Fixed Income
BCA Research continues to recommend an overweight allocation to municipal bonds due to attractive yield ratios, particularly for long maturities, and steady state & local government revenue growth. Against that back-drop of attractive valuations,…
Highlights Stock markets are set to produce low single digit returns in 2020. Favour stocks over bonds and cash, especially where bond yields are zero or negative – specifically, Germany, Switzerland, and Sweden. Underweight zero and negative yielding high-quality bonds versus higher yielding bonds – for example, underweight Swiss bonds versus US T-bonds. Favour lower yielding currencies because the central bank loses the ability to depress its own currency. For 2020, our preferred expression of this is long SEK/USD. The biggest risk in 2020 is if the global bond yield were to rise towards 2.5 percent exposing the fragility of risk-asset prices to higher bond yields. The $400 trillion global risk-asset edifice dwarfs the $80 trillion global economy by five to one. Fractal trade: Short Ireland (ISEQ 20) versus Europe (Stoxx Europe 600). Feature For all the talk of economic growth driving stock markets, the big story through 2018-19 has been bond yields driving stock markets. This is true in Europe as well as more broadly – and it is very easy to demonstrate by decomposing the stock market price into its two components: the underlying profits (earnings per share) and the valuation multiple paid for those profits (Chart of the Week). Chart of the Week2018 And 2019 Were All About Valuations. What About 2020? 2018 And 2019 Were All About Valuations Contrast 2018-19 with 2017. In 2017, the stock market’s stellar return came almost entirely from growth – profits surged while the multiple drifted sideways. But in 2018 and 2019, the story was all about valuation multiples – profits drifted sideways while the multiple plunged in 2018, and then symmetrically surged in 2019 (Chart I-2 and Chart I-3). Chart I-2Decomposing Stock Market Performance... Chart I-3...Into Valuation And Profits The cause of the stock market multiple contraction and re-expansion was the dramatic swing in bond yields. This is hardly surprising given that the prospective return on bonds drives the prospective return on competing long-duration assets, like equities and real-estate. Higher bond yields require a higher prospective return on equities, meaning a lower valuation multiple, while lower bond yields require a higher valuation multiple. In driving the swing in bond yields, the principal player was the Federal Reserve. Again, this is hardly surprising given that the ECB and BoJ are stuck on the side lines with monetary policy already locked at ‘maximum accommodative’, while the Fed can still move the lever in both directions. The cause of the stock market multiple contraction and re-expansion was the dramatic swing in bond yields. Through 2018-2019, the 10-year T-bond yield took a round trip from around 2 percent to 3.3 percent and then down again to around 2 percent where it stands today. This explains the mirror-image round trip in the stock market’s multiple: from 16 down to 13 and then back up again to 16 where it stands today (Chart I-4). Chart I-4The Round Trip In The T-Bond Yield Explains The Round Trip In The Stock Market's Valuation Admittedly, the Fed’s dramatic pivot was influenced by the trade war, and the perceived threat to global growth. But two other considerations loomed large: the persistent undershoot of inflation versus its 2 percent target; and the fragility of risk-asset valuations – and thereby financial conditions – to higher bond yields. Bear in mind that the value of global risk-assets at over $400 trillion now dwarfs the $80 trillion global economy by a factor of five to one. So the main danger is not that economic imbalances and fragilities will drag down the financial markets; the main danger is that financial market imbalances and fragilities will drag down the economy – as we painfully felt in 2000, 2007, and 2011. The Valuation And Growth Outlook In 2020 The two key investment questions for 2020 are: What will happen to bond yields, and what will happen to stock market profits? Starting with bond yields, most of the major central banks are, to repeat, out of play. Leaving the Fed as the principal player. But at the last press conference, Jay Powell, made it crystal clear that the Fed is also out of play for the time being, at least when it comes to raising rates. “We've just touched 2 percent core inflation, and then we've fallen back. So, I think we would need to see a really significant move up in inflation that's persistent before we even consider raising rates to address inflation concerns.” Reinforcing this, Powell also hinted at introducing a potential ‘tolerance band’ around the 2 percent inflation target – perhaps 1.5-2.5 percent – before the central bank would need to react. “We're also, as part of our review, looking at potential innovations… changes to the framework that would be more supportive of achieving inflation on a symmetric 2 percent basis over time… these changes to monetary policy frameworks don't happen really quickly (but)… I think we'll wrap it up around the middle of next year. I've some confidence in that.” What about profits – could 2020 be a repeat of the 2017 stellar growth story? No, there are two reasons why it will be very difficult to repeat the 2017 story on profits. The two reasons come from the two components of profits: sales and profit margins. Unlike in 2017, global sales will not start 2020 at the very depressed levels from which they can play a very strong catch-up. The first reason is that, unlike in 2017, global sales will not start 2020 at the very depressed levels from which they can play a very strong catch-up (Chart I-5). Significantly, the recession in global sales through 2015-16 was comparable to that suffered in 2008-09. The 2015-16 recession just hasn’t been well documented because it was essentially an emerging markets recession rather than the developed market recession of 2008-09. Chart I-5Global Sales Are Not Depressed The second reason is that today’s profit margins are still close to their structural and cyclical peak; whereas at the start of 2017, they were at a cyclical low (Chart I-6). Chart I-6Profit Margins Are Elevated Hence, the two components of profits – sales and profit margins – will start 2020 at elevated levels. The upshot is that profits can grow in 2020, but the growth will be pedestrian at best. Let’s summarise some of the key investment messages for 2020. High quality bond yields that are near the lower bound of -1 percent cannot go much lower, but those yields in the region of 2 percent cannot go significantly higher. It follows that fixed-income investors should underweight zero and negative yielding bonds versus higher yielding bonds – for example, underweight Swiss bonds versus US T-bonds. In a negative growth shock, T-bonds can still offer substantial capital gains but Swiss bonds cannot. For currencies, it is the opposite message. Favour lower yielding currencies because the central bank loses the ability to depress its own currency. For 2020, our preferred expression of this is long SEK/USD. Stock markets are set to produce low single digit returns. This is uninspiring, but in a world of low prospective returns from all major asset-classes, favour stocks over bonds and cash. This is especially true in those regions and countries where bond yields are zero or negative – specifically, Germany, Switzerland, and Sweden. Today’s profit margins are still close to their structural and cyclical peak The biggest risk to this view is if the global bond yield were to rise towards 2.5 percent exposing the fragility of the risk-asset edifice to higher bond yields. To repeat, the value of global risk-assets, at over $400 trillion, dwarfs the $80 trillion global economy. So the biggest risk comes from the valuation of global financial markets, it does not come from the global economy. More About Price To Sales Having completed our 20 paragraphs on 2020, we would like to follow up on the analysis in last week’s report: Are European Stocks Attractive? To recap, we found that price to sales is the stock market valuation metric that has the best predictive power for prospective returns – because unlike other metrics such as assets, profits, and cash flow, sales are quantifiable, unambiguous, and undistorted by profit margins. In last week’s report our prospective return forecasts were based on price to sales data sourced from Thomson Reuters. To which, several clients asked if the analysis would be the same using the price to sales data sourced from MSCI (Chart I-7). The answer is broadly yes. Chart I-8-Chart I-10 illustrate that: Chart I-7Despite The US, Germany, And Japan Trading On Different Valuations... Chart I-8...The Prospective Return From The US Is Low Single Digit... Chart I-9...The Prospective Return From Germany Is Low Single Digit... Chart I-10...The Prospective Return From Japan Is Low Single Digit... First, despite vastly different stock market valuations in Germany, Japan, and the US, the implied prospective 10-year annualised returns are almost identical. Second, the implied prospective returns from the MSCI calculated price to sales are slightly lower than from the Thomson Reuters data, because current MSCI valuations are closer to the dot com bubble peak. Third, this just reinforces the point that stock market valuations are very fragile to higher bond yields, as already discussed in our preceding 20 paragraphs on 2020. Fractal Trading System* This week we note that the strong outperformance of the Irish stock market is vulnerable to a correction based on its broken 65-day fractal structure. Accordingly, this week’s recommended trade is short Ireland (ISEQ 20) versus Europe (Stoxx Europe 600). Set the profit target and symmetrical stop-loss at 4 percent. In other trades, we are pleased to report that long gold versus nickel achieved its 11 percent profit target and is now closed. 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. 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 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
