Equities
Highlights Trump's odds are still only around 55%. Biden remains the frontrunner in the Democratic primary election, albeit a weak one. Sanders brings forward the risk to this view. Evidence does not suggest that Trump would beat Sanders in a landslide. Bloomberg’s “moment” is arriving but Biden and Buttigieg must fall for him to win. The Democrats will likely avoid a contested convention. If they don’t, Trump benefits. Expect equity volatility in the near term. The market must clear the coronavirus and Democratic primary hurdles before it can rally sustainably. Feature Chart 1China: Bad News, Then Stimulus Boost Over the past week we visited clients in New York and Toronto and debated a range of intriguing questions. The coronavirus impact was top of mind. The outbreak will delay the Chinese economic rebound we expected in the first quarter. It also reinforces one of our key geopolitical views on Chinese policy: bad news will be followed by good news in the form of increased stimulus (Chart 1). The problem is that this is good news for the second half of the year at best, while the near term is extremely murky. After the virus, the US election cycle was clearly the greatest source of policy uncertainty. Because clients asked so many questions on this topic, we devote this report to the election. We still expect US equity volatility in the near term. Aren’t Trump’s Odds Of Reelection Better Than 55%? No. Clients hardly raised an eyebrow this time when we argued that President Trump was favored to win reelection – a stark turnaround from just three months ago, when many believed that his goose was cooked. So much has the climate changed that many clients now argue that Trump’s odds have reached 70% and he is likely to win by a landslide. But that is going too far – according to the data. Certainly Trump is coming off a string of successes. So far this year he has deterred Iran, struck trade deals with the US’s top trading partners – China, Canada, and Mexico – and been acquitted of impeachment articles (Chart 2). The Republican-led Senate resisted a last-ditch effort to admit witnesses and prolong the impeachment trial, and few Republicans defected in the final vote.1 Chart 2Trump Acquittal: Political Constraints In Action Chart 3Trade Deals, Impeachment Boosted Trump Approval Trump’s approval rating hit its all-time high just as the Senate voted to acquit (Chart 3). The impeachment process backfired on the Democrats, a point corroborated by the recent shift in the public’s party identification that puts the Republicans right alongside the Democrats after a period in which they trailed (Chart 4). Just before his acquittal, the president delivered a State of the Union Address in which he rattled off a catalogue of record-setting, late-cycle economic statistics. Meanwhile the Democrats suffered a debacle at their first primary election, the Iowa caucus, when a rushed attempt to improve their digital savvy in the electoral process resulted in a software malfunction that delayed the announcement of election tallies. Nevertheless, the ballot is nine months away and the path to reelection is fraught with danger. First, President Trump has not yet proven that he can keep his approval rating in the upper 40s, let alone over 50%. A true game changer would be cracking 50% on a sustainable basis. If Trump slips beneath the 46% of the vote he received in 2016 his odds fall back toward 50%. Assuming the economy rebounds he cannot afford to slip much below his stable range of 43% and still win, according to the model. Second, the manufacturing sector is only just poking its head out of the woods, leaving the critical swing states of Michigan, Pennsylvania, and Wisconsin hanging in the balance, albeit with positive news (Chart 5). Chart 4More Voters Identify As Republican Post-Impeachment Chart 5US Manufacturing Rebounding, But Watch For Virus Hit Our quantitative election model suggests the election is too close to call. Technically the model shows Trump slipping beneath the threshold for victory for the first time since we unveiled it in November (Chart 6). The reason is that the leading economic indicators in Wisconsin and especially Pennsylvania took a turn for the worse in December. These indicators are forward-looking – they predict the 6-month growth rate of the state coincident indexes, which include nonfarm payroll employment, average hours worked in manufacturing by production workers, the unemployment rate, and wage and salary disbursements deflated by the consumer price index. Chart 6Quantitative Election Model Shows Election A Toss Up Chart 7Pennsylvania Job Growth A Risk To Trump Of course, the state leading indicators also tend to be heavily revised in subsequent prints, which can make our model volatile. Month-on-month total employment growth from the Bureau of Labor Statistics corroborates the shaky status of Pennsylvania, but not Wisconsin (Chart 7). This slight shift in our model from a Trump win to a Trump loss does not change our overall election forecast, which has a qualitative overlay. The point is that Trump is still skating on thin ice, the US manufacturing sector.2 Going forward, the US and global economy should continue improving, especially in the second half of the year. The demand shock emanating from the coronavirus outbreak in China should be temporary. The eventual rebound in Chinese demand combined with the lagged effect of China’s new stimulus measures will benefit US manufacturing states. The manufacturing sector’s woes are still a clear and present danger for Trump. Bottom Line: Trump is still favored but his odds of winning are still only 55% qualitatively. The election will remain a major source of uncertainty throughout the year. Investors need to be prepared for either outcome. Volatility is also frontloaded due to the coronavirus shock to the global economy. Is Biden Still The Frontrunner? Yes. Former Vice President Joe Biden bombed in the Iowa caucus, the first of the Democratic Party’s primary elections, coming in fourth place behind South Bend Mayor Pete Buttigieg, Vermont Senator Bernie Sanders, and Massachusetts Senator Elizabeth Warren. He barely beat the sensible but uninspiring Minnesota Senator Amy Klobuchar (Chart 8). Chart 8Iowa: Buttigieg Surged, Biden Slumped Chart 9Biden Still The Democrats’ Frontrunner Traditionally Iowa delivers a polling boost to the victor, since it goes first and attracts attention disproportionate to its size. But this year the first-comer effect is largely moot because of the reporting debacle. Both Buttigieg’s win and Biden’s loss have been drowned out. This is consolation for Biden because he is far more competitive in later states than Buttigieg – he is in fact still the (weak) frontrunner in national polling (Chart 9). Biden also continues to lead our back-of-the-envelope projection of the delegates who will be pledged to candidates at the end of the primary election season on June 6 in Washington, DC. True, Biden is lined up for a plurality at best, not a majority. There are still plenty of “other” delegates to be redistributed, which could leave Biden in the dust if his polling breaks down due to a loss of momentum in the early states (Chart 10A). Nevertheless the centrist “lane” now has a commanding lead over the progressive lane for the first time in the race, creating our base case in which Biden wins a plurality of votes that translates into winning the nomination (Chart 10B). Chart 10ABiden Leads Back-Of-Envelope Delegate Count For Democratic Nomination Chart 10BCentrists Lead Back-Of-Envelope Delegate Count For Democratic Nomination If Biden continues to underperform his polling in New Hampshire and Nevada then he could stumble into a huge disappointment in South Carolina, his bulwark, on February 29 (Chart 11). As the first southern state, South Carolina is the bellwether for Super Tuesday, March 3, when about 35% of the delegates are up for grabs, 54% of which are southern (Chart 12). Anything that shakes Biden’s substantial lead in South Carolina sets him up for failure overall and pushes Sanders into the frontrunner position. Chart 11Biden’s Bulwark Is South Carolina Chart 12Biden’s ‘Southern Strategy’ Should Pay On Super Tuesday Sanders would then face an emerging centrist in the shape of Buttigieg or Bloomberg. (Or Warren will pivot to the center.) Aside from Biden’s lead in the national polling, and many of the southern and Midwestern states, he continues to benefit from a tailwind in that he is the more “electable” or competitive candidate against Trump. Head-to-head polls continue to bear this out (Chart 13). These polls will congeal around almost any candidate once he or she becomes the de facto nominee, but over the past year Biden has performed far better than any of the others. Chart 13Biden Beats Trump Head-To-Head In Every Swing State (So Far) Bottom Line: Anyone who wants to show their electability against Trump must first prove it by dethroning Biden. This could happen in February if Bernie Sanders generates runaway momentum in the early primaries, so the equity market faces major election risk imminently. Is A Sanders Nomination Suicide For The Democrats? Not Necessarily. Chart 14Sanders Generating Momentum In Early Primaries Sanders is only slightly less likely to win the Democratic nomination than Biden. He is clearly capable of doing so – he rivals Biden in the nationwide polling and surpasses him in the early states. Strong finishes in New Hampshire and Nevada are expected and could generate momentum that lasts through Super Tuesday and beyond (Chart 14). Ideologically Sanders is not unthinkable for most Democrats – the average Democrat is shifting to the left of the political spectrum (Chart 15). Most Biden supporters say Sanders is their second choice (Chart 16). Voters are interested in electability, so if Sanders can prove that