Highlights

All of our recent investment recommendations have performed very strongly but have further to go:

1.   Own a combination of European banks plus U.S. T-bonds.

2.   Overweight EM versus DM.

3.   Overweight European versus U.S. equities.

4.   Overweight Italian assets versus European assets.

5.   Overweight the JPY.

Feature

Chart of the Week
Bank Outperformance Corroborates A Growth Rebound

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2019 will be the investment mirror-image of 2018. Last year started with growth fading and inflation on the cusp of picking up, both in Europe and around the world. This year has started with the European and global economies in the mirror-image configuration: growth likely to rebound, albeit modestly, and inflation set to fade (Chart I-2).

Chart I-2
Why 2019 Is The Mirror-Image Of 2018

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However, as 2019 unfolds, the configuration will reverse, requiring a flip from a pro-cyclical to a pro-defensive investment tilt later in the year. This contrasts with 2018 which started pro-defensive and ended pro-cyclical. In this regard, the economic and investment shape of 2019 will be the mirror-image of 2018.

Growth To Rebound, Inflation To Fade

A tell-tale sign of a growth rebound is the recent outperformance of banks. Around the world, yield curves have flattened – or even inverted – meaning that banks’ net interest margins have compressed. This compression of bank profit margins is normally bad news for bank equities. Yet banks have been outperforming, not just in Europe but globally (Chart I-3). If margins are compressing, the plausible explanation for outperformance would be an improved outlook for asset growth, reflecting both a reduction in bad debt provisioning and a pick-up in bank credit growth.

Chart I-3
Banks Have Been Outperforming Since October

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Independently and reassuringly, our proprietary credit impulse analysis supports this thesis (Chart of the Week). Six-month credit impulses have been rebounding not only in Europe, but also in the United States and very impressively in China (Chart I-4).

Chart I-4
6-Month Credit Impulses Have Rebounded Everywhere

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At the same time, inflation is set to disappoint as the recent near-halving of the crude oil price feeds into both headline and core consumer price indexes. With central banks now promising even greater “dependence on the incoming data”, this unfolding dynamic will force them to temper any hawkish intentions and rhetoric, limiting the extent of upside in bond yields.

In this configuration, the combination of European banks plus U.S. T-bonds which we first recommended in November is still appropriate (Chart I-5). The position is up 3 percent in little more than a month and has further to go.¹

Chart I-5
Own A Combination Of Banks And Bonds

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Europe’s largest economy, Germany, should benefit from another support to growth. Last year, the auto sector – a major engine of the German economy – spluttered as it absorbed the new WLTP emissions testing standard. Through the middle of 2018 German motor vehicle exports suffered a €20 billion hit which shaved 0.6 percent from Germany’s €3.4 trillion economy (Chart I-6). Now, if auto exports stabilize, this drag will disappear. And if auto exports recover to the pre-WLTP level after this one-off and temporary shock, Germany will receive a 0.6% mirror-image boost to growth.²

Chart I-6
German Auto Exports Suffered A WLTP Hit

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Regional Allocation Is Always And Everywhere About Sectors

The European equity earnings cycle is tightly connected with global growth oscillations (Chart I-7). The simple reason is that the European equity market is over-exposed to classically growth-sensitive sectors such as banks and industrials.

Chart I-7
The European EPS Cycle Is Tightly Connected With Global Growth Oscillations

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The emerging market earnings cycle is also connected with global growth oscillations (Chart I-8) because emerging markets have a very high exposure to banks. But the much less understood reason is that emerging markets have a near-zero exposure to healthcare (Table I-1). In sharp contrast, the U.S. equity earnings cycle has almost no connection with global growth oscillations (Chart I-9) because the U.S. equity market is over-exposed to technology and healthcare, neither of which are classically cyclical sectors.

Chart I-8
The EM EPS Cycle Is Also Connected With Global Growth Oscillations...

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Chart I-9
...But The U.S. EPS Cycle Is Not Connected With Global Growth Oscillations

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Table I-1
Each Major Stock Market Has A Distinguishing Fingerprint

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Hence the allocation to emerging market (EM) versus developed market (DM) equities, and to Europe versus the U.S. reduce to simple equity sector calls. A quick glance at Chart I-10 and Chart I-11 will reveal two fundamental and inescapable truths:

Chart I-10
EM Outperforms DM When Global Banks Outperform Healthcare

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Chart I-11
European Equities Outperform U.S. Equities When Global Banks Outperform Technology

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1. EM outperforms DM when global banks outperform global healthcare.
2. European equities outperform U.S. equities when global banks outperform global technology.

But is this just about so-called ‘beta’? No, banks can outperform in a rising market by going up more or, as recently, in a falling market by going down less. So this is always and everywhere about head-to-head sector relative performances.

My colleague Arthur Budaghyan, our chief emerging market strategist, remains steadfastly pessimistic on the structural outlook for EM versus DM. We agree with Arthur, albeit we arrive at the structural conclusion from a completely different perspective. To reiterate, for EM to outperform DM global banks must outperform global healthcare. However, over an extended period this will prove to be an extremely tall order.

As detailed in European Banks: The Case For And Against, blockchain is a long-term extinction threat to banks’ business models and profitability. Whereas healthcare is still a major growth sector as people focus more spending on improving the quality and quantity of their lifespans.³ 

Nevertheless, from a purely tactical perspective, the growth up-oscillation phase that started in October can continue for a little while longer allowing the recent countertrend moves to persist – especially as the recent decline in bond yields could further spur credit growth in the near term. So for the moment stay overweight:

1. EM versus DM.
2. European equities versus U.S. equities.
3. Italian assets versus European assets.

Bargain Basement Currencies

Another of my colleagues Doug Peta, our chief U.S. strategist, has coined a lovely metaphor: “you cannot get hurt falling out of a basement window”. The metaphor beautifully captures the asymmetry when you are near the floor or ‘zero-bound’. Doug uses it to explain that small contributors to an economy have a limited capacity to damage economic growth because they cannot fall very far. We think the metaphor applies equally to interest rates when they are at or near their lower bound, which is to say, in the basement.

This begs the obvious question: if interest rates are in the basement, then what is it that cannot get hurt much? The answer is: the exchange rate.

The payoff profile for exchange rates just tracks expected long-term interest rate differentials. This means that when the expected interest rate is in or near the basement, the currency possesses a highly attractive payoff profile called positive skew.

In essence, for any central bank already at the realistic limit of ultra-loose policy – such as the BoJ and ECB – policy rate expectations are effectively in the basement. They cannot go significantly lower. In contrast, policy rate expectations for the Federal Reserve are somewhere between the seventh and twelfth storey of the building (Chart I-12). From which you can get seriously hurt if you fall out of the window!

Chart I-12
You Cannot Get Hurt Falling Out Of A Basement Window

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The upshot is that currency investors should always own at least one currency whose interest rate is in the basement against one whose interest rate is high up in the building, susceptible to fall out at some point, and get seriously hurt.

The near term complication is the risk, albeit low, of a no-deal Brexit which would hurt European economies and currencies to a greater or lesser extent. Until the Brexit fog shows some signs of clearing, we would prefer the currency whose interest rate is in the basement to be a non-European currency.

So for the moment, our favourite major currency remains the JPY.

Dhaval Joshi, Senior Vice President
Chief European Investment Strategist
dhaval@bcaresearch.com

Fractal Trading System*

We are pleased to report that the 50:50 combination of Litecoin and Ethereum has surged by 42 percent in just two weeks! Also, long EUR/NZD achieved its 2.5 percent profit target and is now closed.

This week’s trade is in line with the recommendation in the main body of this report to become pro-cyclical. Go long global industrials versus global utilities with a profit target of 3 percent and a symmetrical stop-loss.

For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes.

Chart I-13

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The post-June 9, 2016 fractal trading model rules are:

1. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position.
2. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss.
3. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks.
4. Use the position size multiple to control risk. The position size will be smaller for more risky positions.

*  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com

Footnotes

• ¹ The European banks position is relative to the broader equity market, and the recommended combination is 25 cents in the banks and 75 cents in the bonds.
• ² German auto net exports and GDP are quoted at annualized rates. The Worldwide Harmonized Light Vehicle test Procedure (WLTP) is a new standard for auto emissions that took effect on September 1, 2018.
• ³ Please see the European Investment Strategy Special Report “European Banks: The Case For And Against”, November 8, 2018 available at eis.bcaresearch.com.

Recommendations

Trades

Asset Performance

Indicators

Bond Yields

Chart II-1
Indicators To Watch - Bond Yields

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Chart II-2
Indicators To Watch - Bond Yields

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Chart II-3
Indicators To Watch - Bond Yields

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Chart II-4
Indicators To Watch - Bond Yields

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Interest Rate

Chart II-5
Indicators To Watch - Interest Rate Expectations

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Chart II-6
Indicators To Watch - Interest Rate Expectations

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Chart II-7
Indicators To Watch - Interest Rate Expectations

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Chart II-8
Indicators To Watch - Interest Rate Expectations

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