Highlights Global Growth: The latest readings from our global leading economic indicator and the global ZEW index show further improvement in growth momentum. Maintain a below-benchmark stance on global duration, favoring inflation-linked bonds/swaps over nominal bond exposure, while positioning for steeper government bond yield curves. New Zealand: The RBNZ is likely done cutting rates, amid signs that the momentum is bottoming for both growth and inflation in New Zealand. Take profits on our long-standing recommended NZ-US and NZ-Germany 5-year government bond spread trades. Feature Investors have a lot of information to process at the moment. The daily ebb and flow of headlines on the US-China trade negotiations remains the biggest source of intraday volatility. Yet there are also mixed signals coming from economic data releases. “Soft” survey data like global manufacturing PMIs are showing some improvement, while “hard” measures of economic activity like export volumes and capital goods orders continue to languish in both the developed and emerging economies. As we have discussed in recent reports, these sorts of cross-currents are typical at cyclical inflection points. “Hard” data is reported with a lag after “soft” data, making the latter a better indicator of future economic activity than exports or fixed investment data (or even GDP data) that can be several months old once reported, reducing their market-moving relevance. The indicators that we trust the most are sending a bullish message on growth – and a bearish message for government bonds. When global growth is in the process of bottoming, as appears to be the case now, leading economic indicators are more reliable guides to follow for investment decision-making. To that end, the indicators that we trust the most are sending a bullish message on growth – and a bearish message for government bonds. The Latest From Our Global LEI & Global ZEW Chart of the WeekMore Cyclical Upward Pressure On Bond Yields We received updates on two of our most reliable indicators – our global leading economic indicator (LEI) and the global ZEW expectations index – last week. Both showed broad-based improvement, highlighting that the sharp downward momentum in global growth seen over the past year is in the process of bottoming out. The global LEI and the global ZEW index are key inputs into our Duration Indicator, which has historically led developed market bond yields by between six and nine months (Chart of the Week). The Duration Indicator bottomed back in January of this year and, right on cue, the yield on the Bloomberg Barclays Global Treasury Index has gone up 28bps from the low seen on September 3. The improvement in our global LEI is also broad based. The diffusion index (i.e. the share of countries with a rising LEI) shows that around 75% of the countries in the global LEI are experiencing improved economic activity. Importantly, that share is consistent across both the developed market (DM) and emerging market (EM) nations in the indicator, heralding a synchronized improvement in global growth. (Chart 2). In absolute level terms, however, the EM sub-component of our global LEI has shown the most dramatic improvement over the past several months, compared to the DM sub-index that is only in the process of bottoming out. The EM index is boosted by improvements in large economies like China and Mexico – countries that have seen significant easing of monetary policy and financial conditions over the past 6-9 months. At the same time, the lagging performance of the DM component of our global LEI is consistent with the more subdued signals to date from the individual DM country data. The US LEI continues to drift lower, while the LEIs within the euro area for Germany, Italy and (most notably) France have all been moving higher (Chart 3). Even the Japan and UK LEIs have picked up a bit, although both remain at only moderate levels. At the same time, the expectations components of the individual country ZEW surveys have all begun to increase (bottom panel), despite more mixed performance within the current conditions components of the same ZEW survey (top panel). Chart 2Our Global LEI Continues to Climb, Led By EM Chart 3A Mixed Bag Of DM Growth Indicators Without a doubt, a reduction of US-China trade tensions would flatter the bullish growth signals seen in the global LEI and ZEW indices. Yet the turn in these indicators is so consistent, across so many countries, that we suspect it has more to do with the easier monetary policies, and the associated loosening of financial conditions, that have taken place in response to the uncertainty over global trade. The turn in these indicators is so consistent, across so many countries, that we suspect it has more to do with the easier monetary policies, and the associated loosening of financial conditions, that have taken place in response to the uncertainty over global trade. Taken together, these signals are all bond-bearish, on the margin. The diffusion index of our global LEI has proven to be an excellent leading indicator of the real component of DM bond yields, leading the latter by around one year, and is pointing to higher yields ahead (Chart 4). At the same time, the inflation expectations component of DM yields (measured using CPI swaps rates) is also expected to drift higher in the next 6-12 months, led by firmer oil prices and some softening of the US dollar. Global central banks will maintain a dovish bias over at least the first half of 2020, to ensure that there is enough positive growth momentum to push inflation expectations back up towards policymaker targets. This means that there can be some modest bear-steepening of government bond yield curves across the major DM nations over the next 6-9 months (Chart 5), as policymakers will not begin to raise policy interest rates too soon. Chart 4Global Yields Moving Higher For The Usual Reasons Chart 5Higher Inflation Expectations = Steeper Yield Curves Chart 6Global Yields Starting To Climb Above Moving Averages The notable exception is the UK. Inflation expectations there are already elevated due to Brexit uncertainty, which has depressed the pound and reduced UK productivity growth while forcing the Bank of England to maintain highly accommodative monetary policy – all factors that should result in higher UK inflation, both realized and expected. Yet even there, the nominal Gilt curve has been bear-steepening of late, alongside the similar trends seen in the other major DM countries like the US and Germany. The move upward in global bond yields suggested by our most reliable leading indicators suggests more of a slow grinding increase in yields (through higher inflation expectations) rather than a rapid acceleration of real rates. The latter would require a shift towards more hawkish central bank monetary policies, which will not happen before there is a sustained pickup in both growth momentum and inflation expectations. The Federal Reserve is the central bank that is likely to lead that transition, but not until late in 2020 and perhaps not until after the November US presidential election. At the country level, the move upward in yields since the early September lows has begun to take out some technical targets (Chart 6). The benchmark 10-year government bond yield is above the 100-day moving average for the major DM countries (the US, Germany, UK, Japan, Canada and Australia). The 200-day moving averages represent the next key resistance level for those markets. The 10-year yield in Japan has already breached that level, perhaps signaling that similar breakouts are on the way in other major markets. Bottom Line: The latest readings from our global leading economic indicator and the global ZEW index show further improvement in growth momentum. Maintain a below-benchmark stance on global duration, favoring inflation-linked bonds/swaps over nominal bond exposure, while positioning for steeper government bond yield curves. Time To (Finally) Take Profits On Our New Zealand Spread Trades We have been structurally positive on New Zealand (NZ) government bonds since mid-2017. This was originally a shorter-term “tactical” view based on expectations that the Reserve Bank of New Zealand (RBNZ) would be forced to keep policy rates steady due to sub-par domestic economic growth and sluggish inflation. Since this was occurring at a time of improving global economic growth in 2017, especially in the US and euro area, we expressed our view as spread trades between 5-year government bonds in NZ versus equivalent maturity debt in the US and Germany (hedged back into US dollars and euros, respectively). The “tactical” trade turned into a medium-term recommendation, as the NZ economy and inflation slowed more than expected. NZ government bonds significantly outperformed global peers as a result, helping boost the returns on our recommended trades. The 5-year NZ-US yield spread has fallen from +74bps when we first initiated the trade to -52bps today, while the spread for 5-year NZ-Germany has narrowed from +292bps to +171bps (Chart 7). We now see several good reasons to take profits on those long-standing positions: NZ economic growth is set to improve The year-over-year growth rate of real GDP in NZ has slowed from 3.1% in mid-2017 (when we initiated our spread trades) to 2.1% in the Q2/2019 (Chart 8). This has occurred in both the manufacturing and services sides of the economy, based on the sharp drop in the PMIs (middle panel). Export growth has also slowed, particularly during the recent global manufacturing downturn, leading to sharp declines in business confidence and capital spending plans. The economic weakness was enough to push NZ real GDP growth below the rate of potential GDP - which is estimated