he is more electable than Biden, voters will flock to him. Chart 15Democrats More Liberal Than In The Past Chart 16Biden Voters Support … Sanders! Thus the question of Sanders is more about the general election than the primary. “Movement candidates” like Alf Landon, Barry Goldwater, and George McGovern have racked up some of the most humiliating defeats in the history of US elections. The self-described democratic socialist Bernie Sanders has some of the defining traits – he has a movement, he is ideologically “pure” and outside the mainstream, and his nomination is a gamble on whether his youthful supporters’ enthusiasm will carry over to the general public. It is plausible that the Democratic Party could choose Sanders out of a desire to fight populist fire with fire, only to find that Trump overwhelmingly benefits from the stigma of socialism in the swing states. Sanders could still win the nomination and even the White House. So far, however, the evidence does not bear out this interpretation. The aforementioned Chart 13 shows that Sanders is second only to Biden against Trump. It is notable that he outperformed Hillary Clinton versus Trump in 2016 (Chart 17). He is specifically competitive against Trump in the Midwest swing states because of his ability to compete for the vote of the blue-collar worker. Thus he has a viable path to winning the Electoral College: the Clinton 2016 states plus Michigan, Pennsylvania, and Wisconsin. Biden’s primary advantage, by this measure, is that he is also competitive in Florida as well as the Midwest, which broadens his Electoral College options. And while Sanders captivates the youth, Biden appeals to African Americans and moderates who turn out to vote more reliably (Chart 18). Chart 17Sanders Outperformed Hillary Versus Trump Chart 18Biden’s Supporters Have Higher Turnout Ultimately presidential elections are referendums on the incumbent party. Since World War II, incumbent parties have lost because of major shifts in the economic, social, or international context that discredit the current administration and drive voters to demand “regime change.” Sitting presidents strengthen the incumbent party and have only lost in a recessionary environment (1980, 1992) or a massive scandal (1976). And Trump’s scandal has been neutralized, for now, due to his acquittal in the Senate. Unless Trump suffers from a faltering economy, a policy humiliation at home or abroad, or a third party candidate who splits the Republican vote, he is unlikely to be discomfited. By the same token, if major changes occur, Sanders will be as good as or even better than Biden at riding the wave of disenchantment with the ruling party and its figurehead. PredictIt, the online betting site, currently puts Sanders at 29% chance of winning the White House, while Biden stands at 7%. Both are underrated given our assessment that Trump’s odds of election still stand at 55% and that he is only likely to fall as a result of economic weakness or an unforeseen policy humiliation. As things stand, either Biden or Sanders would see their chance of winning the White House rise toward 45% if they won the nomination. If Sanders wins the nomination, yet events all play to Trump’s favor such that he wins resoundingly, Sanders will forever after be seen as confirming the curse of the “movement candidate.” Yet under those circumstances Biden would likely have met the same fate. Bottom Line: Investors would be wrong to buy risky assets on a Sanders nomination in the belief that it guarantees Trump’s victory. Clinching the nomination sharply – and mathematically – increases any candidate’s chance of winning the White House. A Sanders White House in turn would be a paradigm shift in US politics: the first left-wing populist president. He would threaten a major increase in economically significant regulation even if no legislation were passed and as such would weigh on corporate profits and animal spirits. As a result, we expect volatility in the near term, since Sanders’s best hope is to build momentum now, unseat Biden, and then fend off Biden’s centrist replacements. Even if Sanders is only successful for a brief period in Q1, the market will have to discount the higher probability of a progressive populist in the Oval Office. What About Mayor Bloomberg? Show Us The Votes, Not Just The Money. Billionaire former New York Mayor Michael Bloomberg is a notable challenger both to other Democrats and to Trump based on the fact that his aggressive advertising campaign is producing some results in opinion polling – as it would for anyone given the volume! He is polling just ahead of Buttigieg and thus is first in line to benefit if Sanders knocks off Biden (Chart 19). Chart 19Bloomberg Benefits If Biden Falls Chart 20Biden Beats Bloomberg In Big Primaries However, Bloomberg’s attempt to pole-vault over the early states and rack up big wins in March is untested. Moreover the data do not yet reflect the elite optimism about Bloomberg’s chances. First, Biden will be harder to knock off than the consensus holds. He has a strong base in the South, he still leads in many Midwestern states, unlike Iowa, while Bloomberg’s base is the Northeast, where he has to split votes with most of the other candidates (including Biden). Looking ahead to March, Biden is beating Bloomberg in all of the key states where Bloomberg’s strategy requires a win (Chart 20). While Biden beats Trump head-to-head in the swing states, Bloomberg loses to Trump in most of them. This reflects Biden’s electability, a tailwind in the primaries (Chart 21). Bloomberg also has the worst favorability among voters – although admittedly Trump once held that distinction (Chart 22). Chart 21Trump Beats Bloomberg In Swing States Chart 22Trump And Biden More Favorable Than Bloomberg Hence Bloomberg can emerge as the leading centrist or establishment candidate if Biden crumbles, and Buttigieg fails to replicate his Iowa success, but not before then. Otherwise his significance lies in that he could become a dark horse candidate at a contested Democratic National Convention in July – say if the leading progressive candidates prove capable of blocking Biden’s nomination but not securing their own. Bloomberg may be waiting in the wings for just such a moment. Bloomberg could also act as the grand spoiler of the election should he decide to run as an independent candidate in November. Ostensibly his candidacy would hurt the Democrats, especially if they choose a candidate who suffers from the taint of socialism. However, contrary to popular wisdom, a strong third party candidate is historically a negative sign for the incumbent.3 Third party candidacies are only strong if the general public is dissatisfied – and when the public is dissatisfied it swings heavily against the incumbent party. Thus on the whole a large third party vote would tend to hurt Trump in 2020, just as it helped him in 2016 (by hurting the incumbent party). The fact that Bloomberg was formerly a Republican reinforces his risk to Trump – like the independently wealthy Ross Perot in 1992, he could produce a Democratic victory by splitting the conservative vote.4 Remember that 9-10% of Republicans believed that Trump should have been removed from office, according to impeachment polls over the past six months. If the economy holds up, this third party challenge is less likely to succeed, but it is still a risk. Such an outcome is far from assured and the Democratic Party would vilify Bloomberg for fear of him stealing votes from the Democratic candidate, especially if the occasion of his independent run were the nomination of a “socialist” like Sanders. Thus far Bloomberg claims he and his billions will support the Democratic Party’s nominee. Bottom Line: If Bloomberg’s intention were solely to unseat Trump, then he should have spent, or will spend, his billions waging a vigorous third party candidacy. On the contrary, by seeking the nomination of one of the two major parties, he apparently seeks to become president of the United States. In doing so he may weaken Biden and thus help Sanders. But we will not know the effect until we can observe his performance in actual elections, which he starts contesting in March. Nevertheless the big surprise of 2020 could well be an independently wealthy candidate capable of stealing enough votes from Trump to erase his very fine margins in the swing states. Bloomberg or someone else could play this role. Will There Be A Contested Convention? Probably Not. A contested convention – or its cousin, the “brokered convention” – is a situation in which the Democratic Party must decide its presidential nominee at its national convention, having failed to do so through the primary elections. Democratic delegates are awarded proportionately to the popular vote, unlike the Republican primary system which features many winner-take-all states. Several candidates each earning less than a third of the popular vote can continue struggling without any one of them hitting the “jackpot” and surging ahead. If none of the candidates has a majority of pledged delegates – or even a strong plurality – at the conclusion of the primaries on June 6 then the candidates will have to negotiate a solution. Otherwise they will show up in Milwaukee on July 13 for a chaotic four days in which the party delegates would have to hold a series of votes, on live television, to determine the nominee. The last time the Democrats had a contested convention was 1952, when they voted for three rounds; the Republicans saw a shorter-lived contest in 1976. In today’s context, in which a left-wing populist could win the nomination, such an unpredictable and arcane process would present a source of uncertainty for investors throughout June and July. A contested convention is more likely than usual because the party has four, possibly five viable candidates