven spreads are in Japan, Canada and, most interestingly, EM. Bottom Line: The relentless rally in global credit markets since the out in February and March has driven credit spreads to near pre-pandemic lows in the US, Europe and even emerging markets. Central bank liquidity is dominating uncertainties over the virus and US politics. Spread valuations are looking more stretched, but “yield chasing” and “spread chasing” behavior will remain dominant with central banks encouraging risk-seeking behavior with easy money policies. Putting It All Together: Recommended Allocations One way to look at the relative attractiveness of global spread product sectors is to compare them all by 12-month breakeven spread percentile rankings. We show that in Chart 12, not just for the overall credit indices by country but also among credit tiers within each country. Sectors rated below investment grade are in red to differentiate from higher-quality markets. Chart 12Global Corporate Bond Breakeven Spreads, Ordered By Percentile Ranks The main conclusion form the chart is that there is a lot of red on the left side and none on the right side. That means junk bonds in the US and Europe have relatively high breakeven spreads, while investment grade credit in most countries have relatively lower breakeven spreads. The only investment grade sectors that have attractive breakeven spreads are in Japan, Canada and, most interestingly, EM. To further refine the cross-country comparisons, we must look at those breakeven spreads relative to the riskiness of each sector. In Chart 13, we present a scatter graph plotting the 12-month breakeven spreads versus our preferred measure of credit risk, duration-times-spread (DTS), for all developed market corporate credit tiers, as well as EM USD-denominated sovereign and corporate debt. The shaded region represents all values within +/- one standard error of the fitted regression line. Thus, sectors below that shaded region have breakeven spreads that are low relative to its DTS, suggesting a poor valuation/risk tradeoff. The opposite is true for sectors above the shaded region. Chart 13Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) The sectors that stand out as most attractive in this framework are B-rated and Caa-rated US high-yield, and EM USD-denominated investment grade corporates. The least attractive sectors are US investment grade corporates, for both the overall index and the Baa-rated credit tier. While those US high-yield valuations suggest overweighting allocations to the lower credit tiers, we remain reluctant to make such a recommendation. Looking beyond the spread and volatility measures presented in this report, we must consider the default risk of high-yield bonds. Our preferred measure of valuation that incorporates default risk is the default-adjusted spread, which measures the current high-yield index spread net of default losses. While those US high-yield valuations suggest overweighting allocations to the lower credit tiers, we remain reluctant to make such a recommendation. The current US high-yield default-adjusted spread is now well below its long-run average (Chart 14). We expect a peak US default rate over the next year between 10-12% (levels seen after past US recessions) and a recovery rate given default between 20-25% (slightly below previous post-recession levels). That combination would mean that expected default loses from the COVID-19 recession could exceed the current level of the US high-yield index spread by as much as 400bps (see the bottom right of the chart). Given that risk of default losses overwhelming the attractiveness of US high-yield as measured by the 12-month breakeven spread, we prefer to stay up in quality by focusing on Ba-rated names within an overall neutral allocation to US junk bonds. For euro area high-yield, where default-adjusted spreads are also projected to be negative next year but with less attractive 12-month breakeven spreads, we recommend a cautious up-in-quality allocation to Ba-rated names only but within an overall underweight allocation. After ruling out increasing allocations to US B-rated and Caa-rated high-yield, that leaves the two remaining valuation outliers from Chart 13 - US investment grade and EM USD-denominated investment grade corporates. The gap between the index OAS of the two has narrowed from the March peak of 446bps to the latest reading of 259bps (Chart 15). We believe that gap can narrow further towards 200bps, especially given the supportive EM backdrop of USD weakness and China policy stimulus – both factors that were in place during the last sustained period of EM corporate bond outperformance in 2016-17. Chart 14No Cushion Against Credit Losses For US & Euro Area HY Chart 15EM IG Corporates Remain Attractive Vs US IG We upgraded our recommended allocation to EM USD-denominated credit out of US investment grade back in mid-July, and we continue to view that as the most attractive relative value opportunity in global spread product on a risk/reward basis. Bottom Line: Valuations now look far less compelling in US investment grade corporates, even with the Fed backstop. EM USD-denominated corporates offer better value versus US equivalents. High-yield spreads offer mixed signals in both the US and Europe: historically attractive breakeven spreads that offer no compensation for likely default losses over the next 6-12 months. Remain neutral US junk and underweight euro area junk, favoring Ba-rated names in both. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-08-10/u-s-junk-bond-market-sets-record-low-coupon-in-relentless-rally 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. 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 The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts. There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates. Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations