Economy
An analysis on Turkey is available below. Highlights Due to the sizable stimulus announced by the NPC, we are upgrading our outlook for Chinese growth for this year. Nevertheless, in terms of investment strategy, we are reluctant to chase China-related plays higher at the moment. Rising geopolitical tensions between the US and China will likely produce a pullback in China-related risk assets, providing a better entry point in the months ahead. The RMB is set to depreciate dragging down emerging Asian currencies. There is evidence that the equity rally from late-March lows has been driven or supercharged by retail investors worldwide. Such retail-driven manias never end well, though they can last for a while. Feature Emerging market equities are facing a critical technical resistance. Chart I-1 shows that over the past decade, EM share prices often found support at the horizontal line during selloffs. The latter could now become a resistance point. In turn, the Australian dollar and the S&P 500 have climbed to their 200-day moving averages (Chart I-2). Chart I-1EM Stocks Are Facing A Technical Resistance Chart I-2S&P 500 And AUD Are At Critical Technical Juncture Having rallied strongly in the past two months, it is reasonable to expect that global risk assets will take a breather as investors assess the economic and geopolitical outlooks. China: Aggressive Stimulus… China has embarked on another round of aggressive stimulus. The government program approved by the National People’s Congress (NPC) last week laid out the following macro policy objectives: Stabilize employment. The NPC has pledged to create more than 9 million new jobs in urban areas. Although this is lower than last year’s target of more than 11 million new jobs, it is very ambitious given the number of layoffs that have occurred year-to-date. Chart I-3China: Money/Credit Is Set To Re-Accelerate Significantly accelerate the growth rate of broad money supply and total social financing relative to last year. Indeed, broad money growth accelerated in April and will continue to move higher (Chart I-3). Lending to enterprises and households as well as overall bank asset growth have all accelerated (Chart I-3, bottom two panels). Boost aggregate government spending (budgetary and quasi-fiscal) growth to 13.2% in 2020 versus 9.5% last year. Local government’s special bond quotas have been set at RMB 3.75 trillion yuan, compared with RMB 2.15 trillion last year. The central government will issue special bonds in the order of 1 trillion yuan. The proceeds will be transferred to local governments to support tax and fee reductions, as well as to boost consumption and investment. Support SMEs. The government will extend its beneficial loan-repayment policy for SMEs until March 2021. It will extend exemptions for SMEs on social security contributions, VAT and other fees and taxes through to the end of this year. The government estimates a total of RMB 2.5 trillion in tax and fee reductions for companies in 2020. Table I-1 details potential scenarios for the credit and fiscal spending impulse (CFI). In our baseline scenario, the CFI will rise to 15.5% of GDP by year-end (Chart I-4). In short, in 2020 the CFI will likely be larger than it was in 2015-’16 and closer to its 2012 level. However, it will still fall short of the 2009-2010 surge. Table I-1Simulation On Credit And Fiscal Spending Impulse For 2020 Chart I-4Our Projections For The Credit And Fiscal Spending Impulse In summary, it is fair to say that for now, the authorities have abandoned their deleveraging objective and are encouraging a substantial acceleration of both debt and credit. However, it will take time before the stimulus filters through the economy and boosts growth. This will be the case because of the following persistent headwinds: First, the reduced willingness of households and enterprises to spend. The top panel of Chart I-5 reveals that consumers’ marginal propensity to spend is falling. Enterprises’ willingness to invest continues to trend lower. Historically, companies’ willingness to invest has been a good indicator for industrial metals prices. So far it has not validated the advance in base metals (Chart I-5, bottom panel). The rationale for this correlation is that Chinese companies account for 50-55% of global industrial metals demand. Second, the COVID-19 economic downturn in China was much worse than previous downturns, and the financial health of companies and households is considerably poorer than before. This is why it will take very large amounts of stimulus to produce even a moderate recovery. In particular, a portion of the credit expansion will go toward plugging operating cash flow deficits at companies rather than to augment investment. For example, in the US, commercial and industrial loan growth surged in 2007/08 and this year (Chart I-6). In all of those cases, the underlying cause for credit acceleration was companies drawing on their credit lines to close their negative operating cashflow gaps. Chart I-5China: Households And Enterprises Are Less Willing To Spend Chart I-6US Loan Growth Spikes In Recessions The same phenomenon is presently occurring in China. This entails more credit origination will be required in China in this cycle before we witness a revival in capital spending. Third, geopolitical tensions between the US and China will escalate further in the months ahead. We elaborate on this in more detail below. As far as China’s growth outlook is concerned, rising geopolitical tensions with the US will weigh on both consumer and business confidence. On the whole, due to the sizable stimulus announced by the NPC, we are upgrading our outlook for Chinese growth for this year. Nevertheless, in terms of investment strategy, we are reluctant to chase China-related plays higher at the moment. Rising geopolitical tensions will likely produce a pullback in China-related risk assets, providing a better entry point in the months ahead. Chart I-7Chinese Economy: Still Very Weak In addition, the mainland economy is still undergoing post-lockdown normalization – not recovery. Both capital spending and household consumption are still in recession (Chart I-7). Bottom Line: China is yet again resorting to aggressive fiscal and credit stimulus. Mainland growth is bound to improve over the remainder of the year. However, financial markets have run a bit ahead of themselves, and we will wait for a pullback before recommending China-related plays. …But Geopolitics Is A Major Risk Despite an improving growth outlook, Asian and China-related risk assets could struggle in the months ahead due to escalating geopolitical tensions between the US and China. On the surface, the COVID-19 crisis seems to be the culprit behind rising tensions between the two nations. However, the pandemic has only accelerated an otherwise unavoidable confrontation between the existing superpower and the rising one. BCA’s Geopolitical Strategy team has been writing about cumulating tensions and the potential for them to boil over in the months before the US election. The contours of the rise in geopolitical tensions will be as follows: President Trump’s chances of re-election have declined, with the recession gripping the US economy and unemployment surging. There is little doubt that he will use external foes to rally the nation behind the flag. Blaming China for the pandemic and acting tough is probably the only way for Trump to switch his campaign’s nucleus from the economy to foreign policy, which will raise the odds of his election victory. The US administration will not resort to import tariffs this time around. Going forward, the administration’s goal will be cutting China’s access to foreign technology. Technology in general and semiconductors in particular will be the key battleground in this new cold war. The US will also step up its pressure on multinationals to move production out of China. The broader idea is to impede China’s technological advance. Even though the US rhetoric on China’s policies toward Hong Kong will be tough, there is little the US can do or will do regarding Hong Kong. Rather, the more important battleground will be Taiwan and its semiconductor industry. Finally, China’s political leadership cannot tolerate being perceived as weak domestically in the face of US pressures. They will retaliate against the US. One form of retaliation against Trump could be pushing North Korea to test its strategic military weapons that could undermine Trump’s foreign policy credibility in the US. Another form of retaliation could be tolerating moderate currency depreciation. The latter will challenge Trump’s claims that he has been victorious in dealing with China. The latest decision to ban US and foreign companies from accepting orders from Huawei and the slide in the value of the RMB are consistent with these narratives. To our surprise, however, financial markets in general and Asian markets in particular have not sold off meaningfully in response to the US ban on Huawei and renewed RMB depreciation. Critically, China is the world’s largest consumer of semiconductors, accounting for 35% of global semiconductor demand. Restricting Chinese purchases would be negative for global semiconductor producers. China has been aware of the risk of US restrictions on its imports of semiconductors and has been ramping up its semi imports since 2018. Semi imports have been booming even though smartphone sales had been shrinking (Chart I-8). This is a sign of large semiconductor restocking in China which has helped global semi sales in general and TSMC sales in particular in the past 18 months. In brief, major semi restocking by China in the past 18 months along with the ban on sales to Huawei all but ensure that global semiconductor sales will be weak this year. It does not seem that global semi stocks in general and Asian ones in particular are pricing in this outcome. Global semiconductor stocks are a hair below their all-time highs, and their trailing P/E ratio is at 21. Specifically, given Huawei is the second-largest customer of TSMC, the latter’s sales will be negatively affected (Chart I-9). Chart I-8Has China Been Stockpiling Semiconductors? Chart I-9TSMC Has Benefited From China Stockpiling Semiconductors Finally, both DRAM and NAND prices are falling anew (Chart I-10). Further, DRAM revenue proxy correlates with Korean tech stocks and points to lower share prices (Chart I-11). Chart I-10Semiconductor Prices Have Begun Falling Chart I-11Semiconductor Prices Are Still Deflating DRAM Revenue Proxy And Korean Tech Stocks Crucially, Chinese, Korean and Taiwanese stocks account for 60% of the MSCI EM equity market cap. Hence, a selloff in these bourses will weigh on the EM equity index. Chart I-12 shows that the latest drawdown in these North Asian equity markets was relatively small compared to the drop in the rest of the EM equity universe. Hence, Chinese, Korean and Taiwanese share prices are not discounting a lot of bad news making them vulnerable to the geopolitical risks that lie ahead. Financial markets in Asia are very complacent to mounting geopolitical risks stemming from the US-China confrontation. The RMB is set to depreciate dragging down emerging Asian currencies. Chart I-12North Asian Stocks Versus The Rest Of EM Bottom Line: Financial markets in Asia are very complacent to mounting geopolitical risks stemming from the US-China confrontation. The RMB is set to depreciate dragging down emerging Asian currencies. The large share of Chinese, Korean and Taiwanese stocks in the MSCI EM equity index implies significant downside risks to the EM equity benchmark. The Global Economic Outlook As economies around the world open, the level of economic activity will certainly begin to rise. The opening of shops, offices and various other facilities will result in a partial normalization and an increase in economic activities. However, we cannot call this a recovery. Rather it is just a snapback from the lockdowns which both equity and credit markets have already fully priced in. The outlook for global share prices and credit markets depends on what happens to the global economy following this post-lockdown snapback. Will the snapback be followed by an actual recovery or will the level of activity stagnate at low levels? For now, our sense is that following the initial snapback a U-shaped recovery is the most likely global scenario. This does not exclude the possibility that activity in some sectors/countries will follow a square root trajectory. From a global macro perspective, we have the following observations to share: Certain industries will likely experience stagflation. Due to social distancing measures, they will be forced to limit their output/capacity and compensate for their increased costs by charging higher prices. In this group, we would include airlines, restaurants, and other service sector businesses. The short-term outlook for consumer spending is contingent on fiscal stimulus. A material reduction in fiscal support for households will weigh on their spending capacity. Capital spending will remain subdued outside China’s stimulus-driven local government and SOE investment outlays, and outside the technology sector, generally. Critically, economic activity in many countries and industries will remain below pre-pandemic levels until late this year. This implies that despite the snapback, some businesses will still be operating below or close to their breakeven points. This will have ramifications on their ability to service debt and on their willingness to invest and hire. Any rise in government bond yields worldwide will be limited as central banks in both DM and EM will cap yields by augmenting their purchase of government and in some cases corporate bonds. We discussed EM QE programs in detail in last week’s report. Bottom Line: It is tempting to interpret the post-lockdown snapback in economic activity as a recovery. However, the nature and depth of this recession is unique. Investors should consider both the direction of economic indicators and the level of economic activity in relation to a company’s breakeven point. This is an extremely difficult task. And that is in addition to gauging the odds of a second wave of COVID-19 infections later this year. In the context of such complexities facing investors, there is astonishing evidence that the recent equity rally has been driven by unsophisticated retail investors. A Retail-Driven Equity Rally There is growing evidence that the equity rally from late-March lows has been driven or supercharged by retail investors, worldwide. There is growing evidence that the equity rally from late-March lows has been driven or supercharged by retail investors, worldwide. Such retail-driven manias never end well, though they can last for a while. The following articles corroborate the worldwide phenomenon that retail investors have been opening broker accounts en masse and investing in stocks: Bored Day Traders Locked at Home Are Now Obsessed With Options Frustrated sports punters turn to US stock market Coronavirus spawns new generation of Japanese stock pickers Stuck at Home, More Filipinos Try Luck at Stock Investing It is fair to assume that retail investors do very little fundamental analysis. Not surprisingly, since March global share prices have decoupled from profit expectations. Although some professional investors have no doubt also played the rally, surveys of asset managers and traders suggest that generally they have stayed lukewarm on stocks. Specifically, the net long position of asset managers and leveraged funds in various US equity index futures remains very low (Chart I-13). Chart I-14 shows that US traders’ and professional individual investors’ sentiment on US stocks are at multi-year lows. Only US investment advisors have become fairly bullish again (Chart I-14, bottom panel). Chart I-13Fund Managers Have Stayed Lukewarm On Stocks Chart I-14Professional Investors’ Sentiment On Stocks Have Been Subdued Who will capitulate first: retail or professional investors? It is hard to predict the behavior of investors but, if we had to guess, our take could be summed up as follows: If geopolitical tensions escalate much more or the number of COVID-19 inflections in some large countries rises anew, retail investors will likely sell before professional investors step in. In this scenario, share prices will drop considerably. In the case of an absence of geopolitical tensions or a new wave of infections, it is hard to see how economic data that is improving could lead to a substantial drawdown in equities even if the level of activity remains very depressed. In this case, corrections will be small and short-lived. Investment Strategy Chart I-15Beware Of Breakdowns For global equity portfolios, we continue recommending underweighting EM stocks. Regardless of the direction of global share prices, EM will continue underperforming DM (Chart I-15, top panel). The basis for this is rising geopolitical tensions in China and weakness in the RMB will spill over into other emerging Asian currencies (Chart I-15, bottom panel). We continue recommending short positions in the RMB and KRW versus the US dollar. In terms of the absolute performance of EM equities and credit markets, as well as EM currencies versus the greenback, we recommend being patient. Global and EM financial markets are presently at a critical juncture, as illustrated in Charts 1 and 2 on pages 1 and 2. If these and some other markets meaningfully break above current levels of resistance, we will upgrade our stance on EM stocks and credit markets and close our short positions in EM currencies versus the US dollar. If they fail to do so, a considerable selloff is likely to follow. As to EM local currency bonds, we are long duration but cautious on EM currencies. For the full list of our recommendations for EM equity, credit, local fixed-income and currency markets, please refer to pages 18 and 19. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, CFA Research Analyst linx@bcaresearch.com Turkish Lira: Facing A Litmus Test The Turkish lira has rolled over at its resistance level on a total return (including carry) basis (Chart II-1). The spot rate versus the US dollar is at its 2018 low. In short, the exchange rate is facing a litmus test. The culprit of a potential downleg in the lira is an enormous monetary deluge. Chart II-2 reveals that broad money supply growth has accelerated to 35% from a year ago. Local currency money supply is skyrocketing because the central bank and commercial banks are engaged in rampant money creation and public debt monetization. Chart II-1Turkish Lira (Including Carry): A Good Point To Short Chart II-2Turkey’s Broad Money: The Sky Is The Limit While such macro policies could benefit economic growth in the short term, they also herald growing inflationary pressures and currency devaluation. First, Turkish commercial banks have been on a government bonds buying binge since 2018 (Chart II-3, top panel). They presently own 62% of total local currency government bonds, up from 45% in early 2018. In addition, the central bank is de-facto engaging in government debt monetization. The Central Bank of Turkey (CBT) has bought TRY 40 billion of government bonds in the secondary market since March (Chart II-3, bottom panel). When a central bank or commercial bank buys a local currency asset from a non-bank, a new local currency deposit is created in the banking system and the money supply expands. Chart II-3Turkey: Public Debt Monetization In Full Force Chart II-4Turkey: Loan Growth Exceeds 30% Second, the commercial banks’ local currency loan growth has surged to 32% (Chart II-4). Government lending schemes and newly introduced regulations are incentivizing commercial banks to continue lending in order to boost domestic demand. In particular, state owned banks are providing loans at interest rates well below both the policy and inflation rates. The most likely outcome from such policies is rampant capital misallocation and an increase in non-performing loans. The former will weigh on productivity in the long turn. Third, the central bank has been providing enormous amounts of liquidity to commercial banks (Chart II-5, top panel). The latter’s local currency excess reserves – which are exclusively created out of thin air by the central bank - have surged (Chart II-5, bottom panel). In fact, the effective policy rate has been hovering below the actual policy rate, suggesting that there is an excess liquidity overflow in the banking system. In a nutshell, the central bank has been providing fuel to commercial banks to expand money supply via the purchases of local currency government bonds and loan origination. Fourth, an overly loose monetary stance will lead to higher inflation and currency devaluation. Moreover, wages continue to expand at an annual rate of 15-20%, confirming the fact that inflationary pressures are genuine and broad within this economy (Chart II-6). Higher inflation, and the consequent loss of purchasing power, is leading residents to switch their holdings of liras to foreign currencies. Chart II-5Central Banks' Liquidity Provision To Banks Chart II-6Turkey: A Sign Of Genuine Inflation Higher inflation, and the consequent loss of purchasing power, is leading residents to switch their holdings of liras to foreign currencies. Finally, Turkey’s current account deficit is set to widen, and the central bank’s net foreign currency reserves are non-existent at best. Booming credit growth will keep domestic demand and imports stronger than they otherwise would be. In the meantime, the complete collapse in tourism revenues and Turkey’s large foreign debt obligations, estimated at $160 billion over the next six months, entail negative balance of payment dynamics. Barring capital controls, Turkey will not be able to preclude further currency depreciation. Investment Implications Short the Turkish lira versus the US dollar. We recommend dedicated equity investors underweight Turkish equities and credit relative to their respective EM benchmarks. Also, we are reiterating our short Turkish banks / long Russian banks position. Local currency yields will offer little protection against currency depreciation. As such, investors should underweight domestic bonds. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Since the COVID-19 crisis began, the Basic Index of the MBA Mortgage Applications data has been lifted by the surge in its Refinancing Index. However, applications for purchases weakened sharply. This divergence is reversing. The Refinancing Index is…
The contraction in Chinese industrial profits is abating. Their annual growth rate rebounded from -34.9% in March to -4.3% in April. On a year-to-date basis, profit growth is also recovering, albeit more slowly. Two factors suggest that this recovery has…
Europe is moving in the right direction. COVID-19 has broken the taboo of common bond issuance in Europe. Last week, Chancellor Merkel, President Macron and EC President von der Leyen hatched a plan to issue common bonds that will finance a EUR500 billion…
Yesterday, the Dallas Fed released its monthly Texas Business Outlook survey. The manufacturing portion of the survey highlighted that an important region of the US is starting to mend despite depressed oil prices. However, the survey revealed that despite a…
Highlights Portfolio Strategy The Fed’s extremely easy monetary backdrop along with easy fiscal policy remain the dominant macro themes, and they will continue to underpin the equity market. We remain constructive on the equity market’s prospects on a cyclical 9-12 month time horizon. While the path of least resistance remains higher for the S&P biotech index, we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. Relative supply/demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha. Recent Changes Initiate a long S&P homebuilders/short S&P real estate trade, today. Table 1 Feature The SPX had a bumper week last week, but failed to pierce through the 200-day moving average. A flare up in the US/China trade war, a barrage of positive coronavirus vaccine news and Jay Powell’s 60 minutes interview brought back some volatility in trading, however, the VIX remains in a steady downturn. Importantly, investors are nowhere near as complacent as during the 2018/19 or early 2020 SPX peaks, judging by VIX futures positioning (net speculative positions shown inverted, Chart 1). Chart 1Positioning Is Far... In other words, there is still room for equities to rise before sentiment reaches greedy levels. A number of other indicators we track confirm that recent SPX trading is associated more with panic than with euphoria. Namely, Chart 2 shows that our Complacency-Anxiety, Capitulation and Equity Sentiment Indicators, all corroborate that investor confidence is far from previous exuberant peaks, and signal that there is scope for additional equity gains on a cyclical 9-12 month time horizon. Delving deeper into investor psyche, our sense is that there are three distinct camps of investors at the current juncture, two of which are fiercely battling it out in the stock market. Chart 2…From Complacent First there are the pessimists that we call “second wavers” that are more often than not also “Fed non-believers” or “Fed fighters”. They argue that stocks are extremely expensive and if a second wave of the corona virus hits, then stocks are going to plunge anew given the lack of a valuation cushion, as all the money in the world (Fed QE5) cannot cure the virus (top panel, Chart 3). Second, there are the optimists that are hopeful that a vaccine/drug cocktail discovery is looming to effectively eradicate the coronavirus. These investors also believe in the smooth reopening of the economy. But, even if there were a second wave, their thinking goes that our societies/governments/health care systems are all going to be more prepared and effective to deal with a second viral outbreak in the fall. In addition, they are in the “do not fight the Fed” camp. Finally, there are the more moderate investors that lie somewhere in between these two camps. They sat tight and held on to their stock positions during the 36% peak-to-trough SPX drawdown and have likely been on the sidelines lately (bottom panel, Chart 3) awaiting a catalyst to either deploy fresh capital or raise some cash. We are in the more optimistic camp and while a vaccine may be months away, we will have to figure out a way as a society to more effectively protect the elderly that are most at risk from the virus and continue to live on, as we first posited in the March 23rd Weekly Report when we outlined 20 reasons to buy stocks and reprint here: "20. Social-distancing measures in the West will ultimately break the Epidemic Curve first derivative and arrest the panic. Even if COVID-19 comes back in force, the fact is that most of the patients who succumb to it are elderly. In Italy, the average age of death is 80 years old. As such, the final circuit-breaker ahead of a GFC would be desensitization by the population, as selective quarantines – targeting the elderly cohorts – get implemented in order to allow other people to return to work. Furthermore, two “silver bullet” solutions remain as tail risks to the bearish narrative. First, a biotech or pharmaceutical company may make a breakthrough in the fight against COVID-19. Not necessarily a vaccine, but a treatment. Finally, upcoming warm weather in the northern hemisphere may also help the fight against the virus."1 Chart 3Cash Hoarding Is Associated With Market Troughs Chart 4Loose Monetary Policy… Moreover, we definitely refrain from fighting the Fed as we outlined in our recent “Fight Central Banks At Your Own Peril” Weekly Report2 and reiterate that view today (Chart 4). While some investors were surprised by Jay Powell’s 60 Minutes interview remarks on the way the Fed digitally creates money, Ben Bernanke in another 60 Minutes interview in March 20093 made a similar comment that we cited in our March 23 Weekly Report (please refer to reason number 6 to buy equities).4 Importantly, we felt that Jay Powell’s demeanor was more like “please test our resolve Mr. Market if you reckon the FOMC is out of ammunition”. As a reminder, the Fed is in a position of strength: devaluing a currency is easy, revaluing/defending a currency is difficult and at times impossible as FX (and gold) reserves eventually run dry. In sum, the Fed’s extremely easy monetary backdrop along with easy fiscal policy (Chart 5) remain the dominant macro themes, and they will continue to underpin the equity market. Eventually, a liquidity handoff to growth will take root, and the SPX will no longer require the immense fiscal and monetary supports. As a result we continue to believe that stocks will be higher in the coming 9-12 months. Chart 5…And Easy Fiscal Policy Are Underpinning Stocks Biotech Delivers We have been overweight the S&P biotech index and adding alpha to our portfolio in the double digits, however we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. While a few technology sectors and subsectors have come close to vaulting to fresh all-time highs, none other than the S&P biotech index has managed such an impressive feat. The stealthy advance in biotech stocks has been earnings driven and is not only confined to the narrow based Big-Pharma lookalike S&P biotech index (Chart 6). The broader-based NASDAQ biotech index comprising 209 stocks has also quietly sprang to uncharted territory. True, relative share prices have yet to make the all-time high leap, but have bested the market roughly by 30% year-to-date irrespective of the biotech index or ETF tracked (Chart 6). Importantly, growth stocks in general and biotech stocks in particular perform exceptionally well in a disinflationary growth environment. Therefore biotech stocks are the primary beneficiaries of the Fed’s QE5 and NIRP policies at a time when inflation is missing in action (top panel, Chart 7). Chart 6Earnings-Led Advance This goldilocks backdrop is also evident in the US bank credit impulse that has gone parabolic. When there is flushing liquidity and growth is scarce and declining, investors flock to any growth they can get their hands on (bottom panel, Chart 7). Chart 7Goldilocks Backdrop US dollar based liquidity, also underpins biotech stocks. In recent research, we have been highlighting that the Fed is indirectly targeting the debasing of the greenback. All this excess US dollar liquidity will eventually boost global growth, and reflate corporate earnings via the export relief valve. Biotech stocks will also get a fillip from a depreciating US dollar (Chart 8). Our overweight thesis in biotech was predicated – among other things – upon Big Pharma taking out biotech players and acquiring their coveted drug pipelines. We continue to side with the potential M&A targets, rather than the acquirers. The number of industry M&A deals has reached fever pitch and deal premia are still averaging over 60% (Chart 9). Chart 8Dollar Flooding Is A Boon For Biotech Equities Currently, the global race to find a coronavirus vaccine has further propelled biotech stocks. Indeed, investors are voting with their feet and are betting on a vaccine breakthrough. Thus, the allure of biotech stocks has also increased a notch as the possibility of a vaccine makes their earnings streams even more valuable and desirable to Big Pharma. A mega M&A deal in the space would not take us by surprise. Chart 9M&A Activity Will Remain Robust A few words are in order on the earnings, valuation and technical fronts. While relative share price momentum is galloping higher, it is moving in lockstep with rising earnings estimates (second panel, Chart 10). We would be extremely concerned if this were a multiple expansion driven relative share price advance. In fact, the biotech forward P/E trades both below the historical mean and at a 39% discount to the broad market hovering near an all-time low (Chart 10). Even on a dividend yield basis, biotech stocks are cheap sporting a higher (and safer) dividend yield than the SPX (bottom panel, Chart 10). Chart 10Biotech Stocks Are As Cheap As They Have Ever Been Chart 11Earnings Hurdle Remains Low Finally, relative long-term profit growth euphoria reaching astronomical levels, preceded previous S&P biotech index peaks: three times in the past two decades biotech stocks were projected to surpass SPX profit growth by roughly 10%. The current reading has plunged to negative 1.2% (Chart 11). Netting it all out, the global race for a coronavirus vaccine, robust earnings growth, ample US dollar liquidity and generationally low interest rates suggest that the path of least resistance remains higher for the S&P biotech index. Bottom Line: Stay overweight the S&P biotech index, but put it on downgrade alert and set a 5% rolling stop in order to protect profits. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, ALXN, AMGN, BIIB, GILD, INCY, REGN, VRTX. Intra-Real Estate Trade Idea There is an exploitable trade opportunity in the real estate market, preferring residential real estate to commercial real estate (CRE). The cleanest way to play this is via a long S&P homebuilders/short S&P REITs pair trade, and we recommend initiating such a market-neutral trade today. Relative performance remains below the upward sloping time trend and at least a mini overshoot phase is in the cards in the coming quarters (Chart 12). One of the key drivers for this pair trade is the ebb and flow of owning versus renting and the current message is positive for homebuilders at the expense of REITs (Chart 13). Chart 12Looming Overshoot Phase Chart 13Own Versus Rent Upswing Is Bullish For The Pair Trade Home ownership has suffered a setback and never reclaimed its pre GFC highs. However, there is pent up demand for single family homes, especially given the recent drubbing of interest rates which should bring first time home buyers back into the market. Millennials up to now have been more of a renter generation, but as household formation increases for the largest cohort in the US, homeownership will make a comeback. One can argue that both real estate segments are interest rate sensitive and that they should benefit from lower rates. However, banks are more willing to lend to consumers in order to buy a home rather than to investors for CRE properties/projects by a factor of 2:1 according to the latest Federal Reserve Senior Loan Officer survey.5 Similarly, whereas demand for CRE loans has collapsed according to the same survey in April, demand for residential real estate loans spiked (top panel, Chart 14). In times of coronavirus-induced social distancing there is a lot more risk associated with CRE versus residential properties. Apartment REITs for example have an element of density-related risk versus the allure of a single family home in the suburbs. Likely social distancing will place a premium on single family homes in coming quarters at the expense of living in high rises in the city. This backdrop bodes well for home prices, but ill for CRE prices which according to Green Street Advisors contracted by 9% in April.6 Keep in mind that residential real estate price only very recently surpassed their 2006 zenith whereas CRE price are still hovering at one standard deviation above the previous peak (Chart 14). Debt deflation is a real threat for CRE prices and given that REITs are at the bottom of this levered asset’s capital structure it is last to collect. Also the long-term ramifications to demand on CRE are grave compared with residential real estate. On the office REIT segment as an example, we deem that corporations will rethink their often expensive downtown office space requirements and likely downsize, as working from home has become mainstream. The unintended consequence of this realization is that demand for (larger) single family homes will also increase as workers opt to set up more comfortable working spaces at suburban homes. Chart 14Homebuilders Have The Upper Hand Shopping mall REITs are under relentless attack from the Amazonification of the economy and now have to contend with social distancing. The retail shopping experience will never be the same again sustaining the threat of extinction for shopping centers. On the construction front, single family housing starts are breaking ground at the historical mean and way below the 2006 peak run-rate, however, multi-family supply has gone parabolic (Chart 15). These diverging supply conditions are a harbinger of rising relative share prices. Finally, with regard to technicals and valuations homebuilders have the upper hand. Our Technical Indicator is in the neutral zone and relative valuations have collapsed near all-time lows offering a compelling entry point to the pair trade (Chart 16). Chart 15Supply Dynamics Favor Homebuilders Chart 16Relative Pessimism Is Contrarily Positive Netting it all out, relative supply and demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha. Bottom Line: Initiate a long S&P homebuilders/short S&P REITs pair trade today. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME – LEN, PHM, NVR, DHI, and BLBG: S5REITS – AMT, PLD, CCI, EQIX, DLR, SBAC, PSA, AVB, EQR, WELL, ARE, O, SPG, ESS, WY, MAA, VTR, DRE, PEAK, BXP, EXR, UDR, HST, REG, IRM, VNO, FRT, AIV, KIM, SLG, respectively. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 2 Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com. 3 https://www.cbsnews.com/news/ben-bernankes-greatest-challenge/2/ 4 Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 5 https://www.federalreserve.gov/data/sloos/sloos-202004.htm 6 https://www.greenstreetadvisors.com/insights/CPPI Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Highlights Duration: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Municipal Bonds: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Inflation & TIPS: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. Treasury Yield Outlook Chart 1Taking A Breather Bond yields have been relatively stable since early April, and the Treasury index has performed roughly in-line with cash for most of the second quarter. This of course follows on the heels of massive outperformance in Q1 (Chart 1). Nonetheless, the recent stabilization in yields raises the question of whether bond returns are approaching a cyclical peak, or merely experiencing a temporary lull. Yields Are Biased Higher In The Near-Term … Our view is that a modest bond sell-off is likely during the next couple of months for four reasons. First, high-frequency global growth indicators are finally starting to hook up (Chart 2). Specifically, we like to track the CRB Raw Industrials commodity price index, emerging market currencies and the relative performance of cyclical versus defensive US equities. All three indicators track bond yields closely, and all three are showing signs of bottoming. Chart 2High-Frequency Global Growth Indicators Second, FLASH PMI estimates for May showed broad-based improvement compared to the April lows. Specifically, FLASH Manufacturing PMIs for the United States, Euro Area and United Kingdom all increased compared to April (Chart 3A). Of countries that have FLASH PMI estimates, only Japan saw a continued decline in May. If these numbers are to be believed, they suggest that April might indeed represent the global economic trough. We are still waiting for May data from China and the rest of the emerging world, important economic blocs that together account for 47% of the Global Manufacturing PMI. But China’s PMI, at least, has already rebounded off its February low (Chart 3B). China’s number will likely pressure the global index higher when it is released next week. Chart 3APMI Estimates For May Chart 3BChina's PMI Is Close To Neutral Third, high-frequency US economic data are consistent with an economy that is close to, or perhaps already passed, its economic trough. Initial jobless claims are still very high but have printed successively lower since peaking seven weeks ago. Similarly, the New York Fed’s Weekly Economic Index remains at its all-time low but is no longer in free fall (Chart 4).1 Chart 4US Economic Indicators Finally, but also most importantly, the slightly better data noted above are the result of economies that are slowly starting to re-open as daily new COVID cases roll over. This is particularly the case in Europe and North America (Chart 5). Restrictions will probably continue to ease during the next couple of months, meaning that both the economic data and bond yields are biased higher. Chart 5Global COVID-19 Cases … But Don’t Expect Anything More Than A Modest Sell-Off Chart 6Fed's Forward Guidance Quickly Dampened Vol However, there are also a few reasons to not get too bearish on US bonds. First, it is entirely possible – and even likely – that COVID cases will start to increase as shelter-in-place restrictions are lifted. If these second waves of the infection aren’t adequately suppressed via testing and contact tracing then restrictions could be re-instated by the fall, putting renewed downward pressure on bond yields. Also, while new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. Brazil and India, for example, have yet to see a peak in new cases, while Russia’s new cases have just started to roll over (Chart 5, bottom 2 panels). Together, Brazil, Russia and India account for 8% of the Global Manufacturing PMI. Slow growth in those nations will significantly dampen any global economic recovery. On top of uncertainty surrounding the speed of any nascent global economic recovery, bond yields will also be held down by the Fed’s highly credible zero-lower-bound interest rate guidance. As we discussed in last week’s report, large bond sell-offs are almost always associated with a significant hawkish shift in monetary policy.2 This will not occur any time soon. In fact, the New York Fed’s latest Survey of Market Participants, taken just prior to the April 28-29 FOMC meeting, reveals that the median market participant expects the fed funds rate to stay at its current level at least until the end of 2022!3 On the one hand, such depressed expectations suggest scope for a massive re-pricing at some point in the future, but this will not occur until inflation forces the Fed to act. We agree with the survey respondents that this is a long way off. While new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. It’s also interesting to note the speed at which the market has bought into the Fed’s zero-lower-bound rate guidance during the past two months. Chart 6 shows that after the Fed first cut rates to zero in December 2008, it still took several years for implied interest rate volatility to reach historically low levels. That is, the market was not initially convinced that rates would stay at zero for the long haul. In contrast, interest rate volatility has plunged dramatically since the Fed cut rates to zero on March 15. This time around, the market has been quick to buy into the Fed’s dovish message. Bottom Line: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Additionally, we can’t rule out the resumption of lockdown restrictions in the fall, should COVID cases rise during the summer. In terms of strategy, nimble investors may want to position for higher yields in the near-term. However, given the risks involved, we prefer to keep portfolio duration close to benchmark while implementing duration-neutral curve steepeners that will profit from rising yields. Specifically, we recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes.4 Munis Carry Some Risk, But Offer A Lot Of Value Chart 7Munis Cheap Versus Treasuries Our spread product investment strategy during the recession has been to favor those sectors that: a) Offer attractive yields/spreads b) Benefit from one or more of the Fed’s emergency lending facilities Municipal bonds check both of those boxes. In terms of value, Aaa-rated municipal bond yields are consistently above Treasury yields across the entire maturity spectrum (Chart 7), a yield advantage that becomes especially pronounced when you factor in munis’ tax-exempt status. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Table 1A shows the yield differential between tax-exempt municipal bonds and corporate bonds that carry the same credit rating and maturity. Not surprisingly, municipal bond yields are below corporate yields in most cases, with A-rated yields and longer-maturity Baa-rated yields being glaring exceptions. To put those yield differentials in context, Table 1B shows the breakeven effective tax rate for each muni/corporate combination. For example, the breakeven effective tax rate between Aaa-rated 5-year municipal and corporate bonds is 23%. This means that an investor will earn more after-tax yield in the municipal bond if his effective tax rate is above 23%, and less if it is below. It is apparent that breakeven effective tax rates are quite low, especially at the bottom-end of the credit spectrum. Table 1ASpread Between Municipal Bonds & Credit Index Yields* (BPs) Table IBMuni/Credit Breakeven Effective Tax Rate* (%) As for our second criterion, the municipal sector clearly benefits from the Fed’s Municipal Liquidity Facility (MLF). Through this facility, the Fed lends directly to eligible state & local governments for up to three years.5 However, there is a problem with the MLF: The cost. The Fed recently revealed that it will charge a rate of OIS + 150 bps for new loans taken out by Aaa-rated issuers through the MLF. That fixed spread rises as the issuer’s credit rating declines. Aa2 issuers are charged OIS + 175 bps, A2 issuers are charged OIS + 250 bps, etc…6 Chart 8MLF Pricing Doesn't Help Muni Investors For each credit rating, the rate available through the MLF is significantly higher than the actual market yield (Chart 8). This means that the MLF currently places a cap on how high municipal yields can rise, but it doesn’t actively pressure them lower. This stands in stark contrast to the rates offered through the Term Asset-Backed Securities Loan Facility (TALF) that are considerably below market yields on Aaa-rated CMBS and similar to market yields on Aaa-rated consumer ABS. Uncharitable MLF pricing structure aside, we think there are several reasons to remain overweight municipal bonds within US fixed income portfolios. First, the Fed is already facing criticism about the MLF rates and it could lower them in the near future. It has already shown a willingness to alter its facilities in response to market pressure. The MLF initially only made loans with maturities of 2 years or less, now it offers loans of up to 3 years. Second, direct federal aid to state & local governments was the centerpiece of the relief bill that recently passed through the House of Representatives. That bill will not get through the Senate in its current form, but another federal government relief package is forthcoming and it will almost certainly include money for state & local governments. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Third, despite the massive challenges ahead, state governments entered the present crisis with relatively strong budget positions and well stocked rainy day funds (Chart 9). State & local governments will obviously be forced to make some tough budget decisions in the coming months, but there is no doubt that they are in a better position to do so than they were prior to the last two recessions. Chart 9State Rainy Day Funds Bottom Line: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Deflation A Bigger Risk Than Inflation, But TIPS Still Make Sense Chart 10Energy Inflation May Have Troughed April’s CPI report saw year-over-year headline inflation fall to 0.4%, the lowest level since 2015. Deflation is clearly a bigger risk than inflation this year, but we would argue that TIPS prices are so beaten down that the sector still offers value. This is true over investment horizons as short as one year. We calculate that headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries (Chart 10). Could we actually see that much deflation during the next 12 months? It is possible, but we’d bet against it. First, the collapse in oil prices and energy inflation has been an important driver of falling inflation during the past couple of months (Chart 10, panel 2). But with oil prices having already dipped into negative territory and massive production cuts about to come on board, energy inflation may have already troughed for the year.7 At the very least, with oil prices already so low there is much less room for them to decline and thus less scope for further energy CPI deceleration. Second, the Great Financial Crisis (GFC) was the last time that headline CPI inflation went significantly below zero. Year-over-year core inflation had to get to 0.6% for that to happen. This year, 12-month core CPI dropped to 1.4% in April from 2.1%, but the trimmed mean measure only fell from 2.4% to 2.2% (Chart 10, bottom panel). During the GFC, both core and trimmed mean inflation fell in tandem. This gives us some reason to doubt the persistence of core CPI’s recent drop. Headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries. Finally, shelter accounts for roughly one third of headline inflation. Year-over-year shelter CPI troughed at -0.6% during the GFC. It also dropped sharply in April – from 3.0% to 2.6% – but it still has a long way to go to get back to GFC levels (Chart 11). We don’t think that shelter inflation will move back into negative territory, and without that drag it is hard to see 12-month headline CPI falling much below zero. Chart 11Shelter Is One Third Of CPI Rental vacancies are the number one driver of shelter CPI. The rental vacancy rate has only been updated through the end of March, and April’s data will definitely show a spike. However, the vacancy rate is starting from below 7%. The vacancy rate needed to spend several years hovering around 10% or higher before shelter CPI saw its big drop in 2008/09 (Chart 11, panel 2). The National Multifamily Housing Council (NMHC)’s Apartment Market Diffusion Index also does a good job predicting shelter inflation. Shelter inflation tends to fall when the index is below 50 and rise when it is above 50 (Chart 11, bottom panel). The Diffusion Index experienced a massive drop in April, back to GFC levels. However, it remains to be seen whether it will recover rapidly or remain below 50 for ten consecutive quarters like it did between 2007 and 2010. In fact, there is some reason to believe that the recovery might be fairly quick. Other data released by the NMHC show that as of May 20 2020, 90.8% of renters had made their monthly payments for May. In April 2020, 89.2% of renters had made their monthly payments by the 20th of the month. Unsurprisingly, both of these figures are below what was seen last year: In 2019, about 93% of renters had made their April and May monthly payments by the 20th of the month. But the fact that May 2020 data show a small increase compared to April indicates that the situation is not worsening, and it may in fact be getting better. Bottom Line: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. We recommend overweighting TIPS versus nominal Treasuries across the entire maturity spectrum. We also recommend implementing TIPS curve steepeners.8 Appendix - Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. Right now, that means we are overweight corporate bonds rated Ba and higher, Aaa-rated Agency and non-agency CMBS, Aaa-rated consumer ABS and municipal bonds. We are underweight residential mortgage-backed securities and corporate bonds rated B and lower. The below Table tracks the performance of these different bond sectors since the Fed’s March 23 announcement. We will use this Table to monitor bond market correlations and evaluate our strategy's success. Table 2Performance Since March 23 Announcement Of Emergency Fed FacilitiesRyan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The Weekly Economic Index is a composite of 10 daily and weekly indicators of real economic activity. For more details on its construction please see https://www.newyorkfed.org/research/policy/weekly-economic-index 2 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 3 https://www.newyorkfed.org/medialibrary/media/markets/survey/2020/apr-2020-smp-results.pdf 4 For more details on our recommended yield curve positioning please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 For more details on the MLF and the Fed’s other emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 For full pricing details please see https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200511a1.pdf 7 For more details on BCA’s outlook for oil prices please see Commodity & Energy Strategy Weekly Report, “US Politics Will Drive 2H20 Oil Prices”, dated May 21, 2020, available at ces.bcaresearch.com 8 For more details on our recommendation for TIPS curve steepeners please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Yesterday, BCA Research's US Investment Strategy service concluded that although the Fed will do "whatever it takes" it cannot defend the economy from monumental job losses all by itself. It seems reasonable to assume that the worst of the public health news…