if we count Bloomberg. Biden, Bloomberg, and Sanders all have the financial ability to persist over the long haul. Yet with Buttigieg having won in Iowa and polling well in New Hampshire, he remains in the race, as does Warren, assuming they keep meeting the minimum threshold of 15% of the vote needed to receive delegates. So why isn’t a contested convention likely? Because there is a clear constraint: it would be a train wreck for the party. It would prolong divisions over ideology, it would exhaust everyone’s coffers (except Bloomberg’s), it would send a picture of a party in disarray to the general public (much like the Iowa caucus debacle), and it would deprive the party of months in which the de facto nominee could challenge President Trump. The bad press and divisiveness would actually increase Trump’s chances of winning. In the wake of the impeachment backfire, the candidates will be more attuned to these risks. Instead, with a common enemy, it is more likely that candidates will be pressured to drop out of the race once it is clear they cannot win. Democrats will bind together to pick a nominee – a contested convention helps Trump. Chart 23Iowans Want A Winner, Not A Platform Democratic voters are primarily concerned with beating President Trump – this has been confirmed in polling at the Iowa caucus (Chart 23). Therefore several candidates have a basis for sacrificing their own presidential bid. In exchange those who drop out will be offered cabinet positions, which they will sell as a political “dream team” against Trump’s small circle of loyalists and family members. The risk is that insurgent progressive candidates defy the party leadership and refuse to bow out. While Buttigieg is young and can live to fight another day, neither Sanders nor Warren will drop out easily if they think they still have a chance of winning the presidency. These two are also unlikely to cooperate with each other to consolidate the left-wing bloc. Bottom Line: Multiple competitive candidates make it possible that instead of bandwagoning around the candidate with a plurality – likely Biden – no candidate will have a commanding plurality of pledged delegates by June 6. If that is the case then expect the candidates to negotiate a solution prior to the convention. If a solution cannot be found, a contested convention will reflect a deeply divided party and hence imply higher odds of President Trump’s reelection, other things being equal. Investment Conclusions Investors can look at the three options as follows. Biden, Buttigieg, or Bloomberg would be a “known known,” a moderate Democratic whose policies would largely seek to restore and solidify those of the Obama administration. However, we still see this as negative for equities because of the increase in regulation that would ensue plus the high chance that victory would also bring the Senate and thus give rise to a more progressive policy shift than the consensus expects. Chart 24Centrists Outperformed In Iowa Trump is a “known unknown,” an unorthodox and aggressive president whose tactics have become familiar but whose approach is globally disruptive and would be more so in a second term relatively free of electoral constraints. We expect any melt-up in equities before or after a Trump win to be a sell signal given our base case that Trump’s reelection means Trade War II. Sanders or Warren would be an “unknown unknown,” the first-ever left-wing populist to take the White House. Above we show this is not at all improbable if one of them wins the nomination – which itself is about a 35% probability. The same odds apply to the Senate as under Biden, although moderate Democrats there would act as a constraint on a progressive pushing revolutionary legislation. Still, a progressive populist would be a generational paradigm shift in US policy and would justify a bear market. Where is the median voter? In the primary election, the Iowa caucus results reinforce the national trend suggesting that the median voter prefers a centrist or establishment candidate (Chart 24). If Biden falters, either Buttigieg or Bloomberg will take up the slack. Nevertheless the risk of a Sanders success is imminent and therefore we expect volatility to be frontloaded this year, especially in February but also possibly in March if Sanders does a bang-up job on Super Tuesday. In the general election, polling consistently shows that the economy is the most salient issue for voters in 2020. This plays to President Trump’s favor. Health care is usually ranked second, which plays to the Democrats’ favor. However, a recent open-ended poll by Morning Consult suggests that security issues have supplanted health care as the second-highest voter concern, which would reinforce Trump’s position (Chart 25). Further economic deterioration would not only undermine Trump’s approval on his handling of the economy but would also increase concern over health care, since insurance is tied to employers. So this is a critical risk to Trump in wobbly swing states like Pennsylvania. Chart 25Median Voter Focused On Economy, Trump’s Strong Suit We maintain that Trump is slightly favored with 55% odds. But our mathematical model highlights how close of a call the election is, at least until the manufacturing sector and broader economy durably rebound. Investors need to be prepared for either electoral outcome, which means hedging against sectors under bipartisan scrutiny such as Big Pharma and Big Tech. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Senator Mitt Romney of Utah, no fan of President Trump, voted to convict him of the charge of abuse of power but not of obstruction of Congress. 2 This is the second time Wisconsin has switched across the threshold in our model since November – all else equal, a 0.01% increase in the state’s leading index would move it back to the Republicans. 3 See Allan J. Lichtman, Predicting The Next President (New York: Rowman & Littlefield, 2016), 30-31. 4 Alternately he could ensure a Trump victory by producing an Electoral College tie! Demographic projections of the US electorate in 2020 by Robert Griffin, Ruy Teixeira, and William H. Frey show that a 2020 election in which voters behave exactly as they did in 2016, except that the third party vote normalizes from 5.7% (2016) to 1.7% (2012), would produce an Electoral College tie of 269-269 votes. Obviously this would be a Black Swan event. And the fact that electors in the college can be “faithless” to the candidate that their state elected complicates such projections. Nevertheless the result would be an extraordinary House of Representative vote according to state delegations in which Trump would emerge as the victor and the legitimacy of the election would be contested and debated once again. See "America’s Electoral Future: Demographic Shifts and the Future of the Trump Coalition," April 2018, brookings.edu.
Underweight The S&P chemicals bear market has entered its third year and we remain underweight this capital intensive basic materials subgroup. China macro dominates the direction of US chemical equities. Chinese authorities continue to ease monetary policy and are injecting liquidity in the banking system by slashing the reserve requirement ratio (RRR). The recent coronavirus epidemic almost guarantees further easing via the RRR channel. Such a monetary setting should eventually stabilize the economy. However, until a turnaround is evident, US chemical stocks will continue to follow down the path of the Chinese RRR (top panel). The Australian currency, which is hyper-sensitive to China’s growth, further corroborates that Chinese economic activity remains soft (second panel). Simultaneously, the resilient US dollar will continue to weigh on the competitiveness of US chemical exporters (bottom panel). Bottom Line: Stay underweight the S&P chemicals index. The ticker symbols for the stocks in this index are: BLBG S5CHEM – LIN, APD, ECL, SHW, DD, DOW, PPG, CTVA, LYB, IFF, CE, FMC, EMN, CF, ALB, MOS.
Highlights Malaysian businesses and households have been deleveraging and the economy risks entering a debt deflation spiral. This macro-backdrop is bond bullish. EM fixed income-dedicated investors should keep an overweight position in both local currency and US dollar government bonds. In Peru, the central bank does not want its currency to depreciate rapidly; it will therefore defend the sol at the cost of slower economic growth. The outperformance of the Peruvian sol heralds an overweight stance in domestic and US dollar government bonds versus EM peers. Malaysia: In Deleveraging Mode Malaysian businesses and households have been deleveraging. The top panel of Chart I-1 illustrates that commercial banks’ domestic claims on the private sector – both companies and households – relative to nominal GDP have been flat to down in recent years. This measure is produced by the central bank and includes both bank loans as well as securities held by banks (Chart I-1, bottom panel). It does not include borrowing from non-banks or external borrowing. Other measures of indebtedness from the Bank of International Settlements (BIS) – which includes non-bank credit as well as foreign currency borrowing – portend similar dynamics: Household and corporate debt seem to have topped out as a share of GDP (Chart I-2). Chart I-1Malaysian Banks' Claims On The Private Sector Have Rolled Over Chart I-2Malaysia's Business And Household Total Leverage Has Peaked Chart I-3Malaysia: The GDP Deflator Is About To Turn Negative The message is that after years of an unrelenting credit boom, households’ and companies’ appetite for new borrowing has diminished, and at the same time, creditors have become less willing to finance them. At 136% of GDP, the combined total of household and company debt is non-trivial. If deleveraging among debtors intensifies, the economy risks entering a debt deflation spiral. To prevent such an ominous outcome, aggressive central bank rate cuts, sizable fiscal stimulus, some currency devaluation or a combination of all of the above is required. Not only is real growth very sluggish in Malaysia, but deflationary pressures are intensifying. Chart I-3 shows the GDP deflator is flirting with contraction. Moreover, headline and core consumer price inflation are both weak, while trimmed-mean inflation is at 1.1% (Chart I-4). Last year's spike in consumer inflation was due to low base effects from the abolishment of the country’s goods and services tax back in June 2018. Going forward, these base effects will dissipate, making deflation in consumer prices a likely threat. If prices or wages begin deflating, the highly-indebted Malaysian economy will fall into debt deflation. The latter is a phenomenon that occurs when falling level of prices and wages cause the real value of debt to rise. In such a case, demand for credit will plummet and banks could become unwilling to lend. A vicious cycle of further falling prices, income and credit retrenchment could grip the economy. Household and corporate debt seem to have topped out as a share of GDP. Nominal GDP growth has already dropped slightly below average lending rates (Chart I-5). When such a phenomenon occurs amid elevated debt levels, it can produce a lethal cocktail – namely, the debt-servicing ability of borrowers deteriorates, causing both demand for credit to evaporate and non-performing loans (NPLs) to rise. Chart I-4Malaysia: Consumer Price Inflation Is Very Low Chart I-5Malaysia: Nominal GDP Growth Dipped Below Lending Rates Critically, falling inflation has caused real borrowing costs to rise. Lending rates in real terms are elevated, from a historical perspective (Chart I-6, top panel).1 Not surprisingly, loan growth has been decelerating sharply, posting a 13-year low (Chart I-6, bottom panel). Even though government expenditure growth has been accelerating over the past year or so and the central bank has cut interest rates twice in the past 8 months, economic conditions remain extremely feeble: Consumer spending has been teetering. Chart I-7 shows that retail sales are dwindling in nominal terms and have plummeted in volume terms. Chart I-6Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Chart I-7Malaysia: Consumer Spending Is Teetering Malaysian exports – which account for a 67% share of the economy – are still contracting 2.5% from a year ago, adding an additional unwelcome layer of deflation to the Malaysian economy. After years of travails, the property sector is not yet out of the woods. Residential property unit sales remain sluggish (Chart I-8, top panel). In turn, the number of unsold residential properties remains elevated and residential construction approvals are rolling over at lower levels (Chart I-8, second & third panels). As a result, residential property prices are beginning to deflate across various segments in nominal terms (Chart I-8, bottom panel). Listed companies’ earnings-per-share (EPS) in local currency terms are contracting (Chart I-9, top panel). Chart I-8Malaysia's Residential Property Market Is Struggling Chart I-9Malaysia: Capital Spending Is Contracting Chart I-10Malaysia: Weak Employment Outlook All of these ominous trends have induced Malaysian businesses to cut capital spending. The bottom three panels of Chart I-9 illustrate that real gross capital goods formation, capital goods imports and commercial vehicles units sales are all contracting. Equally important, the business sector slowdown is weighing on the employment outlook (Chart I-10). This will trigger a negative feedback loop of falling household income and spending. Bottom Line: Only by bringing borrowing costs down considerably for households and businesses and introducing large fiscal stimulus measures, can the Malaysian authorities prevent the economy from slipping into a vicious debt deflation spiral. On the fiscal front, the Malaysian government is committed to reducing its overall fiscal deficit from 3.4% to 3.2% of GDP this year, further consolidating it to 2.8% of GDP by 2021. Importantly, the government is also adamant about lowering its total public debt-to-GDP ratio from 77% to below 50% in the medium term by ridding itself of the outstanding legacy liabilities and guarantees incurred by the previous government. This leaves monetary policy and some currency depreciation as the likely levers to reflate the economy. Investment Recommendations We continue to recommend EM fixed -income dedicated investors keep an overweight position in local currency bonds within an EM local currency bonds portfolio. Malaysia’s macro-backdrop is bond bullish, and the central bank will cut its policy rate further. Consumer spending has been teetering. Consistent with further rate cut expectations, we also recommend continuing to receive 2-year swap rates. We initiated this trade on October 31, 2019, and it has so far produced a profit of 29 basis points. Furthermore, fiscal discipline and the government’s resolve to reduce public debt and government liabilities as a share of GDP will help Malaysian sovereign credit – US dollar-denominated government bonds – outperform their EM peers. Chart I-11The Malaysian Ringgit Is Cheap We recommend keeping a neutral allocation to Malaysian equities within an EM equity dedicated portfolio. In terms of the outlook for the currency, ongoing deflationary pressures are bearish for the MYR in the short-term. The basis is that the Malaysian economy needs a cheaper ringgit in order to help reflate the economy and boost exports. However, the Malaysian currency will sell off less than other EM currencies: First, foreign ownership of local bonds has declined from 36% in 2016-17 to 23% today. Likewise, foreign equity portfolios own about 31% of the stock market, which is less than in many other EMs. This has occurred because foreigners have been major net sellers of Malaysian equities. Overall, low foreign ownership of Malaysian financial assets reduces the risk of sudden portfolio outflows in case EM investors pull out en masse. Second, the current account balance is in surplus and will provide support for the Malaysian ringgit. Malaysia has become less reliant on commodities exports and more of a semiconductor exporter. We are less negative on the latter sector than on resources prices. Third, the currency is cheap, according to the real effective exchange rate, making further downside limited (Chart I-11). Finally, the ongoing purge in the Malaysian economy – deleveraging and deflation – is ultimately long-term bullish for the currency. Deflation brings down the cost structure of the economy and precludes the need for chronic currency depreciation in order to keep the economy competitive. All things considered, the risk-reward profile for shorting the MYR is no longer appealing. We are therefore closing this trade as of today. It has produced a 4% loss since its initiation on July 20, 2016. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Peru: A Pending Policy Dilemma Investors in Peruvian financial markets are presently facing three challenging macro issues: Will the currency appreciate or depreciate? If it depreciates, will the central bank cut or hike interest rates? If policy rates drop or rise, will bank stocks rally or sell off? Chart II-1Peru: Slow Money Growth Heralds Lower Inflation Looking forward, the central bank (also known as the BCRP) is facing a dilemma. On one hand, inflation is low and will likely drop toward the lower end of the central bank’s target band, as portrayed by narrow money (M1) growth (Chart II-1). Weak domestic demand and low and falling inflation – combined – justify additional rate cuts. On the other hand, the Peruvian currency – like most EM currencies – will likely depreciate versus the US dollar in the coming months, if our baseline view – that foreign capital will flow out of EM and industrial metals prices will drop further for a few months – transpires. In such a case, will the BCRP cut rates – i.e., will the monetary authorities choose to target the exchange rate, or inflation? If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the contrary, the BCRP will likely prioritize defending the nuevo sol by selling foreign currency reserves, as it has done in the past. This in turn will shrink banking system local currency liquidity and lift interbank rates (Chart II-2). Higher interbank rates will hurt the real economy as well as bank share prices. Chart II-2Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Is Peru more leveraged to precious or industrial metals? Precious and industrial metals account for 17% and 40% of Peruvian exports, respectively. Hence, falling industrial metals prices will be sufficient to exert meaningful depreciation on the sol, despite high precious metals prices. Foreign investors own about 50% of both Peruvian stocks and local currency bonds. Even if a fraction of these foreign holdings flees, the exchange rate will come under significant downward pressure. Granted that Peru’s central bank does not want its currency to depreciate rapidly, it will defend the currency at the cost of the economy. All in all, the Impossible Trinity thesis is alive and well in Peru: In an economy with an open capital account, the central bank cannot target both interest rates and the exchange rate simultaneously. If the BCRP intends to achieve exchange rate stability, it needs to tolerate interest rate fluctuations. Specifically, interbank rates and other market-determined interest rates could diverge from policy rates. From a real economy perspective, it is optimal to target interest rates and allow the exchange rate to fluctuate. However, the Peruvian economy is still dollarized, albeit much less than before. Dollarization has been a motive to sustain exchange rate stability. If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the whole, Peru’s monetary authorities remain very mindful of exchange rate volatility. Odds are that they will sacrifice growth to avoid sharp currency fluctuations. This has ramifications for financial markets. The Peruvian sol will depreciate much less than other EM and Latin American currencies. This is why it is not in our basket of currency shorts. The central bank will not cut rates in the near term, even though the economy is weak and inflation is low. This is negative for the cyclical economic outlook. Growth will stumble further and non-performing loans (NPLs) in the banking system will rise. NPL growth (inverted) correlates with bank share prices (Chart II-3). Notably, the business cycle is already weak, as illustrated in Chart II-4. Higher interest rates and lower industrial metals prices will weigh further on the economy. Chart II-3Peru: Rising NPLs Will Depress Banks Share Prices Chart II-4Peru: The Economy Is Weak Remarkably, local currency private sector loan growth has moderated, despite the 140 basis points decline in interbank rates over the past 12 months (Chart II-5). This indicates that either interest rates are too high, or banks are reluctant to originate more loans – or a combination of both. Whatever the reason, bank loan growth will decelerate further if interest rates do not drop. Investment Recommendations The Peruvian stock market has underperformed the aggregate EM index over the past five months (Chart II-6, top panel). This underperformance has not only been due to this bourse’s large weight in mining stocks but also because of banks’ underperformance (Chart II-6, bottom panel). Chart II-5Peru: Higher Rates Will Hinder Credit Growth Chart II-6Peruvian Equities Have Been Underperforming Remarkably, bank shares have languished in absolute terms, even though their funding costs – interbank rates – have dropped significantly (Chart II-7). This is a definitive departure from their past relationship. Chart II-7Peruvian Bank Stocks Stagnated Despite Falling Interest Rates As interbank rates rise marginally, bank share prices will be at risk of selling off. This in tandem with lower industrial metals prices warrants a cautious stance on this bourse’s absolute performance. Relative to the EM benchmark, we remain neutral on Peruvian equities. The Peruvian sol will depreciate less than many other EM currencies, which will help the stock market’s relative performance versus the EM benchmark. Currency outperformance heralds an overweight stance in domestic bonds within the EM local currency bond portfolio. Dedicated EM credit portfolios should overweight Peruvian sovereign and corporate credit as well. The key attraction is that Peru’s debt levels are low, which will make its credit market a low-beta defensive one in the event of a sell off. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com Footnotes 1 Deflated by the average of (1) the GDP deflator, (2) core consumer price inflation, and (3) 25% trimmed-mean consumer price inflation. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Dear clients, Over the next couple of weeks, we will be further analyzing China’s coronavirus outbreak, its economic impact, and the likely policy response, as well as the attendant investment recommendations. We will also examine any sector-related or regional themes that stem from the outbreak. Stay tuned. Jing Sima, China Strategist Highlights The peak in the number of new cases outside of the crisis epicenter will be more market-relevant than the total number of infections. New cases outside of the epicenter continue to rise, but a peak may be in sight. Our sense is that financial markets are likely to bottom earlier than the consensus expects. The economic impact on China from the outbreak will be large, but manufacturing activities in the majority of Chinese cities should resume by the end of February. It will take longer for the service sector to recover, implying a larger hit to the economy compared with the SARS episode given that services have grown in importance. This will force Chinese policymakers to set their financial deleveraging agenda aside for the rest of the calendar year. We maintain an overweight stance on Chinese stocks both tactically and cyclically, based on our view that the outbreak will soon be contained outside of Hubei province and that China’s budding economic recovery will be delayed, but not prevented, by the crisis. Feature The coronavirus (2019-nCoV) outbreak in China has sparked a selloff in risk assets around the globe. China’s A-share equity market, after an extended Chinese New Year market closure, was in a free fall when it reopened on February 3. In the offshore market, the MSCI China Index has declined by 9% from its most recent high on January 13, 2020 (Chart 1). When attempting to forecast a turning point in bearish investor sentiment stemming from the outbreak, it is important to note that during the 2003 SARS epidemic, both global and Chinese equity markets rebounded when the number of new cases peaked in Hong Kong SAR and globally (Chart 2). Chart 1Chinese Stocks Have Been Hit Hard By The Virus Outbreak Chart 2Markets Bottomed As Total SARS Infections Peaked We maintain our long stance both tactically and cyclically on Chinese stocks, based on the following assessments: In the next three months, the panic brought on by 2019-nCoV will abate before the total number of new cases peaks, as investors focus on the turning point in the outbreak outside of the epicenter (Hubei province). Beyond the next three months, the outbreak will likely delay China’s economic recovery. However, this means that Chinese policymakers will not likely reduce the scale of their stimulative efforts this year. The Market Correction May Be Short-Lived Since the onset of the 2019-nCoV outbreak, many studies have attempted to predict the speed and magnitude of the spread of the virus. Using a mathematical model called Susceptible-Exposed-Infected-Recovered (SEIR), The Lancet,1 The University of Hong Kong,2 and Johns Hopkins CSSE3 all drew a conclusion that a peak in the current episode is likely to occur between late April and early May. The number of cases outside of the crisis epicenter will likely drive financial market sentiment. While we think this conclusion may be true for the total number of new cases, the total count will be less relevant to investors during this episode than during the 2003 SARS outbreak. Instead, it will be more useful to break down the total infection count into two sets of data: the number of new cases within the city of Wuhan and Hubei Province (the epicenter of the outbreak), and the number of new cases outside of Hubei. The latter is more likely to be the primary driver of short-term outbreak-related market sentiment. While Hubei is experiencing an acceleration in the daily rate of new cases, the number of new cases across the rest of China seems to be flattening off of late (Chart 3). We think that the number of cases outside of Hubei will peak earlier than within the epicenter. This is in contrast to the 2003 SARS outbreak when the peak of new cases in the rest of China and globally lagged the epicenter Hong Kong SAR by a month (Chart 4). Chart 3Number Of 2019-nCoV New Cases Flattening Outside The Epicenter Chart 4SARS Outbreak Peaked Globally A Month After Peaking In The Crisis Epicenter There are two reasons for the difference between the 2003 SARS peak and projections for the 2019-nCoV outbreak: Timely cutoff of virus mobility outside of epicenter: The world responded quickly to contain the virus. During the 2003 SARS episode, Chinese authorities responded with protective measures only after the outbreak had already peaked in the epicenter. This time the Chinese government intervened at an early stage of the outbreak with forceful and in some cases extreme actions, including a near-complete lockdown of Wuhan (the crisis epicenter) and restrictions on inter- and intra-city traffic in other major metropolitan areas. Foreign governments in North America, Europe, and Southeast Asia took unprecedented measures to ban or limit air traffic to/from China. Furthermore, with timely and sufficient medical care, the fatality rate outside of the epicenter has been much lower4 – a significantly underreported fact. Mishandling of the crisis within the epicenter: Within Hubei province, particularly the city of Wuhan where the virus originated, the number of infections will likely continue climbing in the next two to even three months. The abovementioned studies suggest the number of cases in the epicenter is five to seven times higher than the official count. Local hospitals are experiencing severe shortages of medical supplies, meaning that people with mild-to-medium symptoms have reportedly been turned away. These patients are not included in the official statistics as confirmed or suspect cases. The discrepancy in reporting means these cases will be confirmed and recorded at a much later date. Without quarantine and treatment, these patients may continue to transmit the virus to others within the epicenter. This will have a tragic human cost, but it will hold few consequences for financial markets. The corrections in Chinese onshore and offshore stocks, while severe, will be fleeting. Bottom Line: Market sentiment will rebound following the peak in new 2019-nCoV cases outside the epicenter of Wuhan/Hubei. We think the peak may come as early as mid to late-February, which suggests the corrections in Chinese onshore and offshore stocks, while severe, will be fleeting. Economic Recovery In Sight Beyond the near-term, our view on China’s likely policy response and the economy’s fundamentals support a positive outlook for Chinese stocks over the next 6 to 12 months. In absolute dollar terms, the scale of the economic impact from the 2019-nCoV outbreak will likely be larger than the SARS episode in 2003. Unlike with SARS, when disruptions were mild and limited to the travel and retail sectors, the extreme measures China took in response to the coronavirus outbreak have essentially placed Chinese economic activity on hold. Chart 5Service Sector Now A Larger Part Of China's Economy Compared With 2003 China’s service sector is also likely to be more affected than manufacturing, because the outbreak coincided with the Chinese New Year holiday when services are normally in high demand. In addition, the service sector accounts for a much larger share of the Chinese economy than in 2003 (Chart 5). Therefore, the reduction in services output will have a comparatively bigger economic impact. However, as we think the 2019-nCoV outbreak outside of the epicenter will likely peak in February, the majority of nationwide manufacturing activity should resume no later than the last week of February. Chinese authorities have already signaled they will speed up government-led infrastructure investment as early as March. Chart 6Service Sector Took Longer To Recover After SARS Outbreak The service sector will take longer to recover. Following the 2003 SARS outbreak, the recovery in the service sector lagged the manufacturing and primary sectors by one quarter (Chart 6). This will likely delay the bottoming of the aggregate Chinese economy. We project a bottom in China’s economy towards the end of the second quarter of 2020. A delay in economic recovery will force Chinese policymakers to put aside their financial deleveraging agenda, and focus on economic growth for the year. 2020 marks the final year for policymakers to accomplish their goal to double GDP from 2010. This means policymakers will likely augment the amount of stimulus in order to stabilize the economy and avoid falling short of their growth target. Bottom Line: Business activities should resume in late February, with a bottoming in the economy towards the end of the second quarter of 2020. Monetary Support Already Lining Up The Chinese economy is on a structurally slowing trend, but is in an early stage of cyclically recovering from last year (Chart 7). This is in contrast with 2003 during the SARS outbreak when China’s economic growth was structurally accelerating, but the monetary environment was in a tightening cycle and industrial profit growth was downshifting (Chart 8). Chart 7Chinese Economy Is On A Structurally Slowing Trend, But Is Cyclically Recovering... Chart 8...And Is In An Expansionary Monetary Cycle As the performance of Chinese onshore stocks reflects domestic policy, Chinese A-shares, after briefly rebounded when the 2003 SARS outbreak peaked, underperformed the global benchmark during much of the 2004-2006 period when monetary policy tightened (Chart 9). Contrasting with 2003, we expect the PBoC to maintain a more accommodative monetary stance throughout 2020 (Chart 10): the PBoC cut the open market operation interest rates by 10bps on February 3. We expect this move to lead to a 5bps LPR and MLF rate cut in March. Moreover, the chance that the PBoC will cut the bank reserve requirement ratio (RRR) in Q2 is also increasing. Chart 9Chinese Onshore Equity Market Largely Driven By Domestic Policy Chart 10Easy Monetary Stance Is Here To Stay Bottom Line: Monetary policy will become more accommodative this year. Investment Conclusions Chinese stocks just went on sale, but the sale likely will not last long. Chart 11Chinese Stocks Are Priced At An Even Deeper Discount Over the next 0-3 months, Chinese equities will likely rebound as soon as the peak in the number of new cases outside of Wuhan/Hubei occurs. We believe the peak will happen within the next two weeks, and manufacturing activities in the majority of Chinese cities will resume following the peak in the outbreak. Depressed valuations in Chinese stocks compared with the global benchmark and the expectation of a rebound in Chinese economic activity should provide a good buying opportunity for global investors (Chart 11). In short, Chinese stocks just went on sale, but the sale likely won’t last long. Over a cyclical time horizon, we had previously predicted that China’s authorities may reduce the scale of the stimulus in the second half of this year as the economy starts to recover in Q1. The 2019-nCoV outbreak will alter the leadership’s policy trajectory and extend pro-growth support through 2020, and both the central and regional governments have announced a slew of policies in supporting businesses, particularly for the private sector. Our expectation that the viral outbreak will not derail China’s economic recovery suggests that corporate earnings will also rebound over a 6-12 month time horizon. One risk that we will be monitoring over the coming several months is the potential for firm- or sector-specific effects on earnings. The nationwide city lockdowns are certain to reduce or halt the flow of cash to businesses, and it is unclear whether this will have any disproportionate effects on corporate earnings relative to what we expect will occur for the economy beyond Q1. However, for now, our assumption is that the trend in earnings growth is likely to match that of the economy more generally unless evidence to the contrary presents itself. This supports an overweight position in Chinese stocks compared with their global peers over the coming 6-12 months. Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Footnotes 1 “Nowcasting and forecasting the potential domestic and international spread of the 2019-nCoV outbreak originating in Wuhan, China: a modelling study”, The Lancet, January 31, 2020. 2 “Real-time nowcast on the likely extent of the Wuhan coronavirus outbreak, and forecasts domestic and international spread”, Hong Kong University, January 27, 2020 3 “Modeling the Spreading Risk of 2019-nCoV”, John Hopkins Center For Systems Science And Engineering, January 31, 2020. 4 As of February 3, 2020, the fatality rate of 2019-nCoV outside of Hubei stands at 0.2%, compared with a 3% fatality rate in Hubei province and 5.5% in Wuhan, according to the World Health Organization (WHO). Cyclical Investment Stance Equity Sector Recommendations
Feature Everyone’s asset-allocation plans for the year have been disrupted by the novel coronavirus (2019-nCoV). Our view is that, while the virus is serious and will hurt the Chinese and global economy in the short term, it does not change the 12-month structural outlook for financial markets. Once the epidemic is under control (which it is not yet), there will be an excellent buying opportunity for risk assets and for the most affected asset classes. Many commentators have pointed to the lessons from SARS in 2003. Markets bottomed around the time that new cases of the disease peaked (Chart 1). But there are risks with such a simplistic comparison. The US invasion of Iraq happened at the same time – between 19 March and 1 May 2003 – with arguably a bigger impact on global markets. The Chinese economy was much less significant: China represented only 4% of global nominal GDP in 2003 (versus 17% now), 7% of global car sales (35% now), and 10-20% of commodity demand (50-60%). And it is still unclear how similar 2019-nCoV is to SARS: it appears to be spreading more rapidly (Chart 2) but (so far, at least) is less deadly, with a mortality rate of about 2%, compared to 10% for SARS. Recommended Allocation Chart 1The Lesson From Sars Chart 2But Is Novel Coronavirus Different? Nonetheless, the basic theory that markets should bottom around the time that new cases and deaths peak is likely to prove correct. With the number of deaths still growing, however, that is not yet the case. Our advice to investors would be not to sell at this point. The hedges we have in our portfolio (overweight cash and gold) should help to cushion any further downside. But, within a few weeks, assets such as EM equities, airline stocks, commodities, or the Australian dollar should look very attractive again (Chart 3). For the next few months, economic data, particularly from China, will be hard to interpret. In 2003, Chinese GDP was reduced by 1.1% because of SARS, according to estimates by the Brookings Institute.1 The global economy is likely to be more heavily impacted this time, given today’s closely integrated supply chains. On the other hand, most academic research shows that consumption and production lost during an epidemic are later made up. Additionally, the Chinese government is likely to respond with easier fiscal and monetary policy. Once the air clears, we think our thesis that the manufacturing cycle bottomed in late 2019 will remain intact. The data over the past few weeks supports this. In Asia, in particular, PMIs for the major emerging economies are back above 50 (Chart 4). Europe’s rebound has lagged a little but, in the key German economy, indicators of business and investor sentiment have bottomed. Demand in the auto sector, crucial for Europe and Japan, is clearly starting to recover. Data in Europe and EM have generally surprised to the upside recently (Chart 5). Chart 3Some Assets May Soon Look Attractive Chart 4Asian And European Data Picking Up Chart 5Positive Surprises The theory that markets should bottom around the time that new cases and deaths peak is likely to prove correct. To a degree, the new virus gave investors an excuse to take profits in some over-bought markets. The US equity market, in particular, looked expensive at the start of the year, with a forward PE of 19x. But we would dismiss the common view that investors had become too optimistic. The bull-bear ratio is not elevated (Chart 6), with only 37% of US individual investors at the start of January believing that the stock market would go up over the next six months, not particularly high by historical standards – it has fallen now to 32%. Last year, investors took money out of equity funds, despite strong returns from stocks. In the past – for example 2012 and 2016 – when this happened, it was followed by further gains for equities, as investors belatedly bought into the rally (Chart 7). Chart 6Retail Investors Aren't So Bullish... Chart 7...Indeed, They Have Been Selling Stocks On a 12-month investment horizon, therefore, we remain overweight risk assets such as equities and credit, albeit with some hedges. The upside to global growth remains underestimated: the economists’ consensus is for only 1.8% GDP growth in the US and 1.0% in the euro area this year. A combination of accelerating global growth and central banks that will stay dovish should allow equities to outperform bonds over the next 12 months (Chart 8). Chart 8If PMIs Pick Up, Equities Will Outperform Chart 9First Signs Of US Equity Underperformance? Equities: In December, we moved underweight US equities and recommended shifting into more cyclical markets: overweight the euro zone, and neutral on EM, the UK, and Australia. Before the outbreak of 2019-nCoV, this had worked in EM, but less well in Europe (Chart 9). Once the effects of the virus have cleared, we still believe this allocation will outperform as the global manufacturing cycle picks up. But we have a couple of concerns. (1) The recent US/China trade deal will require China to increase imports from the US by a highly unrealistic 83% year-on-year in 2020 (Chart 10). Our China strategists don’t expect this target to be fully met, but think any increase will come from substitution.2 This would hurt exporters in Europe and Asia. (2) The outperformance of euro area equities is very much determined by how banks fare. The headwinds against them continue: the ECB recently decreed that six major banks fall below required capital ratios; loan growth to corporates in the euro area has fallen to 3.2% year-on-year. Much, though, depends on the yield curve (Chart 11). If it steepens, as a result of stronger growth this year, as we expect, bank stocks should outperform, especially since they remain very cheap (the average price/book ratio of euro area banks is currently only 0.65). Chart 10China’s Import Targets Are Unrealistic Chart 11Bank Performance Depends On The Yield Curve Once the air clears, we think our thesis that the manufacturing cycle bottomed in late 2019 will remain intact. Fixed Income: Government bond yields have fallen in recent weeks as investors sought cover, with the US Treasury 10-year yield dropping to 1.55%. While it may test last September’s low of 1.46%, we do not see much further room for global yields to fall. They tend to be highly correlated with manufacturing PMIs, which we expect to rise over the next 12 months (Chart 12). Also, we see the Fed staying on hold this year, not cutting rates twice, as the market is now pricing in. This mildly hawkish surprise should push up rates (Chart 13). We continue to prefer credit over government bonds. Our global fixed-income strategists consider that, from a valuation standpoint, US high yield, and UK investment grade and high yield are the most attractive (Chart 14).3 Chart 12Rates Move In Line With PMIs Chart 13What If The Fed Doesn't Cut Rates? Chart 14US Junk Looks Most Attractive Currencies: Defensive currencies such as the yen, Swiss franc, and US dollar have benefitted from the recent risk-off move. We see this as temporary. Once investors refocus on growth, the US dollar should start to depreciate again (the DXY index did fall by 3% between September and early January). The dollar is a counter-cyclical currency. It is 15% overvalued relative to PPP (Chart 15). It is also very momentum-driven – and, since December, momentum has pointed to depreciation and continues to do so (Chart 16). Chart 15Dollar Is 15% Overvalued... Chart 16...And Momentum Has Moved Against USD Commodities: Industrial metals prices had started to pick up over the past few months, reflecting the stabilization of Chinese growth (Chart 17). How they fare from now will depend on: (1) how sharply Chinese growth slows as a result of 2019nCoV, and (2) how much stimulus the Chinese government rolls out to offset this. Given the degree of decline in some commodity prices (zinc down by 16% since mid-January, and copper by 9%, for example), there should be an attractive buying opportunity in these assets over coming weeks. Gold has proved to be a handy hedge against geopolitical risks (Iran) and unexpected tail risks (the coronavirus), rising by 4% year-to-date. We continue to believe it has a useful place in investors’ portfolios as a diversifier and hedge, particularly in a world of very low interest rates where cash is unattractive (Chart 18). The oil price has been hit by the disruption to air travel in January, but supply remains tight (and OPEC is likely to cut supply further in response to the demand shock).4 As long as economic growth picks up later this year, we see the crude oil price recovering over the coming months. Chart 17Metals Reflect Chinese Growth Chart 18Gold Attractive With Bond Yields So Low Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1 Please see Globalization and Disease: The Case Of SARS, Jong-Wha Lee and Warwick J. McKibbin, Brookings Discussion Paper No. 156, available at https://www.brookings.edu/wp-content/uploads/2016/06/20040203-1.pdf 2 Please see China Investment Strategy Weekly Report “Managing Expectations,” dated 22 January 2020, available at cis.bcaresearch.com 3 Please see Global Fixed Income Strategy Weekly Report “How To Find Value In Corporate Bonds,” dated 21 January 2020, available at gfis.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report “Expect OPEC 2.0 To Cut Supply In Response to Demand Shock,” dated 30 January 2020, available at ces.bcaresearch.com GAA Asset Allocation
Highlights Portfolio Strategy China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Lofty valuations, overbought technicals, declining capex and weak operating metrics, are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Recent Changes Trim the S&P tech hardware, storage & peripherals index to underweight, today. Table 1 Feature The S&P 500 fell for a second straight week and has now given back almost all of the year-to-date gains. While the coronavirus has served as an excuse to sell as we warned last week,1 we are nowhere near in unwinding the extreme overbought conditions in the broad equity market. We are no epidemiology experts, however, what concerns us most is when the news will eventually hit that coronavirus deaths are sprucing up outside of China’s borders. This will likely catalyze more equity selling and a capitulation point will subsequently ensue. Importantly, beneath the surface macro divergences remain wide. The yield curve peaked at the turn of the year. Similarly, the real 10-year Treasury yield crested around the same time and so did the hyper growth sensitive AUD/CHF cross rate all predating the coronavirus epidemic news (Chart 1). Our sense is that the bond market in particular is likely reflecting Bernie Sander’s rise in the polls along with persistently soft economic data. Other indicators we track confirm that the handoff from liquidity-to-growth we have all been waiting for remains on hold. The oil-to-gold and copper-to-gold ratios have no pulse, warning that growth remains elusive (third & bottom panels, Chart 2). Chart 1Souring Macro Predates Coronavirus Chart 2Watch Gold Closely Moreover, in our January 13 report we highlighted that gold was sniffing out two or three fed cuts in 2020, leading the fed funds futures market, as it did in the spring of 2019.2 Since our last update, the fed funds discounter in the coming 12 months has sunk from negative 20bps to negative 42bps (year-on-year change in the fed funds rate shown inverted, second panel, Chart 2). It is disconcerting that despite the sloshing liquidity and de-escalation in the US/China trade war, CEOs remain on the sidelines. The Q4 GDP release showed that non-residential investment is now contracting on a year-over-year (yoy) basis (bottom panel, Chart 3) and has been subtracting from real output growth for three consecutive quarters. Hard data continues to warn that the manufacturing recession is not over as the 15% yoy contraction in non-defense durable goods orders revealed last week (third panel, Chart 3). Equity market internals also warn that the SPX is skating on thin ice. Worrisomely, the Philly semiconductors index (SOX) peaked versus the NASDAQ 100 last year and has been losing steam of late. The equally- versus market cap-weighted S&P 500 and NASDAQ 100 ratios remain near multi-year lows, and small caps are still stalling versus large caps (Chart 4). The implication is that, at least, an indigestion period looms for the broad equity market. Chart 3Ongoing Manufacturing Recession Chart 4Weak Market Internals Netting it all out, there are high odds that the coronavirus epidemic may serve as a catalyst and short-circuit the already frail handoff from liquidity-to-growth, warning that equity market caution is warranted at this juncture. This week we are trimming a key tech subgroup to underweight, and updating a heavyweight basic materials sub-index. To Infinity And Beyond? While we have been neutral the S&P tech hardware, storage & peripherals index and thus participating in the monster rally over the past year, the time is ripe to downgrade exposure to below benchmark. Undoubtedly, relative share prices are extremely extended. The second panel of Chart 5 shows that the relative share price ratio is at the highest level as a percentage of its 200-day moving average since the late-1990s. Shown as a z-score, this technical indicator is stretched to the tune of two standard deviations above the historical mean (third panel, Chart 5). The last three times technical conditions were so overbought, it marked a multi-year peak in relative performance (top panel, Chart 5). Importantly, the forward multiple explains all of the return in this tech sub-group’s stellar relative performance since the 2018 Christmas Eve lows (Chart 6). In fact, stagnant-to-lower relative profit growth subtracted from relative returns over the same time period (bottom panel, Chart 6). Chart 5Up, Up And Away? Moreover, the parabolic move in the forward P/E ratio that climbed from a 25% discount to the SPX to a 15% premium (i.e. a 53% multiple jump), was because the 10-year US Treasury yield plunged by 175 basis points from peak to trough (10-year US Treasury yield shown inverted, Chart 7). Chart 6EPS Have To Do The Heavy Lifting Chart 7Multiple Expansion Phase Has Run Its Course Such enormous easing in financial conditions is unlikely to repeat in the coming twelve months in order to push the forward multiple even higher and sustain the “goldilocks” conditions for the S&P tech hardware, storage & peripherals index. In contrast, BCA’s higher interest rate view is a harbinger of a multiple contraction phase and compels us to trim exposure on this high-flying tech sub group to underweight. Another market narrative substantiating the multiple expansion phase is that heavyweight AAPL is now a services oriented company and rightly so commands a sky-high multiple similar to the cloud and software stocks. While there is some truth to the push into services, the iphone and other hardware still dominates AAPL’s sales and will continue to do so for the foreseeable future especially on the eve of a 5G smartphone rollout. Turning over to the macro backdrop, this still mostly manufacturing-based industry moves with the ebbs and flows of the ISM manufacturing survey. Overall business investment is contracting and so is industry capex. Worrisomely, most of the ISM manufacturing subcomponents remain below the boom/bust line warning that investment will remain soft in the coming months, despite the Sino-American trade détente (middle panel, Chart 8). CEO confidence in capital spending remains downbeat and corroborates that at least a wait and see attitude toward greenfield expansion plans is a high probability outcome (bottom panel, Chart 8). Moreover, global export expectations continue to plumb cyclical lows. Similarly, the Emerging Asian (a key tech manufacturing hub) leading economic indicator broke below the GFC lows warning that industry exports are at risk of a further collapse (second & third panels, Chart 9). Chart 8Something’s Gotta Give Chart 9Weak Operating Metrics Chart 10Soft Pricing Power… Chart 11…Will Continue To Weigh On Margins Beyond soft exports, industry new orders are also contracting (bottom panel, Chart 9). This deficient demand backdrop will continue to weigh on industry sales, owing to the recent drubbing in pricing power (third panel, Chart 10).\ Deflating selling prices are also negative for profit margins. The wide gap between industry and SPX margins is clearly unsustainable (Chart 11). Already there is tentative evidence that S&P tech hardware, storage & peripherals margins have peaked and will remain under downward pressure, especially given our expectation of underwhelming profit growth in the coming months. In sum, lofty valuations, overbought technicals, declining capex and weak operating metrics are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Nevertheless, there is one risk that is worth monitoring: the US consumer. A tight labor market should continue to bid up the price of labor and sustains wage gains which means more money in consumers’ wallets. As a result, brisk consumer outlays on computers & peripherals could reverse the ongoing industry sales deceleration (bottom panel, Chart 12). In sum, lofty valuations, overbought technicals, declining capex and weak operating metrics are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Bottom Line: Downgrade the S&P tech hardware, storage & peripherals index. The ticker symbols for the stocks in this index are: BLBG S5CMPE – AAPL, HPQ, WDC, HPE, STX, NTAP, XRX. Chart 12Risk To Bearish View Hazardous Chemicals The S&P chemicals bear market has entered its third year and we remain underweight this capital intensive basic materials subgroup. Relative share prices have broken below the GFC lows and it would not surprise us if they would retest the 2006 lows (Chart 13). Now that the chemicals M&A activity dust has settled for good, China dominates the direction of chemical equities. Chinese authorities are still easing monetary policy and are injecting liquidity in the banking system by slashing the reserve requirement ratio (RRR). The recent coronavirus epidemic almost guarantees further easing via the RRR channel. Such a monetary setting should eventually stabilize the economy. However, until a turnaround is evident, US chemical stocks will continue to follow down the path of the Chinese RRR (top panel, Chart 13). The Australian currency, which is hyper-sensitive to China’s growth, corroborates that Chinese economic activity remains soft (second panel, Chart 13). Broad-based US dollar strength also confirms that global growth has yet to stage a durable comeback. The implication is that US chemical exports will continue to lose market share, weighing on industry profits (third panel, Chart 13). Chart 13China Leads The Way In fact, sell-side analysts are expecting a relative profit growth acceleration phase, but a decline in relative revenue prospects. This suggests that already uncharacteristically high chemical profit margins will continue to outpace the broad market (bottom panel, Chart 13). Our indicators suggest that it pays to lean against such relative EPS and profit margin euphoria. Importantly, our chemicals profit margin proxy is sinking, warning that a profit margin squeeze looms. Not only are selling prices deflating, but also the industry’s wage bill is gaining steam (bottom panel, Chart 14). Adding it up, China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Moreover, chemical railcar loads are contracting at a time when the ISM manufacturing survey remains squarely below the boom/bust line (middle panel, Chart 14). This deficient chemical demand backdrop is deflationary (second panel, Chart 15) and will eat into industry profit margins. Chart 14Downbeat Demand Backdrop Chart 15Deflation Getting Entrenched On the operating front, our chemicals industry productivity proxy (industrial production/employment) is also in negative territory, underscoring that profits will likely surprise to the downside (third panel, Chart 15). Chemical industrial production is contracting at an accelerating pace and industry shipments are in retreat, warnings that the risk is high of an inventory liquidation phase (bottom panel, Chart 15). While we remain bearish on chemical stocks on a cyclical horizon, there are two key risks we are closely monitoring that would push our view offside. The global reflation handoff to actual growth is the key risk. If the global economy enters a V-shaped recovery, global bond yields will immediately reflect such a growth backdrop and push interest rates higher. This would put downward pressure on the greenback and significantly reflate chemical earnings (middle panel, Chart 16). Finally, chemical stocks are cheap and trade at a steep discount to the broad market. When our relative valuation indicator has plunged to such depressed levels in the past fifteen years, bottom-fishing buyers have come back in the market and added chemical stock exposure to their portfolios (bottom panel, Chart 16). Adding it up, China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Bottom Line: Stay underweight the S&P chemicals index. The ticker symbols for the stocks in this index are: BLBG S5CHEM – LIN, APD, ECL, SHW, DD, DOW, PPG, CTVA, LYB, IFF, CE, FMC, EMN, CF, ALB, MOS. Chart 16Two Risks To Monitor Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “When The Music Stops...” dated January 27, 2020, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of January 31, 2020. The model made a significant change in its allocation this month. The allocation to the US is now overweight from neutral previously. Japan, the UK and France remain the three largest underweight countries, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark in January by 9 bps, driven by the outperformance from the Level 2 mode (21 bps). The Level 1 model also generated two basis points of outperformance. Since going live, the overall model has outperformed by 80 bps, with 297 bps of outperformance by Level 2 model, offset by 55 bps of underperformance from Level 1. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US Model (Level 1) Chart 3GAA Non US Model (Level 2) For more on historical performance, please refer to our website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of January 31, 2019. Chart 4Overall Model Performance The model’s relative tilts between cyclicals and defensives have changed compared to last month. The global growth proxies used in our model continue providing positive signals. This in turn led the model to maintain its overweight on multiple cyclical sectors. The valuation component remains muted across all sectors except Energy. Global central bankers will continue to keep monetary policy accommodative, leading the model to favor a mixed bag of cyclical and defensive sectors. The model is now overweight four sectors in total, three cyclical sectors versus one defensive sector. These are Consumer Discretionary, Information Technology, Communication Services, and Health Care. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates”, dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 3Overall Model Performance Table 4Current Model Allocations Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy Research Associate amrh@bcaresearch.com
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