by the RBNZ to have fallen from 3% to 2.5% due primarily to slowing population growth related to reduced net immigration into the country. Chart 7NZ Bonds Have Solidly Outperformed Chart 8NZ Growth Should Soon Bottom Out The long slump in NZ manufacturing appears to have ended, however. The manufacturing PMI index jumped 3.8 points to 52.6 in October, with the New Orders component rising 5.3 points to 56.2. This pushed the New Orders-to-Inventories ratio – a leading indicator of overall NZ business sentiment – to the highest level since March 2017 (bottom panel). The domestic side of the NZ economy is also set to improve (Chart 9). Consumer spending has been weighed down by both the structural factor of slowing immigration and the cyclical factor of slowing house prices. Median NZ house price growth has perked up of late, however, in response to the RBNZ’s rate cuts this year, which should help boost consumer spending through wealth effects. Business investment should also start to speed up as manufacturing activity improves, especially with the terms of trade (relative prices of NZ exports to imports) now starting to accelerate (middle panel). The external side of the economy is also set for some improvement. In the November 2019 RBNZ Monetary Policy Statement (MPS) published last week, the central bank laid out a very cautious forecast for an increase in the GDP growth of NZ’s trading partners in 2020 (bottom panel). The sharp pickup in the EM component of our global LEI, however, suggests that global growth, and demand for NZ exports, may be much stronger than the central bank envisions next year. NZ’s economy is running at close to full capacity In the November MPS, the RBNZ also presented its own estimates for spare capacity in the NZ economy, using a variety of economic models for both the output gap and the full employment “NAIRU” (Chart 10). The median estimate of the output gap models is around 0% and is expected to stay around those levels for the next two years. The NZ unemployment rate is projected to be stable around 4% through 2020, which is close to the median model estimate of NAIRU. Thus, by the central bank’s own reckoning, the NZ economy is running at full capacity. Chart 9An Upside Growth Surprise In 2020? Chart 10NZ Does Not Need More Rate Cuts The RBNZ also produces model estimates of the neutral level of its policy rate, the Overnight Cash Rate (OCR). The current OCR of 1.0% is at the low end of the range of model estimates (bottom panel). This seems inconsistent with an economy that may be operating with no spare capacity, as the RBNZ’s other models suggest. Those models appear to be giving an accurate read on the inflationary tendencies of the NZ economy, though. Underlying NZ inflation is accelerating While headline CPI inflation fell to 1.5% in Q3/2019, close to the bottom of the RBNZ’s 1-3% target band, core CPI inflation accelerated to 1.9% - just below the midpoint of the band (Chart 11). The decline in headline inflation can be attributed to weakness in the tradeables component of the CPI, but this should soon start to increase based on the lagged impact of the acceleration of energy prices denominated in NZ dollars (middle panel). With both growth and inflation dynamics now bottoming out in NZ, the RBNZ’s recent rate cuts may be working too well. Meanwhile, non-tradeables (i.e. domestically generated) CPI inflation has accelerated over the past few quarters and is now at 3.2% - above the top end of the RBNZ inflation band. This has occurred alongside an acceleration of average hourly earnings growth to 4.2%, suggesting a tight labor market that confirms the message from the RBNZ’s NAIRU models. NZ monetary conditions are now very easy With both growth and inflation dynamics now bottoming out in NZ, the RBNZ’s recent rate cuts may be working too well. The central bank also produces estimates of the neutral real rate in NZ, using the same “r*” framework used by the US Federal Reserve (Chart 12). The neutral real rate is estimated to be 1.25% which, when added to the 2% midpoint of the RBNZ’s target band, produces a neutral nominal rate of 3.25% - a whopping 225bps above the current OCR rate. Chart 11NZ Inflation Bottoming Out Chart 12NZ Monetary Conditions Now Appear Too Easy With rates so far below neutral in nominal terms, it is no surprise that the NZ dollar is at such low levels versus both the US dollar and the euro (bottom panel). This is providing an additional easing of monetary conditions that will help boost NZ growth and inflation over at least the next year – and likely force the RBNZ to stop cutting rates and, perhaps, even begin to lay the groundwork for taking back some of the 2019 rate reductions. In sum, the combination of improving growth momentum, accelerating inflation dynamics, loose monetary policy settings, and overvaluation make a powerful case for closing out our NZ-US and NZ-Germany spread trades at a healthy profit. NZ yields look too low versus the US and Germany Our fair value regression models for both the 5-year NZ-US spread (Chart 13), and the 5-year NZ-Germany spread (Chart 14), are both signaling that NZ government bonds are relatively expensive. These models estimate the fair value of the spreads as a function of relative central bank policy rates, relative unemployment rates and relative inflation rates. Both models suggest that the cross-country yield spreads have tightened too much relative to the economic fundamentals of NZ, the US and Germany. Chart 13NZ Government Bonds Look Expensive Versus US Treasuries ... Chart 14... And German Government Debt In sum, the combination of improving growth momentum, accelerating inflation dynamics, loose monetary policy settings, and overvaluation make a powerful case for closing out our NZ-US and NZ-Germany spread trades at a healthy profit (see the Tactical Overlay Trade table on Page 16). Bottom Line: The RBNZ is likely done cutting rates, amid signs that the momentum is bottoming for both growth and inflation in New Zealand. Take profits on our long-standing recommended NZ-US and NZ-Germany 5-year government bond spread trades Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: The bond market’s bearish trend remains intact, but suffered a hiccup last week as some economic data disappointed. Our sense is that the worst of the global growth slowdown is over, but a rebound in our preferred global growth indicators – Global Manufacturing PMI, US ISM Manufacturing PMI and CRB Raw Industrials index – is necessary to push bond yields higher. We expect that such a rebound will transpire in the coming months. The Credit Cycle & Inflation: Low inflation expectations will keep monetary policy accommodative for the next 6-12 months. This justifies a positive outlook for spread product excess returns. Eventually, inflation will return and force the Fed to adopt a more restrictive stance. This will lead to the end of the credit cycle. We will get more defensive on spread product when long-maturity TIPS breakeven inflation rates move above 2.3%. Municipal Bonds: The main issues facing municipal bonds are long-run in nature, mostly related to underfunded state & local government pensions. These concerns are propping up yield ratios at the long-end of the muni curve, but aren’t likely to cause a wave of ratings downgrades until revenue growth slows during the next downturn. For the time being, investors can grab an attractive after-tax yield premium in long-maturity munis. Hiccups Judging by the bond market, recession fears appear to have peaked in late August. Since then, the Treasury index has lost 2.1% versus a position in cash and the 2/10 yield curve is 23 bps steeper (Chart 1). Curve steepening has also occurred via the real yield curve, while the breakeven inflation curve is moderately flatter, consistent with our expectations.1 However, this bearish bond market trend suffered a set-back last week. The 10-year yield fell 10 bps, back down to 1.84%, and the 2-year yield fell 7 bps to 1.61%. The move was driven by an increase in skepticism about the US and China’s “phase 1” trade deal and some mixed economic data. Both industrial production growth and capacity utilization remain well above their 2016 lows, consistent with stronger PMIs. October’s Industrial Production report was the worst of last week’s data releases. Production declined 0.8% on the month and capacity utilization fell from 77.5% to 76.7% (Chart 2). The data were significantly influenced by the General Motors strike, but the index still fell 0.5% with motor vehicles and parts stripped out. In our prior discussions of the divergence between “hard” and “soft” economic data, we pointed to relatively strong industrial production as a reason to expect a snapback in depressed manufacturing PMIs.2 This month’s weak print challenges that view, though both industrial production growth and capacity utilization remain well above their 2016 lows, consistent with stronger PMIs. The New York Fed’s Manufacturing PMI also came in roughly flat last week, and continues to point to a rebound in the national index (Chart 2, bottom panel). Chart 1Bumps On The Road ##br##To Higher Yields Chart 2Disappointing Data, But Well ##br##Above 2016 Lows October’s retail sales were also released last week, and we continue to observe a wide divergence between strong consumer spending growth and falling consumer confidence (Chart 3). As with the divergence between industrial production and the manufacturing PMI, we suspect that negative sentiment about the US/China trade war has unduly depressed consumer and business sentiment. Sentiment should rebound if trade tensions ease in the coming months, as we expect. Finally, we note that the CRB Raw Industrials index remains downbeat (Chart 4). We should continue to view the recent increase in bond yields as tenuous until it is confirmed by a rebound in this global growth bellwether. Chart 3Retail Sales Still Strong Chart 4Waiting On The CRB Index To Rebound Bottom Line: The bond market’s bearish trend remains intact, but suffered a hiccup last week as some economic data disappointed. Our sense is that the worst of the global growth slowdown is over, but a rebound in our preferred global growth indicators – Global Manufacturing PMI, US ISM Manufacturing PMI and CRB Raw Industrials index – is necessary to push bond yields higher. We expect that such a rebound will transpire in the coming months. Inflation Will End The Cycle … But Not Anytime Soon As global growth improves during the next few months and recession fears fade into the background, discussion will once again turn toward questions about how much longer the credit cycle can run, and what will ultimately bring it to an end. On the first question, we find the slope of the yield curve to be an excellent indicator of the age of the cycle. Specifically, we like to split each cycle into three phases based on the slope of the 3-year/10-year yield curve: 3 Phase 1 starts at the end of the last recession and ends when the 3/10 slope flattens to below 50 bps. Phase 2 encompasses the period when the slope is between 0 bps and 50 bps. Phase 3 begins when the 3/10 slope inverts and ends at the start of the next recession. We expect Phase 2 to persist for some time given that inflation expectations remain downbeat. Table 1 shows that corporate bond excess returns are highest in Phase 1, when the yield curve is steep and spreads are tightening quickly. Excess returns tend to remain positive in Phase 2, but are much lower. Excess returns don’t usually turn negative until after the yield curve inverts and we enter Phase 3. Table 1Corporate Bond Performance During The Three Phases Of The Yield Curve Cycle Though some segments of the yield curve inverted in August, we do not think that the cycle has transitioned into Phase 3. The inversion was quite brief, and the measure we employ in our analysis – the monthly average of daily closing values of the 3-year/10-year slope – never broke below zero. The 3-year/10-year slope is currently +23 bps. We expect the current Phase 2 environment to persist for some time, and consequently, corporate bonds will deliver small positive excess returns relative to Treasuries. The reason why we expect Phase 2 to persist for some time is that inflation expectations remain downbeat (Chart 5). Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are well below the 2.3%-2.5% range that is consistent with the Fed’s target. This means that the Fed has every incentive to maintain an accommodative monetary policy until inflation expectations are re-anchored. An accommodative policy stance will prevent the yield curve from inverting for any sustained period of time. Chart 5The Re-Anchoring Process Will Take Time The upshot is that a re-anchoring of TIPS breakeven inflation rates will be an important signal for us to get more defensive on corporate credit. When the 10-year and 5-year/5-year forward TIPS breakeven inflation rates move above 2.3%, the Fed will have less incentive to maintain an accommodative stance. The pace of tightening will likely quicken, leading to a sustained curve inversion and a transition into Phase 3 of the cycle. How Long Until Inflation Expectations Are Re-Anchored? Given our framework for thinking about the age of the cycle, the big question for our corporate credit call is: How long until inflation expectations are re-anchored? We have previously demonstrated that inflation expectations adapt to changes in the actual inflation data, and that this adaptive process occurs very slowly.4 Note that our Adaptive Expectations Model puts fair value for the 10-year TIPS breakeven inflation rate at 1.9%. This is above the current rate of 1.63%, but still well below our 2.3%-2.5% target range (Chart 5, bottom panel). The gradual nature of the adaptive process means that actual core inflation will probably have to overshoot the Fed’s 2% target for a period of time before long-dated expectations are firmly re-anchored. With that in mind, we are still a long way away from inflation posing a problem for the credit cycle. Core CPI and core PCE inflation are running at year-over-year rates of 2.3% and 1.7%, respectively, both slightly below levels consistent with the Fed’s target (Chart 6).5 Trimmed mean measures are slightly higher and less volatile. They currently suggest that core inflation will remain in a slow and steady uptrend going forward. Any durable increase in core inflation will likely occur via the Core Services (ex. shelter and medical care) component. Looking at the main components of core inflation, we see some reason to expect consumer price acceleration to cool in the coming months. Recent inflation gains have come mostly via the Core Goods component (Chart 7). This component tracks non-oil import prices with a long lag, and import prices have already rolled over. Meanwhile, shelter is the largest component of core inflation and we expect it will remain well supported in the coming months. The National Multifamily Housing Council’s Apartment Market Tightness Index has been in “net tightening” territory for two consecutive quarters (Chart 7, bottom panel). An above-50% reading from this index tends to coincide with rising shelter inflation. Chart 6Expect Core Inflation To Rise Slowly Chart 7A Closer Look At The Core CPI Components Ultimately, any durable increase in core inflation will likely occur via the Core Services (ex. shelter and medical care) component. This component has been relatively stable during the past few months (Chart 7, panel 3). Another interesting dynamic to monitor when assessing how long it will take for inflation to return is the labor share of national income. Chart 8 shows that the wage acceleration seen during the past few years has come mostly at the expense of corporate profit margins, and has not yet been significantly passed through to higher consumer prices. This is typical late-cycle behavior, and at some point firms will need to start raising prices in order to protect margins. Chart 8Where Will The Labor Share Peak? If we use the past few cycles as a guide, we see that the labor share of income peaked at above 70%. If this is an accurate road-map for the current cycle, then it means that firms can stomach quite a bit more margin compression, and it could be a long time before inflation pressures emerge. However, some recent research suggests that the labor share of income might peak at a lower level this cycle than in the past.6 This research documents that many industries are increasingly dominated by a small number of “superstar firms”. These firms have greater pricing power and might be able to sustain higher profit margins indefinitely. This would mean that inflationary pressures could re-emerge at a lower labor share of national income than in previous cycles. Bottom Line: Low inflation expectations will keep monetary policy accommodative for the next 6-12 months. This justifies a positive outlook for spread product excess returns. Eventually, inflation will return and force the Fed to adopt a more restrictive stance. This will lead to the end of the credit cycle. We will get more defensive on spread product when long-maturity TIPS breakeven inflation rates move above 2.3%. Strong Revenue Growth Supports Munis We continue to recommend an overweight allocation to municipal bonds due to attractive yield ratios, particularly for long maturities, and steady state & local government revenue growth. Chart 9 shows that Aaa Municipal / Treasury yield ratios were quite low earlier this year, but have increased significantly during the past few months. Yield ratios are above average pre-crisis levels for maturities of 10-years and greater. Against that back-drop of attractive valuations, credit quality trends are also supportive. Municipal bond ratings upgrades are outpacing downgrades (Chart 10), and history suggests that will continue until state & local government revenue growth slows. On that front, the three main sources of state & local government revenue are all growing at strong rates, a trend that should continue as long as the economic recovery is maintained. Municipal bond ratings upgrades are outpacing downgrades, and history suggests that will continue until state & local government revenue growth slows. Of course, many state & local governments face long-run credit constraints, mostly related to underfunded pension obligations. This is almost certainly the reason why yield ratios for long-maturity bonds are so attractive. Crucially, these long-run issues will not be exposed until revenue growth slows during the next economic downturn, and investors have an opportunity to capture the attractive yield premium in the meantime. Chart 9Great Value At The Long End Chart 10Revenue Growth Will Remain Strong State governments have also made progress shoring up their balance sheets during the past few years. The National Association of State Budget Officers calculates that the overall state & local government total balance has returned back to 2006 levels, while rainy day funds have been built up considerably (Chart 11). Chart 11States Are Growing Rainy Day Funds Bottom Line: The main issues facing municipal bonds are long-run in nature, mostly related to underfunded state & local government pensions. These concerns are propping up yield ratios at the long-end of the muni curve, but aren’t likely to cause a wave of ratings downgrades until revenue growth slows during the next downturn. For the time being, investors can grab an attractive after-tax yield premium in long-maturity munis. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 2Please see US Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 3 For more details on our analysis of the phases of the cycle based on the slope of the yield curve please see US Bond Strategy Special Report, “2019 Key Views: Implications For US Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 5 The Fed targets 2% PCE inflation, which is historically consistent with CPI inflation between 2.4% and 2.5%. 6 https://economics.mit.edu/files/12979 Fixed Income Sector Performance Recommended Portfolio Specification
Highlights There is little risk that inflation will heat up over the next several months, … : Weak growth is more of a threat to the global economy than inflation. … which means the Fed won’t be in any hurry to take away this year’s rate cuts, … : We expect the Fed to leave the target fed funds rate alone for nearly all of 2020. … giving the economy plenty of opportunity to overheat: If trade tensions move to the back burner, and global manufacturing activity revives, the “insurance” rate cuts executed by the Fed and other central banks may turn out to have been unnecessary. The investment punch line is that accommodative monetary policy is likely to push asset prices and Treasury yields higher: Our revised Rates View Checklist supports going back to a below-benchmark duration stance over the tactical timeframe, in line with our cyclical view. Feature BCA researchers’ latest monthly view meeting opened with a discussion of whether inflation or deflation is the bigger risk to financial markets. Should investors be more concerned about signs of overheating or stalling growth? With inflation unable to get traction in any of the major economies, we all agreed that growth is the more critical unknown. An investor who gets the growth call right has the best chance of getting broad asset class positioning right, along with country, sector, duration, credit and currency tilts. While we continue to believe that there are more inflation pressures beneath the surface of the US economy than most investors realize, they are highly unlikely to manifest themselves any time soon. At today’s low-single-digit levels, inflation’s investment import is limited to its impact on monetary policy. Inflation expectations remain far below the levels that are consistent with the Fed’s inflation target (Chart 1), and the Fed is likely to keep policy easy until they adjust higher. Though it is uncertain just what levels of realized inflation, or inflation expectations, would trigger the Fed’s reaction function, we are confident that inflation will not be an issue in the coming year. Chart 1No Pressure To Remove Accommodation Chart 2Global Revival Ahead? We expect that global growth will surprise to the upside, pulling bond yields and risk asset prices higher. BCA’s global LEI bottomed earlier this year, and the diffusion index that leads directional moves in the LEI has turned sharply higher (Chart 2). The improvement is consistent with the easing in global financial conditions and the tentative détente in the trade war. Although we will not count on a completed “Phase I” agreement until it is signed, financial markets’ allergic reaction to trade tensions seems to have encouraged the White House to back off lest it undermine its re-election prospects. Interest Rates – Looking Back Figure 1Rates View Checklist We rolled out our Rates View Checklist a little over a year ago to systematize our interest rate analysis and to clarify the rationale underpinning our views1 (Figure 1). Detailing the key series we monitor to anticipate the future direction of rates helps clients think along with us while giving them the chance to adapt the framework for their own purposes. As we were starting from a position of recommending below-benchmark duration, the checklist was aimed at identifying and tracking the factors that could encourage us to become more constructive about Treasury bonds. We never did warm to duration on a cyclical basis, though we did turn tactically neutral in mid-August. Part of the reason was that we did not give enough weight to events outside of the US. Highly-rated, developed-market sovereign bonds are substitutes for one another, and there is a limit to how much currency-adjusted yields can deviate across countries. Very low to negative yields in the UK, France, Germany and Switzerland have exerted a magnetic pull on Treasury yields (Chart 3), and the different sovereigns should move in tandem going forward, with currency-hedged yields observing a tight range. Chart 3Birds Of A Feather The short end of the yield curve exerts considerable influence on rates across all maturities. Our US bond strategists’ golden rule of bond investing homes in on the deviation between actual and expected moves in the fed funds rate as the key determinant of duration positioning outcomes. Following their lead, our checklist is oriented around anticipating the Fed’s reaction to important incoming data. It seems to have done its job over the last year, highlighting the factors that drove the Fed to switch from dialing back accommodation to dialing it up. Although we never checked more than four of the eleven boxes in the checklist – Inverted Yield Curve, Sluggish Rise in Realized Inflation, Sluggish Rise in Inflation Breakevens and International Duress – those four boxes were enough to inspire the Fed’s dovish pivot. That pivot has so far encompassed three quarter-point rate cuts, pruning back the funds rate to 1.75% from 2.5%. It turns out that the key items in the checklist were the orientation of the yield curve; sluggish inflation expectations that the Fed worried could become “unanchored on the downside;” and the shadow of trade tensions that seem to have induced a global manufacturing recession, even if they have yet to infect the DM economies’ larger services sector. They tipped the scales for Fed policy and we will be especially alert to them going forward. Interest Rates – Looking Ahead Figure 2Revised Rates View Checklist While our interpretation of the checklist left something to be desired, we are convinced that the checklist approach is sound. We return to its framework for insight into the current rates outlook, after making a few tweaks to shore it up (Figure 2). Starting with Fed perceptions, there is still some daylight between our fed funds rate expectations and the market’s, as we think the Fed is done cutting, while the money market assigns a high probability to the possibility of one more cut (Chart 4). The combination of rate cuts and the rally in 10-year Treasury yields got the yield curve back to its typical upward-sloping orientation in October (Chart 5), so we can now uncheck the inverted curve box. We see the five-month inversion as a reason to be more vigilant, but given the unusually negative term premium, we are not treating it as a hard-and-fast sign of looming weakness. The money market has priced out all but one more rate cut, and the yield curve is no longer inverted, suggesting that recession fears are abating. Chart 4Looking For One More Cut Chart 5The Curve Is No Longer Inverted Chart 6Inflation Is Muted, ... We continue to check both of the sluggish inflation boxes. Realized inflation measures, headline and core, have slumped (Chart 6), and below-target inflation expectations remain a hot-button concern, judging by Fed speakers’ repeated references to them. The Fed has strapped itself to the mast with all its talk about inflation expectations, and it will not begin removing accommodation until inflation expectations revive. We cannot directly observe the output gap, but nearly 3% growth in 2018, and a rip-roaring labor market, offer solid evidence that it has closed and we leave its box unchecked. Labor market indicators unanimously point to the conclusion that monetary accommodation is not necessary. The unemployment rate is a full percentage point below the Fed’s and the CBO’s estimates of NAIRU. Ancillary indicators like the broader definition of unemployment including discouraged workers and involuntary part-time workers (Chart 7, top panel), and the openings (Chart 7, middle panel) and quits rates (Chart 7, bottom panel) from the JOLTS survey, testify to an extremely tight labor market. We expect that the pause in wage acceleration will prove temporary (Chart 8). Chart 7... Despite A Red-Hot Labor Market Chart 8Wage Gains Will Pick Up Again Chart 9No Overheating In The Real Economy With cyclical spending well short of past business cycle peaks (Chart 9), the real economy isn’t exerting any pressure on the Fed to intervene to choke off the expansion. (Although a modest pace of Fed hikes would support below-benchmark duration positioning, aggressive tightening to cut off overheating leads to recessions, and would favor long-maturity Treasuries.) We have removed the financial sector imbalances box because there has been no apparent follow through from Governor Brainard’s speech last September, which appeared to set the stage for tightening on the basis of frothy credit conditions. We maintain the international duress box, which is meant to alert us to an overseas crisis or near-crisis that could spark a flight to quality that depresses Treasury yields and/or inspires the Fed to pursue easier policy in an attempt to stave off contagion risks. Green shoots in manufact-uring, here and abroad, support the idea that growth outside the U.S. could be poised to accelerate. Chart 10Global Manufacturing Is Coming Back ... Chart 11... And US Manufacturing May Have Bottomed We add “Flagging Global Growth” to address the global growth blind spot that undermined our call last year. Our US Bond Strategy colleagues find that the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials Index are the global growth measures that exert the strongest influence on Treasury yields. The Global Manufacturing PMI has risen off its lows over the last three months and is within striking distance of getting back above the 50 contraction/expansion line, led by the US2 and China (Chart 10). The outlook for the US ISM Manufacturing PMI looks good on several counts. First, the comparatively modest manufacturing sector tends to move with the much larger services sector, and the sharp bounce in the Services PMI bodes well for the Manufacturing PMI (Chart 11, top panel). Within the manufacturing survey, New Export Orders’ leap back over 50 suggests that the global economy may have already seen the worst of the manufacturing weakness that has swept the rest of the world (Chart 11, bottom panel). The jury is still out on the CRB Raw Industrials-to-gold ratio (Chart 12, top panel), as industrial commodity prices have yet to show any spunk (Chart 12, bottom panel). Chart 12Commodities Have Yet To Turn Chart 13A Weaker Dollar Would Support Higher Rates With our trio of indicators mixed-to-positive on balance, we leave the global growth box unchecked. We have also added a dollar box to monitor when Treasury yields are drifting out of alignment with other sovereign yields. If the dollar and Treasury yields rise together, we would view the rise in yields as suspect and at risk of being reversed.3 There doesn’t appear to be any decoupling pressure now, as Treasury yields have risen while the dollar has bumped around in a narrow range (Chart 13, top panel), and bullish sentiment toward the dollar has cooled off, pointing the way to a currency-approved path to higher yields (Chart 13, bottom panel). Bottom Line: We check only two of the boxes in our revised rates checklist (Figure 2), supporting a below-benchmark duration stance. Investment Implications Like all investors, we hate to get anything wrong. We were wrong on rates, though, failing to see the potential for the 10-year Treasury yield to fall to 1.5%. The duration miss undermined results within the fixed income sleeve of our recommendations, as we didn’t take it off until the 10-year Treasury yield had fallen to 1.74% .4 We have modified our rates checklist to force ourselves to be more aware of the world beyond the US, but the available data still support below-benchmark duration positioning, and we now recommend going back to it over the tactical (0-3-month) timeframe. The date when monetary policy turns restrictive has been pushed out, and so have the dates when the bull markets in risk assets will end. We note that our overall asset allocation calls have performed well. Since we upgraded equities in our first 2019 report,5 the S&P 500 Total Return Index has gained 24% while our Treasury underweight, as proxied by the Bloomberg Barclays US Treasury Total Return Index, is up 7% (Chart 14, top panel). Since we upgraded spread product in late January,6 the Bloomberg Barclays US Corporate Investment Grade and High Yield Total Return Indexes are up 12% and 8%, respectively, versus the Treasury Index’s 7% (Chart 14, bottom panel). Chart 14Underweighting Treasuries Has Been The Way To Go The run-up to the Fed’s series of mid-cycle rate cuts doomed our duration call, but it has fortified the case for overweighting equities and spread product. We still expect the expansion, the equity bull market, and spread product’s long period of generating excess returns to die at the hands of the Fed. Now that the date when monetary policy settings become restrictive has been indefinitely delayed, the end-dates of the equity and credit bull markets have as well. We continue to recommend overweighting equities and spread product, and underweighting Treasuries. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 17, 2018 US Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?” available at usis.bcaresearch.com. 2 The Global PMI is compiled from Markit’s individual country PMIs, so the chart shows the Markit US PMI instead of the more familiar ISM measure. 3 It the dollar were to rise significantly while Treasury yields rose faster than other DM sovereign yields, currency-adjusted Treasury yields would decouple from peer yields and arbitrage activity would likely bring them back down. 4 Please see the August 12, 2019 US Investment Strategy Weekly Report, “When The Facts Change,” available at usis.bcaresearch.com. 5 Please see the January 7, 2019 US Investment Strategy Weekly Report, “What Now?” available at usis.bcaresearch.com. 6 Please see the January 28, 2019 US Investment Strategy Weekly Report, “Double Breaker,” available at usis.bcaresearch.com.
Highlights Prevailing winds are still blowing in favor of the US dollar. Continue shorting a basket of EM currencies versus the greenback. Deflationary forces are gaining momentum in EM/China while inflationary pressures are accumulating in the US economy. The dollar will appreciate further, distributing inflationary pressures away from the US and into EM/China. Feature Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered. Last week the EM index closed a hair short of this level. Our strategy remains intact: We continue to recommend caution and defensive positioning for EM investors, but will recommend playing the rally if the index breaks above this level. The fact that industrial metals and oil prices have failed to rally substantially even though the S&P 500 is making new highs gives us comfort that the Chinese industrial cycle is not experiencing a revival. Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered. Absent a sustained recovery in the Chinese capital spending and rising commodities prices, EM equities and currencies will not be able to maintain their rebound. Chart I-1 illustrates that the total return on EM ex-China currencies (including the carry) correlates strongly with industrial metals prices. Similarly, EM share prices move in tandem with global materials stocks (Chart I-2). Chart I-1EM Currencies Correlate Strongly With Industrial Metals Prices Chart I-2EM Share Prices Move In Tandem With Global Materials Stocks The basis for these relationships is as follows: The majority of EM economies, and hence their share prices and exchange rates, are leveraged to China’s business cycle. The latter also drives industrial commodities prices, as the mainland accounts for 50% of global metals consumption. We elaborated on these relationships in our recent report titled EM: Perceptions Versus Reality. In this report, we examine the dichotomy between inflation in EM and US and discuss the macro rebalancing required and the implications for financial markets. Inflation: A Dichotomy Between EM… Low and rapidly falling inflation accompanying extremely weak real growth constitute the current hazards to EM economies and their financial markets: Headline and core inflation in EM ex-China, Korea and Taiwan1 – the universe pertinent for EM bond portfolios – are low and falling, justifying lower interest rates (Chart I-3). Consistently, aggregate nominal GDP growth in these economies is hovering close to its 2015 low (Chart I-4). Chart I-3EM: Inflation Is Low And Falling Chart I-4EM: Nominal GDP Is Subdued And Decelerating Chart I-5EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing In China, core consumer price inflation is at 1.5% and falling, and producer prices are declining. Even though many EM central banks have been cutting rates, narrow and broad money as well as bank loan growth are either weak or decelerating (Chart I-5). In brief, policy easing in these economies hasn’t yet revived money and credit growth. The reason why low nominal interest rates have not yet led to a recovery in money/credit is because real (inflation-adjusted) borrowing costs remain elevated. In addition, poor banking system health stemming from lingering non-performing loans – a legacy of the credit boom early this decade – has also hindered credit origination. Corroborating the fact that borrowing costs are high in real (inflation-adjusted) terms, interest rate and credit-sensitive sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. In particular, high-frequency data such as capital goods imports and car sales are shrinking (Chart I-6). Residential property markets are very sluggish in the majority of developing economies (Chart I-7). Chart I-6EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking Chart I-7Property Prices In Local Currency Terms Chart I-8Chinese Imports For Domestic Consumption And EM Exports Finally, the combined exports of EM ex-China, Korea and Taiwan – which are correlated with mainland imports for domestic consumption – are shrinking (Chart I-8). Without a revival in Chinese domestic demand in general, and commodities in particular, EM exports will continue to languish. Bottom Line: Risks stemming from low and falling inflation in EM are rising. While central banks are cutting rates, they are behind the curve. For now, investors should not expect an imminent domestic demand recovery based on EM central bank interest rate cuts. …And The US In contrast to EM, investors and financial markets are complacent about inflation risks in the US. This is not to say that there is a risk of runaway inflation in the US. Our point is as follows: If US growth slows further, US inflation will subside. However, if US growth accelerates, consumer price inflation will surprise to the upside. Sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. US core consumer price inflation has been trending upwards in the past several years, consistent with a positive and widening output gap (Chart I-9, top panel). The average of six core consumer price inflation measures – core CPI, core PCE, trimmed mean CPI, trimmed PCE, market-based core PCE, and median CPI – is slightly above 2% and looks to be headed higher (Chart I-9, bottom panel). US unit labor costs are rising faster than the corporate price deflator (Chart I-10, top panel). A tight labor market will translate to robust wage growth. Chart I-9Barring Slowdown, US Core Inflation Will Rise Further Chart I-10Beware Of A US Profit Margin Squeeze With corporate profit margins already shrinking (Chart I-10, bottom panel) and consumer spending robust, companies will try to pass on higher costs to consumers. Hence, barring a slowdown in US consumer spending, consumer price inflation will likely rise. If global growth recovers, the dollar will sell off and US manufacturing will revive. Provided these two factors have been counteracting inflationary pressures in the US, their reversal will allow inflation to rise. Bottom Line: Underlying core inflation in the US has been drifting higher. Unless growth slows, inflation will surprise to the upside. Macro Rebalancing: In The Dollar’s Favor Bond yields and exchange rates often act as shock absorbers and re-balancing mechanisms for the global economy. The agility and corresponding adjustments of these financial variables assure a more stable real global economy. Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. A strong greenback will redistribute inflationary pressures away from the US and into EM. An analogy for this adjustment process is the role of wind in rebalancing air pressure around the globe. When air pressure in location A is higher than in location B, the air moves from location A to location B, causing wind. This allows for a rebalancing of air pressure around the earth. US core consumer price inflation has been trending upwards in the past several years. When air pressure differences are substantial, winds become forceful – potentially to the point of causing damage. In a nutshell, this adjustment could come at the cost of strong winds, or even a storm. Global currency markets play a similar role to wind. A strong greenback will help cap US inflation by dampening activity and employment in America’s manufacturing sector. Slumping manufacturing will moderate activity in the service sector, as well as slowdown aggregate income and spending growth. In turn, weakening currencies will help reflate EM economies by mitigating the negative impact of lower exports in general and commodities prices in particular. EM economies need an external boost, especially now when their banking systems are in hibernation mode and China is not boosting its demand to the same extent it did during downturns since 2008. A caveat is in order here: In the case of many EMs, currency deprecation will initially hurt growth. The reason is that companies and banks in many EMs still hold large amounts of US dollar debt (Chart I-11). As the dollar appreciates, the cost of foreign debt servicing will escalate, prompting them to reduce corporate spending and bank lending. Hence, wind could turn into a storm. All in all, we continue to bet on EM currency depreciation, regardless of the direction of US bond yields. The basis is as follows: Contrary to widespread consensus, EM exchange rates correlate more strongly with commodities prices – please refer to Chart I-1 on page 1 – than US bond yields as shown in Chart I-12. Chart I-11EM External Debt Is A Risk If EM Currencies Depreciate Chart I-12EM Currencies And US Bond Yields: No Stable Relationship Emerging Asian currencies correlate with their export prices and the global trade cycle. Neither global trade activity nor Asian export prices are recovering (Chart I-13). Therefore, the recent bounce in EM currencies is not sustainable. Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. Could it be that US inflationary pressures are dampened by deflationary tendencies originating from EM/China, producing a benign (goldilocks) scenario for financial markets? It is possible but not likely in the case of EM financial markets. Exchange rates hold the key to all EM asset classes. If the US dollar continues drifting higher – which is our bet – it will stifle the performance of EM equity, local bonds and credit markets (Chart I-14). Chart I-13Asian Export Prices And Container Freight Herald Weaker Regional Currencies Chart I-14Trade-Weighted Dollar And EM Share Prices Are Still Correlated Further, Box I-1 on page 10 discusses the 2008 clash between inflationary forces in EM and deflation in the US. Bottom Line: We continue to recommend playing the following EM currencies on the short side versus the dollar: ZAR, CLP, COP, IDR, KRW and PHP. We are also short CNY versus the dollar. For allocations within EM equity, domestic bonds and sovereign credit, please refer to our investment recommendations on pages 16-17. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Box 1 Inflationary + Deflationary Forces = Goldilocks? Will inflationary pressures in the US be offset by disinflation in EM, resulting in a goldilocks outcome globally? A goldilocks period is one in which strong growth is accompanied by moderate inflation. It is possible, but in the global macro world inflation + deflation does not always equal goldilocks. In other words in global macro, (1-1) does not always equal zero. For instance, an inflation dichotomy was present in the first half of 2008. Back then, the US economy was already in recession, with acute deflationary pressures stemming from the deflating housing and credit bubbles. In turn, EM growth was still rampant and inflationary pressures were acute. In fact, in the period between March and mid-July of 2008, US and global bond yields were climbing on the back of rising worries about inflation. In retrospect, such an inflation dichotomy between the US and EM did not result in a goldilocks environment, but occurred on the precipice of the largest deflationary black hole in the post-war period. In the second half of 2008, US deflation overwhelmed EM inflation, generating a major deflationary tsunami worldwide. Russia: Long Domestic Bonds / Short Oil Chart II-1Undershooting CB's 4% Inflation Target Russia’s growth is already very sluggish. Lower oil prices2 entail both weaker growth and ruble weakness. The primary risk in Russia is low and falling inflation rather than rising inflation. Therefore, unlike in previous downturns, the central bank will be able to engage in counter-cyclical monetary policy, namely continue cutting interest rates. This makes a long position in local currency bonds a “no-brainer”. The only risk to owning Russian domestic bonds is the ruble depreciation due to falling oil prices and a risk-off phase in EM exchange rate markets. To hedge against these risks, we recommend the following trade: long Russian domestic bonds / short oil. The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. As a result, local bonds on a total- return basis in US dollar terms will outperform oil. The basis to expect a further meaningful drop in interest rates in Russia is as follows: Inflation Is Low And Falling: Various measures of inflation suggest that disinflation is broad based (Chart II-1). As a result, inflation will continue falling towards the central bank’s inflation target of 4%. Crucially, wage growth is decelerating both in nominal and real terms (Chart II-2). Monetary Policy Is Still Restrictive: Even though the central bank has cut rates by 125bps over the past 6 months, monetary policy remains behind the dis-inflation curve. Both policy and lending rates remain too high, especially relative to the low nominal growth environment (Chart II-3). Real borrowing costs stand at 9% for consumer and 4.5% for corporate loans (Chart II-4). The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. Chart II-2Russia: Sluggish Wage Growth Chart II-3Russia: Tight Monetary Policy Notably, weakening credit impulses for both business and consumer segments suggest that domestic demand will disappoint (Chart II-5). Chart II-4Russia: High Real Lending Rate Across Sectors Chart II-5Weakening Credit Impulses = Lower Demand And Investment Since October 1, the CBR has taken measures to curb consumer borrowing from banking and non-banks credit institutions. These new guidelines limit the latter’s lending to consumers with high debt loads. In short, much lower nominal and real interest rates will be required to reinvigorate domestic demand. Fiscal Policy Is Tight: The government has overplayed its hand in running very tight fiscal policy. The government primary budget surplus now stands at 3.8% of GDP. Government spending growth both in real and nominal terms remains very weak (Chart II-6). The National Project initiative has not yet been sufficient to expand government expenditures. In fact, a recent report from the Audit Chamber suggests that total spending under this National Project program for 2019 will be below government targets of 3% of GDP per year. Finally, the authorities committed a policy mistake at the beginning of year by hiking the VAT tax which has hurt consumption. Russian local currency bond yields are set to fall, even as oil prices decline over the coming months. A Healthy Balance Of Payment (BoP) Position: Total external debt and debt servicing are extremely low by emerging markets standards. Russia has the lowest external debt amongst its EM counterparts. Likewise, Russia’s international investment portfolio liabilities – foreigners’ ownership of equities and bonds – remain one of the lowest amongst EM (Chart II-7). Chart II-6A Lot Of Room To Boost Government Spending Chart II-7Foreigners' Holding Of Russian Financial Assets Are Low Investment Recommendations Chart II-8Local Bonds Are Decoupling From Oil Russian local currency bond yields are set to fall, even as oil prices decline over the coming months (Chart II-8). In light of this, we recommend the following pair trade: long local currency bonds / short oil. Dedicated EM fixed-income portfolios should continue to overweight Russian sovereign and corporate credit, as well as local currency government bonds relative to their respective EM benchmarks. Tight fiscal and monetary policies favor creditors. We have been bullish on Russian markets for some time arguing that they will behave as a low-beta play in EM selloff as discussed in our previous report. This view remains intact. Dedicated EM equity portfolios should continue overweighting Russian stocks, a recommendation made in October 2018. Given the ruble will likely depreciate gradually rather than plunge amid falling oil prices, the authorities will continue cutting rates and provide fiscal stimulus. That will benefit Russia versus many other EM countries. Finally, we remain long the RUB versus the Colombian Peso, a trade instituted on May 31, 2018. Andrija Vesic Research Analyst andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 We exclude economies of China, Korea and Taiwan because they are different in their economic structure and inflation dynamics compared with majority of EMs. 2 BCA’s Emerging Markets Strategy team expects lower oil prices consistent with its thesis of EM slowdown. This is different from BCA’s house view that is bullish on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights The attractiveness of European stocks is relative to European bonds rather than relative to non-European stocks. Despite vastly different stock market valuations in Germany, Japan, and the US, the implied prospective 10-year annualised returns are almost identical – at around 5 percent per annum. Overweight the DAX versus German long-dated bunds. Equities would lose their attractiveness if the global 10-year bond yield were to rise through 2.5 percent, because the required excess return from equities would viciously normalise. Tactically overweight EM versus DM. Fractal trade: short GBP/NOK, as the recent rally in the pound appears technically extended. Feature Chart of the WeekOverweight Europe Vs. World = Overweight Consumer Staples Vs. Technology Stock markets recently broke to new highs, begging the perennial question: how attractive are equities at current valuations? To answer, we need to assess the prospective return that is now ‘baked in the equity valuation cake’. But which valuation metric gives the most credible assessment of prospective returns? Equity valuations based on assets are problematic – because nowadays, assets comprise intellectual capital or intangibles or ‘virtual’ assets, which are extremely difficult to value. Equity valuations based on earnings are problematic. Equity valuations based on earnings (profits) are also problematic – because they take no account of structurally high profit margins (Chart I-2). The problem is that earnings will face a headwind when profit margins normalise, depressing prospective returns. Some people suggest adjusting the earnings to derive a cyclically adjusted price to earnings multiple (CAPE), but by definition this does not correct for the structural rise in profit margins. Chart I-2Structurally High Profit Margins Flatter Earnings Hence, the most credible assessment comes from price to sales – because sales are quantifiable, unambiguous, and undistorted by profit margins. Significantly, while price to earnings missed the high valuation of world equities in 1990 (Japanese bubble) and 2007 (credit bubble), price to sales did not (Chart I-3 and Chart I-4). Chart I-3Price To Earnings Missed The Japanese Bubble And The Credit Bubble... Chart I-4...But Price To Sales ##br##Didn't Are Stocks Attractive? Based on the credible assessment from price to sales, today’s prospective 10-year annualised return from world equities is around 5 percent (Chart I-5). This is not that different to the 4 percent prospective return at the peak of the credit bubble in 2007.1 Which raises an obvious question. Back in 2007, a secular growth boom provided the excuse for the rich absolute valuation, but today, if anything, investors fear a ‘secular stagnation’. What can excuse today’s rich absolute valuation? Chart I-5The Prospective Return From World Equities Is 5 Percent The answer is ultra-low bond yields. In 2007, the global 10-year bond yield stood at 5 percent; today, it stands well below 2 percent (Chart I-6). A lower prospective return on bonds means a lower prospective return on competing long-duration assets, like equities. Chart I-6The Global 10-Year Bond Yield Has Plunged To Below 2 Percent Moreover, as bond yields approach their lower bound, the riskiness of bonds rises because they take on an unattractive ‘lose-lose’ characteristic. As holders of Swiss government bonds discovered this year, prices do not rise much in a rally, but they do plunge in a sell-off. This higher riskiness of bonds justifies an abnormally low (or zero) ‘risk premium’ on competing long-duration assets, like equities. The 5 percent prospective return makes equities look attractive relative to bonds. The upshot is that the 5 percent prospective return from equities is low in absolute terms. But in a world of ultra-low numbers – for both bond yields and equity risk premiums – the 5 percent prospective return makes equities look attractive relative to bonds. At the peak of the credit bubble in 2007, equities were offering a lower prospective return than the 5 percent available from bonds. But today’s equity risk premium over bonds is generous. The caveat is that this would change if the global 10-year bond yield were to rise through 2.5 percent because the required risk premium on equities would viciously normalise. Are European Stocks Attractive? Turning to the relative attractiveness of major stock markets, it is tempting to think that the markets trading on the best head-to-head valuation comparisons are the most attractive. For example, Germany and Japan, both trading on a price to sales multiple of 0.9, appear compelling buys compared to the US, trading on a multiple of 2.1 (Chart I-7). But such a knee-jerk conclusion is wrong, for two reasons. Chart I-7Germany And Japan Trade On Much Lower Multiples Than The US First, stock markets have very different sector compositions. Two sectors with vastly different structural growth prospects – say, technology and banks – 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. Second, major stock markets are dominated by multinational companies with mixed currency sales and profits, while the stock price is quoted in the domestic currency. Hence, if the market expects the mixed currency profits to depreciate in domestic currency terms, the stock will trade at a discount. Put another way, if the domestic currency is cheap the stock market will appear cheap. The best way to see this is to look at the two valuations of dual-listed multinationals like the UK/US cruise operator Carnival. In London, the stock trades on a price to forward earnings at 9.7; in New York it trades at 10.3. But it would be absurd to suggest that Carnival is cheaper in London than in New York! The discrepancy is simply because the market expects the pound to appreciate versus the dollar. A head-to-head comparison of stock market valuations is misleading. Allowing for the distortions from sector skews and currency adjustments, the best way to assess an equity region’s attractiveness is to quantify the prospective return implied by its valuation versus its own history. The method is to regress historic starting price to sales with the (historic) prospective 10-year returns that followed. Then apply this relationship to the current price to sales to predict the (current) prospective 10-year return. The results are amazing. Despite the vastly different price to sales multiple of 0.9 in Germany and Japan, and 2.1 in the US, the implied prospective 10-year annualised returns are almost identical – at around 5 percent from each of the three stock markets (Chart I-8-Chart I-10). Chart I-8Expect Near-Identical Returns From The US... Chart I-9…Germany… Chart I-10...And Japan Still, there is one significant difference: the 10-year bond yield is much lower in Germany and Japan than in the US, equating to a much more attractive equity risk premium of over 5 percent in Germany and Japan. So to answer this week’s title, yes, European stocks are attractive. But the attractiveness is not relative to non-European stocks, the attractiveness of European stocks is relative to European bonds. Bottom Line: maintain a structural overweight to the DAX versus German long-dated bunds. Europe’s ‘Sector Fingerprint’ Is No Longer Pro-Cyclical Over the short term, stock market relative performance is just the result of global sector relative performance combined with the unique sector fingerprint of each stock market. It follows that regional and country equity allocation must always start with a sector view combined with an awareness of the sector fingerprint of the major bourses (Table 1-1). Table I-1EM, DM, And Europe Have Unique ‘Sector Fingerprints’ In this regard, there is an important change. Market action plus index composition changes are making the European index less cyclical. Specifically, the European index is no longer over-weighted to Financials relative to the world index. Instead, the European sector fingerprint is now: ‘Overweight Consumer Staples, Underweight Technology’ (Chart of the Week). With the overweight skew being to defensive staples and the underweight skew to partly-cyclical tech, the cyclicality of the European index has become ambiguous. By contrast, emerging market (EM) equities remain ultra-cyclical with a sector fingerprint that is: ‘Overweight Banks, Underweight Healthcare’ (Chart I-11). Suffice to say, this is ultra-cyclical because the 10 percent overweight is to an unambiguously cyclical sector, while the symmetrical 10 percent underweight is to an unambiguously defensive sector. Chart I-11Overweight EM Vs. DM = Overweight Banks Vs. Healthcare The upshot is that a pro-cyclical sector tilt no longer implies an overweight to European equities versus other regions, but it does strongly imply an overweight to EM equities. This is our recommended stance, albeit only on a tactical horizon until our leading indicators show that the current growth rebound can be sustained well into 2020. Stay tuned. Fractal Trading System* The broken 65-day fractal structure of GBP/NOK suggests that its recent rally is susceptible to a countertrend sell-off, albeit UK election campaign developments are likely to be the near-term sentiment drivers. Go short GBP/NOK, setting a profit target at 2.5 percent with a symmetrical stop-loss. In other trades, short Italian 10-year BTP achieved its 3 percent profit target and is now closed, while long gold / short nickel is very close to its 11 percent profit target. 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. 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 Total (capital plus income) nominal annualised returns Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations
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