Financial Markets
Highlights So What? U.S. policy uncertainty adds to a slew of geopolitical reasons to remain tactically cautious on risk assets. Why? U.S. fiscal policy should ultimately bring market-positive developments – though the budget negotiation process could induce volatility in the near-term. We expect spending to go up and do not expect a default due to the debt ceiling or another prolonged government shutdown. Former Vice President Joe Biden remains the frontrunner for the Democratic Party’s presidential nomination in 2020. But left-wing progressive candidates are gaining on him and their success will trouble financial markets. With Persian Gulf tensions still elevated, go long Q1 2020 Brent crude relative to Q1 2021. Feature Chart 1U.S. Politics Poses Risks Through Next November Economic policy uncertainty is rising in the United States even as it falls around the world (Chart 1). Ongoing budget negotiations and the Democratic primary election give equity investors another reason to remain cautious in the near term. We expect more volatility. There also remain several persistent global threats to markets posed by unresolved geopolitical risks – rising Brexit risks with Boris Johnson likely to take the helm in the United Kingdom; oil supply threats amid Iran’s latest rejection of U.S. offers to negotiate its missile program; and a major confirmation of our theme of geopolitical risk rotation to East Asia, with Japan, South Korea, Hong Kong, Taiwan, and the South China Sea all heating up at once. In sum, political and geopolitical risks are showing investors a yellow light, even though the macroeconomic outlook still supports BCA’s cyclical (12-month) equity overweight. U.S. Fiscal Policy Will Remain Accommodative While U.S. monetary policy has taken a dovish turn – supported by other central banks – fiscal spending is now coming into focus for investors. We expect the budget battle to be market-relevant this year, injecting greater economic policy uncertainty, but the end-game should be market-positive. Brinkmanship will not get as bad as during the debt ceiling crises of 2011 and 2013, though market jitters will be frontloaded if Pelosi and the White House fail to conclude a deal immediately. Chart 2The 'Stimulus Cliff' Awaits President Trump The U.S. budget process is always rocky and is usually concluded well into the fiscal year under discussion. This year the fight will be more important than over the past few years because, as the two-year bipartisan agreement of 2018 lapses, the so-called “stimulus cliff” looms over the U.S. economy and will get caught up in the epic battle over the 2020 election. The stimulus cliff is the automatic imposition of fiscal spending cuts (“sequestration”) in FY2020 that would take effect as a result of the Budget Control Act of 2011. Standard estimates of the U.S. budget deficit expect that the deficit will shrink in 2020 if the spending caps are not raised, resulting in a negative fiscal thrust (Chart 2). The result would be to decrease aggregate demand at a time when the risk of recession is relatively high (Chart 3). Chart 3Recession Odds Still High Over Next 12 Months This is clearly not in President Trump’s interest, since a recession would devastate his reelection odds. Hence, Treasury Secretary Steve Mnuchin and other White House officials are pushing for a budget deal before the House of Representatives goes on recess on July 26 and the Senate on August 2. Ideally, an agreement would raise the spending caps, appropriate funds for the rest of the budget, and lift the “debt ceiling,” the statutory limit on U.S. debt. But it would be surprising if a deal came together as early as next week. A failure to agree on a budget deal before Congress goes on recess will make the market increasingly jittery. Congress can cancel the August recess, or wait until September 9 when they reconvene, but a failure to agree on something between now and then will make the market increasingly jittery. The U.S. has already surpassed the current debt limit and the latest estimates suggest that the Treasury Department’s “extraordinary measures” to meet U.S. debt payments could be exhausted by early-to-mid September.1 This would give Congress only a week in September to raise the debt limit. There are three main reasons to expect that the debt ceiling fight will not get out of hand: Chart 4Americans Stopped Worrying And Love Debt First, a technical default on U.S. debt could result in a failure to meet politically explosive obligations, such as sending social security checks to seniors. No one in Washington would benefit from such a failure and President Trump would suffer the most. Second, the public is not as worried about national deficits and debt today as it was in the aftermath of the financial crisis (Chart 4). Democrats, as the pro-government party, do not have an incentive to stage a showdown over the debt like Tea Party Republicans did under the previous administration. To be fair, they did do so in January 2018, but backed off after merely two days due to high political costs. Third, the one budget conflict that could create a catastrophic impasse – funding for Trump’s border wall – can be assuaged by Trump’s use of executive action, as he demonstrated by declaring a national emergency and appropriating military funds for fencing. Trump is fighting a general election in 2020 and is unlikely to use the debt ceiling as leverage to the point that the U.S. defaults on its obligations. The risk to investors, however, is that he goes back to threatening a 25% tariff on Mexico if it fails to staunch the flow of immigrants from Central America. What if the Republicans and Democrats cannot agree on the budget and spending caps? Democrats say they will not raise the debt limit unless they get non-defense spending increases. House Democrats need to reward their constituents for voting for them in 2018 and want to increase non-defense spending at “parity” with increases to defense spending. They also want to reduce the defense increases that Republicans seek in order to pay for non-defense increases. President Trump and the Republicans have a higher defense target and a lower non-defense target. The truth is that the Republicans and Democrats have agreed three times to increase spending caps beyond the levels required under the 2011 law – and they have done so most emphatically under President Trump with the FY2018-19 agreement (Chart 5). This year the two parties stand about $17 billion apart on defense and $30 billion apart on non-defense spending.2 We would expect both sides to splurge on spending and get what they want, but they could also split the difference: the amounts are small but the acrimony between the two parties could extend the talks. Congress may have to pass one or more “continuing resolutions” (stopgap measures keeping spending levels constant) to negotiate further. A continuing resolution could at least raise the debt ceiling and leave the rest of the budget negotiation until later, removing the majority of the political risk under discussion. Is another government shutdown possible? Yes, but not to the extent of early 2019. Trump saw a sharp drop in his approval ratings during the longest-ever government shutdown last year (Chart 6). Brinkmanship could lead to another shutdown, but he is likely to capitulate before it becomes prolonged. In early 2020, he wants to be lobbing grenades into the Democratic primary election rather than giving all of the Democrats an easy chance to criticize him for dysfunction in Washington. Ultimately, Trump can simply refrain from vetoing whatever the House and Senate agree – it is not in his interest to shrink the budget deficit in an election year. The Democrats’ spending increases would boost aggregate demand and are thus in President Trump’s personal interest. Trump is the self-professed “king of debt” – he is not afraid to agree to a deal that will be criticized by fiscal hawks. The latter have far less influence in Congress anyway since the 2018 midterm election. Why should House Democrats extend the economic expansion knowing that it would likely improve President Trump’s reelection chances? Because Trump will capitulate to most of their spending demands; voters would punish them if they are seen deliberately engineering “austerity”; and they need to show voters that they can govern. As for the 2020 race, they will focus on other issues: they will attack Trump on trade and immigration and focus on social policy: health care, the minimum wage, taxes and inequality, climate change, and student debt. What will be the fiscal and economic impact of a budget deal? The budget deal under negotiation ($750 billion in defense discretionary spending, $639 billion in non-defense discretionary spending) would raise the spending cap by about $145 billion – this is slightly above the $112 billion negative fiscal thrust expected in 2020.3 The result is that the U.S. fiscal drag expected in 2020 will at least be eliminated (if not turned into a fiscal boost), helping to prolong the cycle. The removal of fiscal drag will coincide with monetary easing, which is positive for markets since inflation is subdued. The Federal Reserve abandoned rate hikes this year (after four last year) because of the asymmetric risk of deflation relative to inflation (Chart 7). The FOMC believes that they can always jack up interest rates to combat an inflation overshoot, as their predecessors did in the 1980s, but that they are constrained by the zero lower-bound in interest rates. They may never recover from a loss of credibility and collapse of inflation expectations, so an insurance policy is necessary. The result is likely to be one or two rate cuts this year, which has already improved financial conditions. Chart 7The Fed Fears The Asymmetric Threat Of Deflation Bottom Line: Budget brinkmanship could become a near-term source of volatility but it is ultimately likely to be resolved with the pro-market outcome of less fiscal drag in 2020. The debt ceiling debate is unlikely to result in a U.S. default and any government shutdown is likely to resemble the short one of 2018 more than the long one of 2019. We expect U.S. equities to grind higher over the 12-month cyclical horizon, but we remain exceedingly cautious on a three-month tactical horizon. The price of Trump’s capitulation on border funding could be a renewed threat of tariffs against Mexico. The Budget Deal, Geopolitics, And The Dollar Chart 8China Shifts From Reform To Stimulus What does this fiscal outlook imply for the U.S. dollar? Near-term moves will probably be negative, since the fiscal boost outlined above will not be comparable to 2018-19, and meanwhile our view on China’s stimulus is bearing out reasonably well (Chart 8). Improvements in global growth, Fed cuts, and rising oil prices will weigh on the greenback even though later we expect the dollar to recover on the back of renewed U.S.-China conflict and global recession in 2021 or thereafter. Beyond the recession, two of our major political and geopolitical themes continue to point to large downside risk to the dollar: populist politics and multipolarity, or geopolitical competition among the world’s great powers. Beyond the recession, two of our major political and geopolitical themes continue to point to large downside risk to the dollar: populist politics and multipolarity. Populism and the Fed: Domestically, the United States is seeing a rise in populism that is continuing across administrations and political parties. This is conducive to easier monetary policy. Left-wing firebrand Alexandria Ocasio-Cortez’s (AOC) recent exchange with Fed Chairman Jay Powell highlights the trend. AOC asked one of the most frequent questions that BCA’s clients ask: Does the Phillips Curve still work? Powell answered that in recent years it has not. President Trump’s Economic Director Larry Kudlow applauded AOC, saying “she kind of nailed that” (obviously the administration is pushing for lower rates). If inflation is not a risk, monetary policy need not guard against it. This interchange should be taken in the context of President Trump’s attempts to jawbone Powell into rate cuts and the notable monetary promiscuousness of his ostensibly “hard money” Federal Reserve nominees. The extremely different ideological and institutional profiles of these various policymakers suggests that a new consensus is forming that is conducive to more dovish monetary policy than otherwise expected over the long run. Populists of any stripe, from Trump to AOC, would like to see lower interest rates, higher nominal GDP growth, and a lower real debt burden on households. We are reminded of an oft-overlooked point about the stagflation of the 1970s. Fed Chair Arthur Burns is usually depicted as a lackey of President Richard Nixon who succumbed to political influence and failed to raise interest rates adequately to fight inflation. But this is only part of the story. Leaving aside that the Fed only had a single mandate of minimizing unemployment at that time, Burns was conflicted. He saw the need to fight inflation, but he had more than Nixon’s wrath to fear. He also dreaded the impact on the Fed’s credibility and popular support as an institution if he hiked rates too aggressively and stoked unemployment (Chart 9).4 Chart 9Rate Hikes Are Hard To Defend Amid High Unemployment In other words, populism can constrain the Fed from the bottom up as well as from the top down in a context of rising unemployment.5 Multipolarity and Currency War: Since President Trump’s election we have highlighted that dollar depreciation is likely to be the administration’s ultimate aim if President Trump’s overall economic strategy is truly to stimulate growth, reduce the trade deficit, and repatriate manufacturing. Jacking up growth rates relative to the rest of the world while disrupting global trade via tariffs is a recipe for a strong dollar that undermines the attempt to bring jobs back from overseas. We have always argued that China would not grant the U.S. “shock therapy” liberalization and market opening – and that neither China, nor Europe, nor Japan would or could engage in currency appreciation along the lines of a new Smithsonian or Plaza Accord. The U.S. does not have as much geopolitical clout as it had in the 1970s-80s when it forced major currency deals on its allies and partners. The remaining option is for the U.S. to attempt unilateral depreciation. The combination of profligate spending, easy monetary policy, and populism may do the trick. But it is also possible that President Trump will attempt to engineer depreciation through Treasury Department intervention. If a slide toward recession threatens his reelection – or he is reelected and hence gets rid of the first-term reelection constraint – his unorthodox policies pose a significant risk to the dollar. Bottom Line: The U.S. dollar faces near-term risks as growth rebalances towards rest of the world, but will probably resume its rise in the impending recessionary environment and expected re-escalation of tensions with China. Over the long run, it faces severe risks due to fiscal mismanagement, domestic populism, and geopolitical struggle. A Progressive Overshoot Will Hurt Democrats … And Equities Chart 10A Democratic Win Will Weigh On Animal Spirits The Democratic Party’s primary election is also a risk to the equity rally. We see a 45% risk that President Trump will be unseated in November 2020 and hence that the U.S. will once again experience a dramatic policy reversal (as in 2000, 2008, and 2016). The risks are to the downside because the market is at all-time highs and Democratic proposals include raising taxes on corporations and re-regulating the economy (Chart 10). Whether you accept our 55% odds of Trump reelection, the race will be a continual source of uncertainty for investors going forward. How extreme is the uncertainty? Former Vice President Joe Biden remains the frontrunner in the race, though he has lost his initial bump in opinion polls (Chart 11). Biden’s success is market-positive relative to the other Democratic candidates since he is an establishment politician and a known quantity. Given his age, a Biden presidency would likely last for one term and focus on repudiating Trumpism and consolidating the Obama administration’s signature achievements (the Affordable Care Act, Dodd-Frank, the Joint Comprehensive Plan of Action, environmental regulation, etc). Greater predictability in the health care sector and a return to lower-level tensions with Iran would be market-positive. The financial sector would be consoled by the fact that nothing worse than Dodd-Frank would be in the offing. A Biden victory would be more likely to yield Democratic control of the senate than a progressive candidate’s victory.6 This means that the risk of Democrats taking full control of government and passing more than one major piece of legislation after 2020 increases with Biden. Yet any candidate capable of defeating Trump is likely to take the senate in our view; and Biden’s legislative initiatives are likely to be more centrist.7 So as long as Biden remains in the lead in primary polling, he increases his chances of winning the nomination, maximizes the 45% chance of Democrats winning the White House, and decreases the intensity of the relative policy uncertainty facing markets. The risk to the Democrats is … a left-wing or progressive overshoot that knocks out Biden in the primary, replacing him with a progressive candidate who may not be as electable in the general election. The risk to the Democrats is that the leftward policy shift within the party (Chart 12) may lead to a left-wing or progressive overshoot that knocks out Biden in the primary, replacing him with a progressive candidate who may not be as electable in the general election. This would give President Trump the ability to capitalize on his advantage as the incumbent by inveighing against socialism. Most of the major progressive candidates are electable – they have a popular and electoral path to the White House – as revealed by their successful head-to-head polling against Trump in battleground state opinion polling (Chart 13). But these pathways are narrower than Biden’s. Biden is the only candidate whose name has been on the ballot in two presidential elections carrying the critical Rust Belt swing states Michigan, Pennsylvania, and Wisconsin (not to mention Ohio and Florida). He is from Pennsylvania. And he is more competitive than most of his rivals in the American south and southwest, giving him the potential to pick up Florida or Arizona in the general election. But none of this matters if Biden cannot win the Democratic nomination first. The risk of a progressive overshoot is growing at present. Biden is losing his lead in the primary polling, as mentioned. Progressive candidates taken together are polling better than centrists, contrary to previous Democratic primaries (Chart 14). This is true even if we define centrists broadly, for instance to include Buttigieg (Chart 15). Biden is in a weaker position than Hillary Clinton in 2007 – and the more progressive candidate Obama ultimately defeated her (Chart 16). Biden has now slipped to second place in one national poll and some state polls. The second round of Democratic debates on July 30-31 will be a critical testing period for whether Biden can maintain frontrunner status. The first round fulfilled our expectation of boosting the progressives at his expense, especially Elizabeth Warren. It surprised us in dealing a blow to the campaign of Bernie Sanders, the independent Senator from Vermont who initiated the progressive left’s surge with his hard-fought race against Hillary Clinton in 2016. Sanders is more competitive than the other progressives in the Rust Belt, and in the general election, based on his head-to-head polling against Trump. Yet he has fallen behind in recent Democratic primary polling, ceding ground to Warren, Harris, and Buttigieg, who are all his followers in some sense. The second debate is a critical opportunity for him to arrest the loss of momentum. Otherwise he is likely to be fatally wounded: a collapse in polling beneath his floor of about 15%, and relative to other progressives, despite extensive name recognition, will make it very difficult for him to recover in the third round of debates in September. His votes will go toward other progressives, particularly Buttigieg – the other white male progressive-leaning candidate who is competitive in the Midwest.8 Our 55% base case that Trump is reelected rests on the high historical reelection rate for incumbents, particularly in the event of no recession during the first term – yet discounted due to Trump’s relatively low nationwide popularity, as it is reminiscent of a president in a recessionary environment (Chart 17). Trump has his ideological base more fired up than Obama did (Chart 18), which helps drive voter turnout, although as a result he risks losing support from the rest of the population. Still, Trump’s approval rating is in line with Obama’s at this stage in his first term. As long as the economy holds up and Trump does not suffer a foreign policy humiliation, he should be seen as a slight favorite. A Trump victory is not positive for risk assets, aside from a relief rally on policy continuity. This is because in a second term he cannot reproduce the same magnitude of pro-market effects (huge tax cuts and deregulation) yet, freed from the need for reelection, he has fewer political constraints in producing higher magnitude anti-market effects (tariffs and/or sanctions on China, Iran, Russia, and possibly the EU and Mexico). This view dovetails with the BCA House View which remains overweight equities relative to bonds and cash over a cyclical (12 month) horizon but underweight over the longer run with the expectation that a recession will loom. Bottom Line: The Democratic Primary election should start having an impact on markets – the general election is likely to be too close for market participants to have a high conviction, driving up uncertainty. Uncertainty will be especially pronounced if, and as, leftwing or progressive candidates outperform in the primary races and poll well against Trump in the general election. This dynamic is negative for business sentiment and the profit outlook, especially if Biden’s polling falls further in the wake of the second debate. Investment Conclusions We recommend staying long JPY-USD, long gold, and short CNY-USD. We remain overweight Thai equities within emerging markets, a defensive play. And we would not close our tactical overweight in health care sector and health care equipment sub-sector relative to the S&P 500. The rally in Chinese equities – despite China’s Q2 GDP growth rate of 6.2%, the worst in 27 years – brings full circle the view we initiated in April 2017 that Chinese President Xi Jinping’s consolidation of power would result in a major deleveraging drive that would drag on the global economy. Since February we have argued that the U.S. trade war has pushed Chinese policymakers to favor stimulus over reform – but we have also maintained that the effectiveness of stimulus is declining, especially as a result of the trade war hit to sentiment. Nevertheless, as a result of this turn in Chinese policy – along with the turn in U.S. monetary and fiscal policy – we see the global macroeconomic outlook improving. Combining this view with ongoing tensions in the Persian Gulf and the expectation that oil markets will tighten, we recommend our Commodity & Energy Strategy’s trade of going long Brent crude Q1 2020 versus Q1 2021. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See U.S. Department of Treasury, “Secretary Mnuchin Sends Debt Limit Letter to Congress,” July 12, 2019, home.treasury.gov. Jordan LaPier, “New Projection: Debt Limit “X Date” Could Arrive in September,” July 8, 2019, bipartisanpolicy.org. 2 See Jordain Carney and Niv Elis, White House, Congress inch toward debt, budget deal,” July 17, 2019, thehill.com. 3 See the Congressional Budget Office, “The Budget and Economic Outlook: 2019 to 2029,” January 2019; “Final Sequestration Report for Fiscal Year 2019,” February 2019; and Theresa Gullo, “Discretionary Appropriations Under the Budget Control Act,” Testimony before the Committee on the Budget, United States Senate, February 27, 2019, www.cbo.gov. 4 See James L. Pierce, “The Political Economy of Arthur Burns,” The Journal of Finance 34: 2 (1979), pp. 485-96, esp p. 489 regarding a congressional testimony: “Interestingly, no questions were raised or innuendo offered that monetary expansion would be excessive to support Richard Nixon’s reelection efforts. Instead, Burns was urged by the Democrats to follow an expansionary monetary policy in order to reduce the level of unemployment.” See also Athanasios Orphanides and John C. Williams, “Monetary Policy Mistakes and the Evolution of Inflation Expectations,” Federal Reserve Bank of San Francisco, Working Paper 2010-12 (2011), www.frbsf.org. 5 An analogy might be drawn with the Supreme Court, whose independence as one of three constitutional branches is much more firmly grounded in U.S. law than the Fed’s, but nevertheless cannot make decisions in an ivory tower. It must consider the effects of its judgments on popular opinion, since universally deplored decisions would reduce the court’s credibility and legitimacy in the eyes of the public over time and ultimately the other government branches’ adherence to those decisions. 6 This is both because Biden is more electable (thus more likely to bring a vice president who can break a tie vote in the senate) and because his candidacy can help Democrats in all of the senate swing races – for example, Arizona as well as Colorado and Maine. Harris is not as helpful in Maine while Warren and Sanders are not as helpful in Arizona. 7 Biden would return to the 39.6% top marginal individual tax rate and double the capital gains tax on those earning incomes of more than $1 million. See Biden For President, “Health Care,” joebiden.com. 8 Conversely, if Biden somehow collapses, Buttigieg unlike Sanders has the option of moving toward the political center to absorb Biden’s large reservoir of support.
Highlights Portfolio Strategy Recession odds continue to tick higher, according to the NY Fed’s probability of recession model, at a time when global growth is waning, U.S. profit growth is contracting and the non-financial ex-tech corporate balance sheet is degrading rapidly. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. The souring macro backdrop coupled with a firming industry demand outlook signal that more gains are in store for hypermarket stocks. The global growth slowdown, declining real bond yields, missing inflation, rising policy uncertainty and a favorable relative demand backdrop suggest that there is an exploitable tactical trading opportunity in a long global gold miners/short S&P oil & gas E&P pair trade. Recent Changes Upgrade the S&P hypermarkets index to overweight, today. Initiate a long global gold miners/short S&P oil & gas exploration & production (E&P) pair trade, today Table 1 Feature Obsession with the Fed easing continues to trump all else, with the SPX piercing through the 3,000 mark to fresh all-time highs last week. However, it is unrealistic for the Fed to do all the heavy lifting for the equity market as we have argued recently (see Chart 3 from June 24),1 at a time when profit cracks are spreading rapidly. This should be cause for some trepidation. Since the Christmas Eve lows essentially all of the 26% return in equities is explained by valuation expansion. The forward P/E has recovered from 13.5 to nearly 17.2 (Chart 1). There is limited scope for further expansion as four interest rate cuts in the coming 12 months are already priced in lofty valuations. Now profits will have to do the heavy lifting. But on the eve of earnings season, more than half of the S&P 500 GICS1 sectors are forecast to have contracted profits last quarter, and three sectors could not lift revenue versus year ago comps, according to I/B/E/S data. Looking further out, there is a plethora of indicators that we highlighted last week that suggest that a profit recession is looming.2 Our sense is that once the euphoria around the looming Fed easing cycle settles, there will be a massive clash between perception and reality (Chart 2) that will likely propagate as a surge in volatility. Chart 1Multiple Expansion Explains All Of The SPX’s Return Chart 2Unsustainable Divergence This addiction to low rates has come at a great cost to the non-financial corporate sector. As a reminder, this segment of the economy is where the excesses are in the current cycle as we have been highlighting in recent research.3 Using stock market related data for the non-financial ex-tech universe, net debt has increased by 70% to $4.2tn over the past five years, but cash flow has only grown 18% to $1.7tn. As a result, net debt-to-EBITDA has spiked from 1.7 to 2.5, an all-time high (Chart 3). While stocks are at all-time highs (top panel, Chart 3), the debt-saddled non-financials ex-tech universe will likely exert substantial downward pressure to these equities in the coming months (Chart 4). Chart 3Balance Sheet Degrading Chart 4Something’s Got To Give Moving on to the labor market, we recently noticed an interesting behavior between the unemployment rate and wage inflation since the early-1990s recession: a repulsive magnet-type property exists where like magnetic poles repel each other (middle panel, Chart 5). In other words, every time the falling unemployment rate has kissed off accelerating wage growth, a steep reversal ensued at the onset of recession during the previous three cycles. A repeat may be already taking place, as average hourly earnings (AHE) growth has been stuck in the mud since peaking in December 2018. Importantly, the AHE impulse is quickly losing steam and every time the Fed embarks on an aggressive easing cycle it typically marks the end of wage inflation (bottom panel, Chart 5). Chart 5Beware Of Repulsion Chart 6Waiting For Growth Meanwhile, BCA’s global manufacturing PMI diffusion index has cratered to below 40% (middle panel, Chart 6). Neither the G7 nor the EM aggregate PMIs are above the boom/bust line (top panel, Chart 6). Our breakdown of the Leading Economic Indicators into G7 and EM14 also signals that global growth is hard to come by, albeit EMs are showing some early signs of a trough (bottom panel, Chart 6). As the early-May announced increase in Chinese tariffs begin to take a toll, we doubt global growth can have a sustainable recovery for the rest of 2019, despite Chinese credit growth picking up. Now, even Japan and Korea are fighting it out and are erecting barriers to trade, dealing a further blow to these economically hyper-sensitive export-oriented economies. Netting it all out, the odds of recession by mid-2020 continue to tick higher according to the NY Fed’s model (NY Fed’s probability of recession shown inverted, top panel, Chart 5) at a time when global growth is waning, U.S. profit growth is contracting and the non-financial ex-tech corporate balance sheet is degrading rapidly. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. This week we are upgrading a consumer staples subgroup to overweight and initiating an intra-commodity market neutral trade. Time To Buy The Hype The tide is shifting and we are upgrading the S&P hypermarkets index to an above benchmark allocation. While valuations are stretched, trading at a 50% premium to the overall market on a 12-month forward P/E basis (not shown), our thesis is that these Big Box retailers will grow into their pricey valuations in the coming months. The macro landscape is aligned perfectly with these defensive retailers. Consumer confidence has been falling all year long and now cracks are spreading to the labor market (confidence shown inverted, top panel, Chart 7). ADP small business payrolls declined for the second month in a row. Similarly, the NFIB survey shows that small business hiring plans are cooling (hiring plans shown inverted, middle panel, Chart 7). As a reminder, 2/3 of all new hiring typically occurs in the small and medium enterprise space. In the residential real estate market, the drop in interest rates that is now in its eighth month has yet to be felt, and house price inflation has ground to a halt. Historically, Costco membership growth has been inversely correlated with house prices (house price inflation shown inverted, bottom panel, Chart 7). Chart 7Deteriorating Macro Backdrop … Chart 8…Is A Boon To Hypermarkets… Chart 8 shows three additional macro variables that signal brighter times ahead for the relative share price ratio. The drubbing in the 10-year U.S. treasury yield reflects a souring macro backdrop, melting inflation and a steep fall in U.S. economic data surprises. The ISM manufacturing index that continues to decelerate and is now closing in on the boom/bust line corroborates the bond market’s grim message. Tack on the Fed’s expected four cuts in the coming 12 months, and factors are falling into place for a durable rally in relative share prices. This disinflationary backdrop along with the Fed’s looming easing interest rate cycle have put a solid bid under gold prices. Hypermarket equities and bullion traditionally move in lockstep, and the current message is to expect more gains in the former (top panel, Chart 9). On the trade front specifically, these Big Box retailers do source consumer goods from China, but up to now these imports have been nearly immune to the U.S./China trade dispute as prices have been deflating (import prices shown inverted, bottom panel, Chart 9). However, this does pose a risk going forward and we will be closely monitoring it for two reasons: First, because downward pressures may intensify on the greenback and second, President Trump may impose additional tariffs, both of which are negative for industry pricing power. Chart 9Profit Margins… Chart 10…Will Likely Expand Meanwhile, industry demand is on the rise and will likely offset the potential trade and U.S. dollar induced margin pressures. Hypermarket retail sales are climbing at a healthy clip outpacing overall retail sales (bottom panel, Chart 10). Already non-discretionary retail sales are outshining discretionary ones, which is a precursor to recession at a time when overall consumer outlays have sunk below 1% (real PCE growth shown inverted, top panel, Chart 10). The implication is that hypermarkets will continue to garner a larger slice of consumer outlays as the going gets tough. In sum, the souring macro backdrop coupled with a firming industry demand outlook signal that more gains are in store for hypermarket stocks. Bottom Line: Boost the S&P hypermarkets index to overweight. The ticker symbols for the stocks in this index are: BLBG – S5HYPC – WMT, COST. Initiate A Long Global Gold Miners/Short S&P Oil & Gas E&P Pair Trade One way to benefit from the global growth soft-patch and looming global liquidity injection is to go long global gold miners/short S&P oil & gas E&P stocks on a tactical three-to-six month basis. While this market neutral and intra-commodity pair trade has already enjoyed an impressive run, there is more upside owing to a favorable macro backdrop. The key determinant of this share price ratio is the relative move in the underlying commodities that serve as pricing power proxies (top panel, Chart 11). Given the massive currency debasement potential that has gripped Central Banks the world over, such a flush liquidity backdrop will boost the allure of the shiny metal more so than crude oil. Global manufacturing PMIs are foreshadowing recession and our diffusion index has plummeted to the lowest level since 2011 (diffusion shown inverted, middle panel, Chart 11). In the U.S. specifically there is a growth-to-liquidity handoff and the ISM manufacturing survey’s new order versus prices paid subcomponents confirms that global gold miners have the upper hand compared with E&P equities (bottom panel, Chart 11). Chart 11Global Soft-Patch… Chart 12…Disinflation… As a result of this growth scare that can easily morph into recession especially if the U.S./China trade war continues into next year, inflation is nowhere to be found. Unit labor costs are slumping (top panel, Chart 12), the NY Fed’s Underlying Inflation Gauge has rolled over decisively (not shown),4 and the GDP deflator is slipping (middle panel, Chart 12). Parts of the yield curve first inverted in early-December and the 10-year/fed funds rate slope is still inverted, signaling that gold miners will continue to outperform oil producers (yield curve shown on inverted scale, bottom panel, Chart 13). The near 100bps dive in real interest rates since late-December ties everything together and is a boon to bullion (and gold producers) that yields nothing (TIPS yield shown inverted, top panel, Chart 13). Meanwhile, bond volatility has spiked of late and the bottom panel of Chart 14 shows that historically the MOVE index has been joined at the hip with relative share prices. Chart 13…Melting Real Yields And… Chart 14…The Spike In Bond Vol, All Favor Gold Miners Over Oil Producers On the relative demand front, we peer over to China to take a pulse of the marginal moves in these commodity markets. China (and Russia) has been aggressively shifting their currency reserves into gold, and bullion holdings are rising both in volume terms and as a percentage of total FX reserves. In marked contrast, oil demand is feeble and Chinese apparent diesel consumption that is closely correlated with infrastructure and manufacturing activity has tumbled. Taken together, the message is to expect additional gain in relative share prices (middle & bottom panels, Chart 15). Adding it all up, the global growth slowdown, declining real bond yields, missing inflation, rising policy uncertainty and a favorable relative demand backdrop suggest that there is an exploitable tactical trading opportunity in a long global gold miners/short S&P oil & gas E&P pair trade. Bottom Line: Initiate a tactical long global gold miners/short S&P oil & gas E&P pair trade on a three-to-six month time horizon with a stop at the -10% mark. The ticker symbols for the stocks in these indexes are: GDX:US and BLBG – S5OILP – COP, EOG, APC, PXD, CXO, FANG, HES, DVN, MRO, NBL, COG, APA, XEC, respectively. Chart 15Upbeat Relative Demand Backdrop Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Cracks Forming” dated June 24, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment” dated June 10, 2019, available at uses.bcaresearch.com. 4 https://www.newyorkfed.org/research/policy/underlying-inflation-gauge Current Recommendations Size And Style Views Favor value over growth Favor large over small caps
Highlights A lower fed funds rate will not necessarily boost equities, … : A chorus of Wall Street strategists has recently advised investors to curb their enthusiasm about looming rate cuts. … because stocks are more sensitive to the relative level of the fed funds rate than they are to its direction: The Street strategists’ advice is sound, even if they haven’t homed in on its true rationale. Monetary policy’s influence on equity returns is primarily a function of the fed funds rate’s relationship to the equilibrium rate, not the direction in which it’s moving. Monetary policy settings remain accommodative, in our view, … : We estimate that the equilibrium fed funds rate remains well above the target fed funds rate. One or two rate cuts will push monetary policy even further into accommodative territory. ... and investors should therefore remain at least equal weight equities: Over the last 60 years, investors would have done exceptionally well if they had simply owned stocks when monetary policy settings were easy, and avoided them when they were tight. Feature Dear Client, We are in the midst of collaborating with several of our colleagues on a roundtable Special Report outlining the view differences between BCA’s most bullish and bearish strategists, scheduled to be published on Friday, July 19th. In the absence of a major event between now and then, the July 19th roundtable report will replace the July 22nd U.S. Investment Strategy. We will return to our usual format on Monday, July 29th. Best regards, Doug Peta U.S. equities have rallied smartly since Fed officials began hinting at rate cuts in early June. The S&P 500 advanced nearly 7% last month on rate cut hopes, and tacked on close to another 2% by making new highs in each of July’s first three sessions. As the gains grew, however, so too did the admonitions from equity strategists at leading broker-dealers that they were getting out of hand. Over the last month, no less than four shops wrote reports warning that rate cuts will not necessarily boost equities. From the financial media’s summaries of the reports, the curb-your-enthusiasm conclusion stems from a straightforward analysis of rate-cut impacts over the last 35 years. According to Goldman Sachs by way of Barron’s, the S&P 500 posted double-digit returns in the year following the start of all five of the rate-cutting cycles that occurred from the mid-eighties to the end of the nineties, before performing terribly following the cuts that began in 2001 and 2007.1 The Street-wide takeaway was that rate cuts worked wonders for stocks when the Greenspan put was still a fresh concept, but the inverse relationship between interest rates and equity multiples that initially prevailed has since been supplanted by a direct relationship. It is surely true that rate cuts are not a magic bullet for equities, but we find the flipped-correlation hypothesis wanting. There is more to the question of how monetary policy impacts equities than just the direction of rates. The state of monetary policy – accommodative or restrictive – matters, too. Even though assessments of the state of policy are necessarily uncertain, they allow for a much more sophisticated analysis of policy impacts. Without estimating the equilibrium fed funds rate, an investor cannot go beyond simple observations of the correlation between policy rates and equity returns to the causal interactions that drive the observed correlations. Numerators And Denominators When an investor buys a stock, s/he is buying a pro rata claim on the future earnings of the company that issued it. The value of that claim is a function of the company’s estimated future earnings and the interest rate used to discount them. Expressed as an equation, the fundamental value of a share of stock is as follows, where r is the reference interest rate: Year 1 Earnings + Year 2 Earnings + Year 3 Earnings + … + Year n Earnings (1+r) (1+r)2 (1+r)3 (1+r)n That equation can be simplified and rewritten as: Fundamental Value = ∑nt=1(Year t Earnings) (1+r)t It’s a stretch to think that equities’ reaction to rate cuts reversed after the year 2000. The final form of the equation shows that the underlying value of a share of stock is directly related to its future earnings and inversely related to interest rates. When the broker-dealer analyses conclude that the ‘80s-‘90s inverse relationship between stock prices and rate cuts has flipped since the turn of the millennium, they’re asserting that the relative sensitivities of stock prices to changes in the numerator (earnings) and the denominator (interest rates) have changed. That’s a mouthful, but the effect can be seen clearly by holding the numerator constant: if earnings don’t change, stock prices are inversely related to changes in interest rates. Relaxing the constant earnings assumption, the inverse relationship between rate cuts and stock prices in the ‘80s and ‘90s could only have occurred if earnings rose when the Fed cut, or if earnings fell when the Fed cut rates, but not so much that they offset the beneficial impact of the reduction in the discount rate. An Empirical Curveball When investors think about the impact of changes in interest rates on stock prices, they tend to assume that earnings remain constant. They therefore conclude that lower rates are good for stocks and higher rates are bad for them. The underlying assumption is flawed, however, because it ignores the fact that earnings are themselves a function of the macro backdrop that influences interest rates. Rising real interest rates are most often a sign of gathering economic momentum; since the end of World War II, U.S. equities have performed markedly better when real long-term Treasury yields were rising than they have when they were falling (Chart 1). Chart 1Stocks Do Better When Real Rates Rise Investors’ appetite for equities reinforces the direct relationship between earnings and rates, as long as rates are not at extremes. Trailing P/E multiples have risen with real interest rates except when rates are negative or above 4% (Chart 2). When real rates are negative, deflation is a real possibility and fearful investors value future earnings streams conservatively. When they’re above zero, investors have been willing to let multiples rise with real rates, until rates get high enough to squeeze profitability. The key, then, is what is going to happen with real yields if the Fed does indeed cut rates. Will 50 basis points (“bps”) of incremental accommodation (we expect 25-bps cuts in July and September) help to extend the expansion, or will it be too little, too late to impede the course of a recession that’s already begun? In the former case, economic growth will get a boost, and real yields and corporate earnings will go along for the ride. In the latter, the economy will contract, drawing real yields and corporate earnings into its vortex. We believe monetary policy is still squarely accommodative, and therefore have both feet planted firmly in the bullish camp. The Fed Funds Rate Cycle Our fed funds rate cycle framework helps us to assess the line of demarcation between accommodative and restrictive policy settings and thereby project the direction of corporate earnings following rate cuts. To refresh, we decompose the fed funds rate cycle into four phases based on the interaction between the level of rates and their direction (Diagram 1), as follows: Diagram 1The Fed Funds Rate Cycle Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first rate hike of a new tightening cycle and ends when the fed funds rate crosses above our estimate of the equilibrium rate. Phase II represents the latter stages of the tightening cycle, when the Fed hikes its target rate above equilibrium in a deliberate effort to cool an overheating economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate falls from below its equilibrium level to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Plotting the course of the fed funds rate is a simple matter; the challenge in Diagram 1 comes in deciding where to draw the dashed line. That decision requires estimating the policy rate that neither encourages nor discourages economic activity. Our equilibrium estimate, which uses potential GDP growth to adjust a smoothed and filtered long-run series of the actual fed funds rate, can be viewed as a line in the sand separating the point where monetary policy goes from encouraging activity to discouraging it. When the funds rate is above our estimate of equilibrium, we consider policy to be tight; when it’s below our estimate of equilibrium, we consider policy to be easy. Since equilibrium is a concept, rather than an observable objective data point, we have to look at the broad sweep of economic activity to infer whether or not our equilibrium estimate is accurate. As we’ve repeatedly written, we interpret the economic data received so far this year as indicating that the U.S. economy is decelerating from its stimulus-fueled 2018 surge, but is on track to meet or exceed its long-term potential growth pace of 2 - 2.25%. We therefore do not believe that policy is tight, and that a recession has already begun, or is in the offing. Recession? What About Stock Prices? We didn’t forget about stock prices. Markets are always our primary focus, and we study the economy for insight into how it might impact their direction. The business cycle is a robust link connecting the state of monetary policy with equity performance. In the 60 years covered by our equilibrium fed funds rate estimate, recessions have only occurred when the funds rate has exceeded our estimate of equilibrium (Chart 3). Equity bear markets typically coincide with recessions – Black Monday in October 1987 is the only instance of a bear market occurring independently of a recession in the last half-century. Chart 3Recessions Only Occur When Policy Is Tight For 60 years, stocks have thrived when monetary policy is easy and staggered when it is tight. S&P 500 performance across the four phases of the fed funds rate cycle reveals that it has been the level of rates vis-à-vis the equilibrium rate that has mattered for equity returns, not the direction. Annualized nominal S&P 500 price returns have been nine percentage points higher when policy is easy than when it is tight (Table 1), and the disparity widens to ten-and-a-half percentage points after adjusting for inflation (Table 2). The disparity is even more pronounced when the Fed is cutting rates – annualized Phase IV price returns beat Phase III by eleven percentage points on a nominal basis, and by thirteen-and-a-half percentage points on a real basis. Table 1Stocks Love Easy Policy, ... Table 2… Especially After Adjusting For Inflation Our base case is that the FOMC will cut the fed funds rate by 25 bps at its July and September meetings. The investment strategy question arising from our base-case scenario is what will that mean for equities? With reference to the dot-com bust and the financial crisis, the broker-dealers say, “nothing much.” We posit that a more sophisticated answer would consider the monetary-policy climate in which the cuts occur. Reduce equity exposure if you believe the Fed went too far hiking rates last year, but maintain/increase it if you think monetary policy has always remained accommodative. 60 years of history say that incremental accommodation will boost equities if it occurs against a backdrop of already easy policy. The S&P 500 will decline, on the other hand, if the monetary policy starting point is restrictive.2 In terms of our fed funds rate cycle framework, the equity market outcome turns on whether the cuts occur in Phase III or Phase IV. We estimate that the equilibrium rate is currently in the neighborhood of 3¼%, so we have a high level of conviction that equities will spend the rest of the year in Phase IV, the rate cycle phase that has been most conducive to equity outperformance. Investment Implications From the perspective of our monetary policy cycle framework, positioning a balanced portfolio for impending rate cuts boils down to one’s take on current monetary policy settings. If one thinks the Fed’s already tightened policy enough to squeeze the economy, s/he should sell stocks. (Some of our BCA colleagues advocate that course, and we will share the stage with them in next week’s roundtable Special Report). If one thinks, like we and the overall BCA consensus do, that the Fed hasn’t yet crossed the easy/tight Rubicon and is on a course to push the date when it will out to 2021 or beyond, one should maintain his/her equity positions and consider adding to them. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Hough, Jack, “The ‘Fed Put’ Is Kaput and Interest Rate Cuts Might Hurt Stocks,” Barron’s, July 1, 2019. 2 Remember that monetary policy impacts the economy with a lag. Cuts ameliorating too-tight policy don’t have an effect until after the initial overtightening makes its way through the system.
Highlights Analysis on Indonesia starts below. The U.S. dollar is a counter-cyclical currency – it exhibits a negative correlation with the global business cycle. Ongoing weakness in the global economy – which is emanating from China/EM – will support the dollar in the coming months. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. A new trade: Long gold / short equal amounts of copper and oil. Feature Chart I-1The Dollar's Technicals Are Still Positive As we argued in last Week’s Report, emerging markets are facing a make-it-or-break-it moment. The U.S. dollar will serve as a litmus test. If the dollar pushes higher, EM risk assets will sell off. Conversely, if the greenback breaks down, EM risk assets will stage a sustainable cyclical rally. The basis of why the dollar will be a litmus test for EM risk assets is because the greenback is a counter-cyclical currency. It appreciates when global growth is relapsing and depreciates when global growth is reviving. In contrast, EM risk assets are pro-cyclical. Hence, the negative correlation between EM risk assets and the dollar stems from their opposite-reaction functions to the global business cycle. Notably, despite plunging U.S. interest rates and the risk-on mode in global financial markets, the dollar has so far held up relatively well. In particular, the dollar’s advance-decline has also been holding above its 200-day moving average (Chart I-1, top panel). Critically, our composite momentum indicator for the broad trade-weighted dollar has not declined below zero (Chart I-1, bottom panel). All of the above affirm the U.S. currency’s relative resilience. When a market exhibits resilience relative to the headwinds it is facing, it is often a bullish sign. Our EM strategy takes its cues from the fact that the greenback has softened but has not broken down. An upleg in the trade-weighted dollar is consistent with our view of a pending relapse in EM risk assets. The Dollar: Review Of Indicators There are a wide range of indicators that herald further U.S. dollar appreciation: Liquidity in the U.S. dollar interbank market has been tightening. The top panel of Chart I-2 demonstrates that the effective fed funds rate has exceeded the interest rate that the Fed pays to banks on excess reserves (IOER) for the first time since 2009 (herein the difference between the two is referred to as the spread). The bottom panel of the same chart illustrates that in the periods when this spread is rising, the dollar tends to appreciate, and when the spread is flat or falling (the shaded intervals), the greenback weakens. Notably, despite plunging U.S. interest rates and the risk-on mode in global financial markets, the dollar has so far held up relatively well. A positive, rising spread reflects a shrinking supply of U.S. dollar liquidity in the interbank market relative to demand. Notably, Chart I-3 illustrates that the dollar - inverted in this chart - is more strongly correlated with U.S. banks’ excess reserves at the Fed than with interest rates. This implies that the argument that lower rates will drive down the value of the greenback is exaggerated. Chart I-2Another Dollar Positive Factor Chart I-3Do U.S. Rates Drive The Dollar? Chart I-4Investors Are Long EM Currencies Vs. Dollar One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors - asset managers and leverage funds - have neutral exposure to DM currencies, such as the Swiss franc, the euro, GBP, JPY, AUD, NZD and CAD versus the U.S. dollar, but they are massively long the liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback (Chart I-4). Remarkably, various emerging market currencies have rebounded to major technical resistance levels but have not yet broken out, despite a dramatic decline in U.S. interest rates and the risk-on phase in global financial markets (Chart I-5). It remains to be seen whether they can stage a decisive breakout. We have our doubts. Chart I-5AEM Currencies Have Not Yet Broken Out Chart I-5BEM Currencies Have Not Yet Broken Out Finally, one aspect where we differ from the consensus is in terms of currency valuations. The U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value (Chart I-6). Often financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. In aggregate, investors - asset managers and leverage funds - have neutral exposure to DM currencies, such as the Swiss franc, the euro, GBP, JPY, AUD, NZD and CAD versus the U.S. dollar, but they are massively long the liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. Bottom Line: BCA’s Emerging Markets Strategy service maintains that the path of least resistance for the dollar is still up. Global Growth Conditions Are Still Conducive For Dollar Strength As discussed previously, the U.S. dollar is a counter-cyclical currency – it exhibits a negative correlation with the global business cycle (Chart I-7). Meanwhile, it is only loosely correlated with U.S. interest rates, as shown in the bottom panel of Chart I-3 on page 3. Chart I-6The U.S. Dollar Is Only Moderately Expensive Chart I-7The U.S. Dollar Is Counter-Cyclical The Fed will cut rates by more than what is currently priced in the market only in a scenario of a complete collapse in global growth. Yet, this scenario would be dollar bullish. In this case the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. The Fed will cut rates by more than what is currently priced in the market only in a scenario of a complete collapse in global growth. So far, neither economic data nor the performance of cyclical segments within financial markets are signaling a meaningful amelioration in the global business cycle: Global cyclical sectors’ relative performance against the global overall equity index is lingering close to its December lows (Chart I-8). This measure of global cyclicals is composed of equal-weighted share prices of global industrials, materials and semiconductors. Further, this global cyclical equity index has not outperformed 10-year U.S. Treasurys (Chart I-9). It is difficult to envision a looming global economic recovery when global cyclical equities are failing to outperform even government bonds. Chart I-8Global Cyclical Sectors Have Not Outperformed Chart I-9Global Cyclical Sectors Versus U.S. Bonds The Chinese manufacturing PMI import sub-component – a leading indicator of Chinese imports – foreshadows renewed weakness in the EM ex-China, Korea and Taiwan currencies (Chart I-10). In turn, the Korean won and Taiwanese dollar are also vulnerable as China is by far their largest export destination, and their shipments to the mainland continue to shrink rapidly. Further, odds are high that the RMB will depreciate, dragging down the KRW and TWD along with it. Japanese foreign machinery tool orders and German industrial orders are in deep contraction, and have not improved even on a rate-of-change basis (Chart I-11, top and middle panels). Meanwhile, China’s imports of capital goods are contracting at a double-digit pace (Chart I-11, bottom panel). Chart I-10Chinese Imports Are Key To EM Currencies Chart I-11Global Trade Is Shrinking At A Fast Rate Chinese auto sales improved dramatically in June, but almost entirely due to hefty price discounts. Such bulky price discounts (up to 50% in certain cases) cannot go on indefinitely. Auto sales will soon tumble as these incentives to purchase expire. While U.S. growth has slowed, it is still holding up better than the rest of the world. Consistently, not only have U.S. large caps been outperforming their global counterparts, but America’s equal-weighted equity index has also been outpacing that of its global peers (Chart I-12). Broad-based U.S. equity outperformance in local currency terms versus the rest of the world denotes U.S. growth outperformance, and heralds another upleg in the greenback. Bottom Line: Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. We continue to recommend a short position in a basket of currencies such as ZAR, CLP, COP, IDR, MYR, PHP and KRW against the dollar. We believe gold has made a major breakout. The biggest risk to our dollar-bullish view is not the dollar’s fundamentals, but China’s decision to diversify away from U.S. dollars and U.S. President Donald Trump’s determination to weaken the greenback. We discussed the latter at great length in our August 30, 2018 Special Report, and will deliberate on the former below. Buy Gold / Short Copper And Oil Despite our positive view on the dollar, we believe gold has made a major breakout (Chart I-13). Pairing a long position in gold with shorts in copper and oil will likely deliver solid returns with low volatility in the next three to six months and beyond (Chart I-14). Chart I-12U.S. Equity Outperformance Heralds A Stronger Dollar Chart I-13Gold Is In A Bull Market Chart I-14Go Long Gold / Short Copper And Oil The primary reason to buy gold is not global inflation. Rather, it is due to China’s decision to accumulate the yellow metal. Unhappy with U.S. pressures and import tariffs, Chinese authorities have decided to materially reduce the share of dollars in their foreign exchange reserves. The People’s Bank of China (PBoC) holds 62 million ounces of gold. Hence, gold holdings represent only 2.8% of the $3.1 trillion stockpile of the PBoC’s total foreign currency reserves (Chart I-15). In contrast, U.S. assets account for 52%. In this regard, the Russian experience could act as a roadmap for Chinese policymakers. Hit by U.S. and EU economic and financial sanctions following Russia’s seizure of Crimea in 2014, the country decided to accelerate its diversification away from U.S. dollars into gold. Since then, the Russian central bank has continuously boosted its gold holdings, with the yellow metal now accounting for 22% of its foreign currency assets (Chart I-16). Chart I-15Chinese Central Bank's Gold Holdings Chart I-16Russian Central Bank's Gold Holdings Even if the PBoC accumulates gold at a slower pace than the Russian central bank, the former’s bullion purchases will exert considerable upward pressure on gold prices due to its sheer size. In short, odds are that China’s central bank will be buying gold on any dips. To accommodate such a large buyer, the gold price will need to surge to discourage potential demand from other buyers. In contrast to gold, China’s demand for copper and oil will be subdued from a cyclical perspective. Copper demand will be tame due to weak capital spending growth. Regarding oil, as we argued in our June 21, 2018 report titled, China’s Crude Oil Inventories: A Slippery Slope, the nation has been importing more oil and petroleum products than it has been consuming. As a result, its crude oil inventories have swelled (Chart I-17, top panel). Adding China’s aggregate crude oil inventories to the OECD’s commercial inventories reveals that global inventories have not really declined since 2017 (Chart I-17, bottom panel). Simply put, crude inventories have moved from the OECD to China. Going forward, given both underlying subdued oil demand and elevated crude inventories in China, its oil imports are likely to expand at a slower pace vs. the past five years (Chart I-18). This combined with high net long positions among global investors in crude oil makes us negative on oil prices. This downbeat view on oil differs from BCA’s house view, which is bullish on the commodity. Chart I-17Oil Inventories: China + OECD Chart I-18China's Oil Demand While we cannot rule out the risk that geopolitical tensions could escalate in the Middle East, we believe the appropriate strategy for investors should be to sell oil on strength. Besides, pairing this strategy with a long position in gold reduces potential drawdowns in the event of an outburst in U.S.-Iran tensions. Bottom Line: We recommend investors initiate the following position: Long gold / short equal amounts of copper and oil. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indonesia: Treading On Thin Ice Foreign investors have been rushing into Indonesian financial markets on expectations of the Fed cutting rates. As a result, Indonesian financial markets have been more resilient than we expected. While the Fed’s monetary policy is important for Indonesian financial assets, there are other critical drivers of the Indonesian economy and financial markets that investors should take heed of. Namely, global growth and domestic demand. Both factors are currently negative. Cracks are appearing in the Indonesian property market. Persisting exports contraction will keep the country’s current account deficit wide (Chart II-1). A wide current account deficit entails that the rupiah will remain heavily reliant on volatile foreign portfolio inflows. Lesser known but equally important, Indonesia’s domestic demand is anemic. Particularly, the marginal propensity to spend among businesses and consumers is diminishing (Chart II-2). Truck and passenger car sales are contracting, while motorcycle sales are edging closer to contraction (Chart II-3). Chart II-1Indonesian Exports: Double-Digit Contraction Chart II-2Indonesia: Domestic Spending Is Subdued Critically, cracks are appearing in the Indonesian property market. Residential property prices are rising only by 2% from a year ago in local currency terms (Chart II-4). Additionally, domestic cement consumption is shrinking and revenues of two MSCI-listed real estate companies are also contracting. Chart II-3Indonesia: Vehicle Sales Are Declining Chart II-4Cracks In Indonesia's Property Sector Chart II-5Non-Bank Stocks Are Not Rallying Turning to the equity market, Indonesia’s stock market breadth is extremely narrow. The rally of the past several months has been almost entirely led by a few stocks, in particular by Bank Central Asia and Bank Rakyat Indonesia. In fact, these two banks - alone - now account for around 32% of the overall MSCI Indonesia market cap. Meanwhile, the performance of non-financial stocks has been extremely poor (Chart II-5, top panel). As for small cap stocks they are now below their 2016 lows (Chart II-5, bottom panel). This has occurred due to chronically weak profitability among non-financial companies. As for banks, in-line with ongoing deceleration in the real economy, their bad-loan provisions are now rising. Additionally, the aggregate banking system’s net interest margin is still falling. These will hurt banks’ profits. On the whole, the deepening growth slump in Indonesia warrants lower interest rates. Yet, reducing interest rates when faced with a wide current account deficit could trigger currency depreciation. At a certain point – when the frenzy about the Fed’s easing subsides, investors will realize the severity of the ongoing growth downturn in Indonesia and the need for lower rates. When this occurs, the rupiah will depreciate and the currency selloff will spread into equities and bonds. Bottom Line: The risk-reward profile of Indonesian markets is not attractive both in absolute term and relative to their EM peers. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The onset of a down-oscillation in growth strongly suggests a rotation out of the growth-sensitive Industrials and Materials into the relatively defensive Healthcare sector. But if the sharpest move in bond yields has already happened, it also suggests that Banks might hold up versus other cyclical sectors. New recommendation 1: Overweight Banks versus Industrials. New recommendation 2: Overweight Eurostoxx50 versus Nikkei225. Remain overweight Eurostoxx50 versus Shanghai Composite and neutral versus the S&P500. Feature Chart of the WeekEuro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Several decades ago, English football’s top division was a showcase for the top English and British footballers. But not anymore. This year, the top six footballers in the English Premier League hail from Argentina, the Netherlands, Belgium, Senegal, Portugal, plus a token Englishman. Nowadays, if you want to see English or British footballers you have to go to the lower divisions.1 The English Premier League provides a powerful analogy for the FTSE100. Many of the top companies in this blue-chip index have their origins and main businesses outside the U.K. The names say it all: Royal Dutch, Hong Kong and Shanghai Banking Corporation, British American Tobacco, and so on. Just like in football, if you want stock market exposure to the U.K, you now have to go to the lower divisions: the FTSE250 or the FTSE Small Cap. A view on an economy does not necessarily translate into the same view on its mainstream stock market. The leading companies in the FTSE100 are multinationals, whose sales and profits have a minimal exposure to the economic fortunes of the U.K. This leads to a result which causes investors a great deal of cognitive dissonance: a view on an economy does not necessarily translate into the same view on its mainstream stock market. Picking Stock Markets The Right Way Royal Dutch is neither a Dutch company nor a U.K. company, it is a global company. And the same is true for the vast majority of companies in the FTSE100 and all other major indexes such as the Eurostoxx50, Nikkei225, and S&P500. However, Royal Dutch is most definitely an oil and gas company which moves in lockstep with the global energy sector. Hence, by far the most important performance differentiator for any mainstream equity index is the sector fingerprint that distinguishes the equity index from its peers. Each major stock market has a distinguishing ‘long’ sector in which it contains up to a quarter of its total market capitalisation, as well as a distinguishing ‘short’ sector in which it has a significant under-representation. The combination of this long sector and short sector gives each equity index its distinguishing fingerprint (Table 1): FTSE100 = long energy, short technology. Eurostoxx50 = long banks, short technology. Nikkei225 = long industrials, short banks and energy. S&P500 = long technology, short materials. MSCI Emerging Markets = long technology, short healthcare. Another important factor is the currency. Royal Dutch receives its revenues and incurs its costs in multiple major currencies, such as euros and dollars. In other words, Royal Dutch’s global business is currency neutral. But the Royal Dutch stock price is quoted in London in pounds. Hence, if the pound strengthens, the company’s multi-currency profits will decline in pound terms, weighing on the stock price. Conversely, if the pound weakens, it will lift the Royal Dutch stock price. This means that the domestic economy can impact its stock market through the currency channel. Albeit it is a counterintuitive relationship: a strong economy via a strong currency hinders the stock market; a weak economy via a weak currency helps the stock market. Be Careful With Valuation Comparisons Chart of the Week to Chart I-7 should prove beyond doubt that the sector plus currency effect is all that you need to get right to allocate between these four major regions. The charts show all the permutations of relative performances taken from the S&P500, Eurostoxx50, Nikkei225 and FTSE100 over the last decade. Chart I-2FTSE 100 Vs. S&P 500 = Global Energy In Pounds Vs. Global Technology In Dollars Chart I-3FTSE 100 Vs. Nikkei 225 = Global Energy In Pounds Vs. Global Industrials In Yen Chart I-4FTSE 100 Vs. Euro Stoxx 50 = Global Energy In Pounds Vs. Global Banks In Euros Chart I-5Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Chart I-6Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Chart I-7S&P500 Vs. Nikkei225 = Global Tech In Dollars Vs. Global Industrials ##br##In Yen One important implication of sectors and currencies driving stock market allocation is that the head-to-head comparison of stock market valuations is meaningless. Two sectors with vastly different structural growth prospects – say, energy and technology – must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Likewise, if investors anticipate the pound to ultimately strengthen – because they see that the pound is structurally cheap today – they might downgrade Royal Dutch’s multi-currency profit growth expectations in pound terms and trade the stock at an apparent discount. But allowing for the anticipated decline in other currencies versus the pound there is no discount. It follows that any multinational listed in Europe will give a false impression of cheapness if investors see European currencies as structurally undervalued. Another implication is that simple ‘value’ indexes may not actually offer value. In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. The sector plus currency effect is all that you need to allocate between equity markets. Some people suggest comparing a valuation with its own history, and assessing how many ‘standard deviations’ it is above or below its norm. Unfortunately, the concept of a standard deviation is meaningful only if the underlying series is ‘stationary’ – meaning, it has no step changes through time. But sector valuations are ‘non-stationary’: they do undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange! The Current Message Last week, we pointed out that current activity indicators are losing momentum, or outright rolling over. The reason being that “both the interest rate impulse and short-term credit impulses are now on the cusp of down-oscillations, which will bear on economies and financial markets in the second half of the year.” This week’s profit warning from BASF supports this analysis. To be clear, this is not a binary issue about recession or no recession. This is just a common or garden down-oscillation in European (and global) growth which tends to happen every 18 months or so with remarkable regularity. Nevertheless, the down-oscillation has a major bearing on sector allocation (Chart I-8) and, therefore, a major bearing on regional equity allocation. Chart I-8Switch Out Of Growth-Sensitives Into Healthcare Based on the major equity index ‘sector fingerprints’ we need to rank the attractiveness of six major global sectors: Materials, Energy, Industrials, Banks, Healthcare, and Technology. In the first half of the year, Industrials outperformed while Banks underperformed. Why? Because Industrials were following the up-oscillation in growth whereas Banks were tracking the bond yield down, as the flattening (or inverting) yield curve ate into their margins. Now, the onset of a down-oscillation in growth strongly suggests a rotation out of the growth-sensitive Industrials and Materials into the relatively defensive Healthcare sector (Chart I-8). But if the sharpest move in bond yields has already happened, it also suggests that Banks might hold up versus other cyclical sectors (Chart I-9 and Chart I-10). Meanwhile, for Energy and Technology we do not hold a high-conviction view. Hence, our ranking of the sectors is as follows: Chart I-9Banks Have Tracked The Bond Yield ##br##Down... Chart I-10...But If The Sharpest Move In Yields Is Over, Banks Can Outperform Other Cyclicals Healthcare Banks Energy and Technology Industrials and Materials On the basis of this ranking, and the major equity index sector fingerprints we are making two new recommendations. Overweight Banks versus Industrials. Overweight Eurostoxx50 versus Nikkei225. For completeness, remain overweight Eurostoxx50 versus Shanghai Composite and neutral versus the S&P500. A New Look To Our Recommendations Finally, from this week onwards we are changing the way we show our investment recommendations. Trades will refer to an investment horizon of 3 months or less, and these will mostly fall within the Fractal Trading System. Cyclical Recommendations will refer to an investment horizon usually between 3 months and a year, and will be sub-divided into asset allocation, equities, and bonds, rates and currencies. Structural Recommendations will refer to an investment horizon longer than a year, and will also be sub-divided into asset allocation, equities, and bonds, rates and currencies. We are changing the way we show our investment recommendations. We have also taken the opportunity to close long-standing stale positions. We hope you find the new look more user-friendly. Next week we will be publishing a jointly written round table discussion in which we debate and explore the interesting view differences within BCA. Absent a major development in the markets, this will replace the normal weekly report. Fractal Trading System* This week we note that the strong rally in the Australian stock market has reached a 65-day fractal dimension which has signalled previous countertrend reversals especially in relative terms. Accordingly, this week’s recommended trade is short ASX 200 vs. FTSE100. The profit target is 2% with a symmetrical stop-loss. In other trades, we are pleased to report that short euro area industrials vs. market achieved its profit target and is now closed. This leaves five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The top six players are based on the six nominations for the 2019 PFA Footballer of the Year: Sergio Aguero (Argentina), Virgil Van Dijk (Netherlands), Eden Hazard (Belgium), Sadio Mane (Senegal), Bernardo Silva (Portugal), and Raheem Sterling (England). Virgil Van Dijk was the winner. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations