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When we upgraded the S&P industrial machinery group to overweight, we held back the S&P construction machinery & heavy trucks sibling to a neutral weighting. Our reasoning was threefold: heavy truck sales were very weak, the outlook for agriculture and food prices was shaky and the resource industry was not in a mood to deploy capital into expansion. That rationale has shifted somewhat. First, heavy truck sales have turned a corner and have pushed positively for the first time in two years (second panel). Still, in advance of a surge in orders, manufacturers boosted production earlier this year, likely offsetting a portion of the calendar 2017 earnings expansion. Second, food prices (to which the industry is highly correlated) have rebounded to some extent this year, arresting the general downtrend of the past five years (third panel). This is a sign for optimism, though whether the uptick becomes a trend remains unknown. Lastly, Caterpillar's machine sales to dealers to all regions have finally pulled out of their multiyear contraction (fourth panel), signaling a commodity production rebound. However, the resilience of this rebound is questionable with the recent Chinese fiscal and monetary tightening and a leadership change coming in the fall. Importantly, valuation multiples have fallen well off their peaks (bottom panel) as earnings estimates have surged, while the market has remained skeptical. We side with the market and remain on the sidelines, until some earnings growth validation materializes. Nevertheless, we acknowledge the mild positive macro backdrop shift and the S&P construction machinery & heavy trucks index is now on upgrade alert. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI.
Highlights Despite a tightening in Chinese monetary conditions, dollar bloc currencies have continued to rally. Rising global reserves and strong carry inflows into EM prompted by low global financial volatility have created plentiful liquidity conditions in EM, supporting dollar-bloc currencies. The beginning of the Fed's balance-sheet runoff could reverse these dynamics, hurting the AUD, CAD and NZD in the process. Monitor U.S. inflation, cross-currency basis swap spreads, gold, EM currencies and Chinese monetary conditions to judge when a break in dollar-bloc currencies will materialize. Feature The rally in the dollar-bloc currencies since July 2016 has been nothing short of stunning. We did highlight in April last year that commodity currencies had room to appreciate, but we did not anticipate such a prolonged move.1 In fact, the up leg that began in April 2017 caught us by surprise. At this juncture, it is essential to analyze whether or not the bull move in commodity currencies has further to run, or whether it is in its final innings. A principal component analysis of the returns of the AUD, the CAD, and the NZD shows that despite differing central bank postures in the three countries, a simple common factor explains 86% of their variability against the USD since 2010 (Chart I-1). Because of this result, our focus in this week's report are the global forces that may be driving this factor. Today, the key risk to the dollar-bloc currencies is global liquidity tightening. Behind this danger lies the removal of policy accommodation in the U.S., and the risks to carry trades created by the already-very-low volatility of risk assets. A China-Fueled Rebound, But Something Is Amiss... The key reason behind the rally in commodity currencies has been improvement in EM growth relative to DM economies since 2016 (Chart I-2). This growth outperformance has been underpinned by a few factors. Chart I-1One Factor To Drive Them All Chart I-2Commodity Currencies And EM Growth China has played an essential role. As the Chinese economy decelerated in 2015, Beijing implemented a large amount of fiscal stimulus, which saw government spending grow at a 25% annual rate in November 2015. Due to the lags of stimulus on the economy, the full force of that stimulus was felt in 2016. Direct fiscal goosing was not the only road taken by Beijing. The Chinese authorities also applied a considerable amount of monetary pressure on China. After tightening massively through 2015, Chinese monetary conditions eased greatly in 2016 as real borrowing costs collapsed from a peak of 10.5% in the fall of 2015 to a trough of -3.5% earlier this year (Chart I-3). Directed expansion of credit through banking channels was also used to support the economy, resulting in a surge in the Chinese credit impulse. However, in recent months these positives have dissipated. Chinese money growth has slowed, and the combined credit and fiscal impulse has been lessened. Yet EM equity prices, copper prices and commodity currencies are all continuing their rally, and are now re-testing their May 2015 levels - levels last experienced right before EM assets and related plays entered a vicious tailspin that lasted all the way until January 2016 (Chart I-4). Chart I-3China: From Tailwind ##br##To Headwind Chart I-4EM, Copper, Dollar Bloc: ##br##Back To May 2015 Levels Bottom Line: The rally in dollar-bloc currencies that begun in January 2016 was powered by improving growth performance within EM economies. The original driver behind this move was Chinese monetary and fiscal stimulus. However, even once the easing faded, EM plays, including the AUD, the CAD and the NZD continued to appreciate. Another factor is currently at play. ...And This Something Is Global Liquidity Our view is that global liquidity is now the key factor supporting EM plays in general and dollar-bloc currencies in particular. Since the end of 2016, we have seen a rebound in the Federal Reserve's custody holdings - one that has happened as foreign central banks resumed their purchases of Treasury securities (Chart I-5). Fed custodial holdings for other monetary authorities are a key component of our dollar-based liquidity indicator. A rebound in this indicator tends to be associated with a surge in high-powered money globally. The capital outflows from China have dissipated, helping high-powered money find its way into EM plays and the commodity-currency complex. Private FX settlements - a proxy for the Chinese private sector's selling of yuan - was CNY -43 billion in July, a massive improvement compared to the CNY 800 billion in outflows experienced in August 2015 (Chart I-6). Through stringent administrative controls and a lessening of deflation, China gained the upper hand over its capital account. This development has two implications: it means that China does not need to sell reserves anymore, and in fact has been accumulating Treasurys since February 2017. It also means that investors are now less afraid of a sudden devaluation in the CNY, which has heartened risk-taking globally - especially in assets most exposed to China, which includes EM, commodities and dollar-bloc currencies. Chart I-5Easing Global Liquidty In 2017 Chart I-6Chinese Capital Account Under Control The collapse in the volatility of risk assets has been an additional element helping global liquidity make its way into EM plays and commodity currencies. As Chart I-7 illustrates, there is a relationship between the realized volatility of the U.S. stock market and the performance of dollar-bloc currencies. The first hunch is to dismiss the relationship as an artifact of the fact that both stock prices and commodity currencies are "risk-on" instruments. But there is an economic underpinning behind this relationship. As we argued in a Special Report on carry trades last year, the main reason carry trades have been able generate high Sharpe ratios since the 1980s is because they offer investors a risk premium for taking on exposure to unforeseen spikes in volatility.2 As a result, when the volatility of risk assets collapses, as has been the case recently, carry currencies outperform. The opposite holds true when volatility spikes back up. Chart I-7Dollar Bloc Currencies Like Low Vol When carry trades do well, investors end up aggressively buying EM currencies. As a result of these purchases, they inject funds - i.e. liquidity - into these economies. These injections of liquidity end up boosting money growth and supporting their economic activity, which stimulates global trade, commodity prices, and thus commodity currencies - even if these are not currently "high-yielders." Bottom Line: Chinese monetary conditions have deteriorated, creating a handicap for EM assets and the dollar-bloc currencies. Nonetheless, an increase in high-powered money growth, a decline in the risk premium to compensate investors for the risk of sudden new Chinese devaluation, and a collapse in global financial volatility have reinforced each other to create the ideal breeding ground for a rally in the AUD, the CAD and the NZD. The Sweet Spot Is Passing At the current juncture, the sweet spot for the dollar-bloc currencies may be passing. To begin with, commodity currencies are trading at a significant premium to underlying commodity prices, suggesting they are expensive and vulnerable to a decrease in global liquidity (Chart I-8). The AUD and the NZD stand out as especially expensive, while the CAD is only trading at a small premium to its long-term fair value (Chart I-9). This suggests that the Canadian dollar is likely to continue to outperform the Australian and New Zealand currencies, as it has been doing in choppy fashion since November 2016. Chart I-8Dollar Bloc Currencies Are Expensive Chart I-9AUD And NZD Are Expensive Another problem for dollar-bloc currencies is that they have greatly overshot global liquidity metrics. Historically, the commodity currencies have moved in lockstep with the evolution of global central bank reserves - a key measure of global liquidity (Chart I-10). While global reserves have improved, the average of the AUD, the CAD and the NZD has over-discounted this positive, pointing to potential vulnerability once liquidity ebbs. The problem with this overshoot is that liquidity is likely to decline with the imminent reduction in the Fed's balance sheet size. As Chart I-11 shows, the USD has been closely linked to changes in the reserves of commercial banks held at the Fed. As commercial banks accumulate excess reserves, this provides fuel for the repo market and the Eurodollar market, creating a supply of globally available USD for offshore markets. However, mechanically, once the Fed lets the assets on its balance sheet run off (its holdings of Treasurys), a liability will also have to decrease. This liability is most likely to be excess reserves as banks buy the Treasurys sold by the Fed. A fall in the accumulation of reserves of commercial banks in the U.S. is also directly linked with weaker dollar-bloc currencies (Chart I-12). This is because falling reserves push up the dollar and hurt commodity prices - a negative terms-of-trade shock for the AUD, the CAD and the NZD. Moreover, less reserves point to less liquidity making its way into EM economies. This also hurts the expected returns of holding assets in dollar-bloc economies. This therefore means that not only is there less liquidity available to move into these markets, the rationale to do so also dissipates. Without this dollar-based liquidity support, the tightening in Chinese monetary conditions could finally show its true impact on commodity currencies. Chart I-10Commodity Currencies Have##br## Overshot Global Liquidity Chart I-11Falling Excess Bank Reserves##br## Equals Strong Greenback Chart I-12Falling Excess Reserves Equals##br## Falling Commodity Currencies The last worrisome development for the dollar-bloc currencies is the volatility of financial assets. When volatility falls, it creates a wonderful environment for these currencies. But today, historical volatility is near the bottom of its distribution of the past 28 years. Being a highly mean-reverting series, it is thus more likely to rise than fall further going forward. There are three fundamental factors pointing to a potential reversal. First, share buyback activity has been declining, which historically points to rising volatility. Second, the U.S. yield curve slope also points toward a higher level of volatility. Volatility tends to bottom before the stock market peaks, and the stock market tends to peak before the economy enters recession. The yield curve itself tends to invert a year or so before a recession emerges. As a result, the yield curve begins to flatten around two years before volatility picks up (Chart I-13). Third, the anticipated decline in bank reserves - an important factor that has supported risk-taking around the globe - is likely to be the key catalyst supporting the relationship between the yield curve and volatility. If volatility increases, carry trades are likely to perform poorly, which will hurt EM currencies and result in outflows from these markets. This will cause liquidity conditions in EM economies to dry out, hurting their growth outlook. EM M1 growth has already weakened considerably, and is currently pointing to problems for commodity currencies (Chart I-14). The dry out in liquidity resulting from a reversal in carry trades will only amplify this phenomenon. Chart I-13Listen To The Yield Curve: ##br##Volatility Will Pick Up Chart I-14EM M1 Growth Is Becoming ##br##A Headwind For The Dollar Bloc Bottom Line: Global liquidity conditions are set to begin to tighten. While it is probably not enough to cause the bull market in stock prices to end now, it could be enough to affect the area of the global economy most exposed to this risk factor: carry trades and the dollar-bloc currencies. Specifically, commodity currencies are likely to be negatively affected by their elevated valuations, their strong sensitivity to excess bank reserves, and their high responsiveness to changes in financial market volatility. Key Indicators To Monitor After the surge that the dollar-bloc currencies have experienced since the spring and the large increase in the long exposure of speculators to these currencies, they are naturally at risk of experiencing a period of weakness. However, what worries us is not a retracement of 3-4%, but rather a 10-15% move. We suggest monitoring the following: First, watch U.S. inflation closely. The U.S. dollar is only likely to genuinely rally once the market believes the Fed can actually increase rates. So long as inflation remains tepid, investors will continue to second-guess the Fed. The market's response to this week's release of the most recent Federal Open Market Committee minutes only confirmed this. Mentions of debate on inflation within the FOMC was enough to send bond yields and the dollar reeling. However, based on the dynamics in the U.S. velocity of money, we continue to expect inflation to pick up in the second half of 2017 (Chart I-15).3 Second, follow cross-currency basis swap spreads. The cost of hedging U.S. assets back into euro or yen has normalized somewhat after hitting record levels in early 2016 (Chart I-16). If the removal of excess bank reserves in the U.S. system does affect global liquidity conditions, this market will be one of the first to be affected. Third, scrutinize the price of gold. The yellow metal remains a key gauge of global liquidity. Moreover, it is extremely sensitive to real rates and the dollar - two major determinants of the cost of global liquidity. In the summer of 2015, EM and dollar-bloc currencies severely suffered once gold broke below 1150. Today, a break below 1200 would be a sign of danger ahead. Fourth, watch EM currencies. A breakdown in EM currencies would be a key indication that carry trades are being reversed, and that global liquidity is no longer making its way into EM and EM-related plays. Commodity currencies are currently trading at a premium to their historical relationship with EM currencies, suggesting they would be highly vulnerable to such an event (Chart I-17). Chart I-15Watch U.S. Inflation Chart I-16Monitor Cross-Currency Basis Swap Spreads Chart I-17Dollar-Bloc Currencies At The Mercy Of EM FX Finally, keep an eye on Chinese monetary conditions. If Chinese monetary conditions improve from here, it would alleviate some of the negative pressure exercised on dollar-bloc currencies by the upcoming deterioration in global liquidity. However, if Chinese monetary conditions deteriorate further, this would negatively affect commodity prices, EM returns and the commodity currency complex. It would also hurt expected returns on Chinese assets, re-kindling outflows out of China and thus raising the risk premium associated with what would become a growing risk of CNY depreciation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Pyrrhic Victories", dated April 29, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled, "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report titled, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been mixed this week: The Empire State Manufacturing Index increased to 25.2, a significant jump and beat Retail Sales increased at a 0.5% monthly pace, with the ex. Autos measure increasing at 0.5%, both beating expectations; The Import Price Index increased by 1.5% since last year; Initial jobless claims dropped to 232,000, beating expectations significantly; However, housing starts and building permits both underperformed expectations. While the DXY has rebounded, the FOMC's July minutes discussed the recent shortfall of inflation, which was interpreted bearishly by markets. The Fed is likely to begin normalizing its balance sheet very soon, as well as raising rates again by the end of this year. The greenback will likely continue its ascent when firmer inflation data emerges. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Improving euro area growth prospects have propelled the euro 12% higher since the beginning of the year. However, the market seems to begin questioning the ECB's hawkishness. In its minutes, the ECB expressed worries about a potential euro overshoot. Additionally, rumors emerged that Mario Draghi will not give much guidance in Jackson Hole. Together, these stories have reversed some of the euphoria that had engulfed the euro. The tightening in euro area financial conditions relative to the U.S. has prompted a roll over in relative economic and inflation surprises, justifying these budding doubts. Furthermore, U.S. inflation should begin to meaningfully accelerate in the fall. This is likely to add to the euro's weakness, as the greenback will resume its upward trend. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Data in Japan was mixed this week: Annualized gross domestic product growth grew by 4% on an annualized basis, crushing expectations. Additionally the month-to-month growth of industrial production came in at 2.2%, also beating expectations. However both export and import growth underperformed, coming in at 13.4% and 16.3% respectively. On cue, after we placed a long USD/JPY trade last week, USD/JPY rallied half percentage point, even if it gave up some of the gain now. We continue to be bearish on the yen as we expect U.S. yields to start picking up, in an environment where market expectations are very depressed. But could a correction in EM caused by the rise in the dollar help the yen? Not in the short term, given that historically the yen only gains in very sharp EM selloffs that themselves weigh on bond yields. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data in the U.K. was mixed this week: Retail sales prices increased by 3.6% year-on-year, outperforming expectations. However, The trade balance not only worsened since last month but also came in below expectations, at -4.564 Billion pounds Crucially, most inflation metrics came in below expectations, with headline inflation coming in at 2.6% while PPI core output inflation came in at 2.4%. Overall, we continue to believe that the market's rate expectations for the BoE remain too hawkish. As the pass through from the currency dissipates, inflation should also start to come down. Furthermore, one has to remember that the BoE has a higher hurdle for raising rates than other central banks due to the unique situation in which the U.K. is currently in. Lowered rate expectations will be negative for cable in the short term. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Despite initially weak data, a risk-on environment and increasing copper prices have fueled a rally in the AUD. Data from China has been soft, and Australian data has been neutral: Chinese retail sales increased annually by 10.4%, less than expected; Chinese industrial production also underperformed at 6.4%; Australian wages increased at a 1.9% annual pace, in line with expectations; Australian unemployment dropped to 5.6%; participation rate increased to 65.1%; and a net of 27,900 jobs were filled. However, full-time employment went down by 20,300 while part-time employment increased by 48,200, so hours worked contracted. This development is likely to comfort the RBA in its dovish stance. In its minutes, the RBA discussed its worries concerning the housing market, and that "borrowers investing in residential property had been facing higher interest rates". This further worries the RBA regarding the impact of higher interest rates, limiting the room for more hawkish speeches. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Retail sales and retail sales ex-autos Quarter-on-quarter growth strengthened relatively to the previous quarter, coming in at 2% and 2.1% respectively. Moreover quarter-on-quarter inflation both for producer prices in outputs and inputs outperformed expectations, coming in at 1.3% and 1.4%. Currently, differences in perception adjustment between the dovishness of the RBNZ and the RBA have pushed Australian rate expectations to the point that the market is now pricing a hike in Australia before New Zealand. Overall, this seems like a mispricing, as the kiwi economy is on a stronger footing than the aussie one. Moreover, a slowdown in China would be more harmful for Australia as iron ore is more sensitive to the Chinese industrial cycle than dairy products. Thus we remain bearish on AUD/NZD. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The CAD has regained some composure despite weak oil prices. Even with the U.S. dollar weakening and inventories drawing massively, oil dropped. This dynamic is particularly worrying for oil, as the markets are doubting the durability of the curtailment in global oil production. While this could be worrying for the CAD, we still believe the USD 40-60/bbl equilibrium price level, as postulated by the BoC, will have a limiting effect on the oil-based currency, which has been driven by interest rate differentials. Both central banks are now hiking, but we believe that markets are underpricing Fed hikes. Thus, the CAD should weaken against USD. However, it will outperform other G10 currencies. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data has continued to show a mixed picture for the Swiss economy: Consumer prices inflation, increased slightly from the previous month, coming in at 0.3%, in line with expectations. The unemployment rate also came in in line of expectations at 3.2%, unchanged from the previous month. However, producer prices contracted by 0.1%, underperforming expectations. EUR/CHF has been weakening since its August second overbought extreme. For the moment, we expect the SNB to stand pat in its ultra-dovish monetary policy, at least until inflation and other economic indicators start to strengthen considerably. USD/CHF however might appreciate, given that the euro might fall the ECB minutes this week showed that the ECB is concerned by a potential euro overshoot. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Data in Norway this week was mixed: Headline inflation came in at 1.5% in July, outperforming expectations. However, it softened from June's 1.9% reading. Core inflation came at 1.2% in July, in line with expectations, decreasing from 1.6% in June. Moreover, manufacturing output contracted by 0.6% year-on-year. We continue to be bullish on USD/NOK, as the increasing gap in real rate differentials between the United States and Norway should outweigh any oil rally. Indeed, the recent numbers in Norway illustrate the lack of inflationary pressures in this Scandinavian country. This should keep a lid on rates, and thus help USD/NOK. On the other hand EUR/NOK should follow the path of oil. Thus, the OPEC supply cuts will ultimately support oil prices and thus, weigh on this cross. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has had a particularly strong week, as inflation surprised to the upside on both a monthly and a yearly basis, coming in at 0.5% and 2.2% respectively. While it initially appreciated against all currencies, the uptick in commodity currencies on Wednesday made it lose its gains against AUD, CAD, NZD and NOK. As inflationary pressures grow, the SEK is likely to appreciate further, especially against the EUR and GBP. Additionally, with current Riskbank governor Stefan Ingves' term coming to an end by the end of this year, the hawkish rhetoric is likely to only increase. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades
The S&P advertising index broke down after a tough Q2 earnings season that saw caution, particularly from consumer goods clients holding back advertising budgets. However, management teams maintained their full-year guidance with expectations of a second half recovery; the analyst community concurred and earnings estimates barely budged (bottom panel). The market appears to have much less faith, driving valuation multiples to their lowest level since the GFC (second panel). We think this capitulation has created a significant buying opportunity. This mostly variable cost industry has a proven ability to downshift its cost base in line with a pullback in revenues; a steep decline in wages has been underway since the start of the year (third panel). This is driving a steep divergence between our vibrant industry margin proxy and muted EPS growth expectations (bottom panel). If management forecasts pan out, an EPS recovery should follow; more patient investors will be rewarded. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5ADVT - IPG, OMC.
Overweight Amidst a slew of weak retail earnings reports in Q2, HD surprised with a positive result as it benefited from a surge in remodeling activity. Existing home prices are pushing against highs, which benefits home improvement retailers (HIR) in two ways. First, high prices drive a shift toward renovation versus buying a new home as the latter becomes relatively more expensive. Second, existing owners can use their higher home equity as a source of funds for a renovation. Net, existing home prices and HIR sales move in lockstep (second panel). At the same time as sales are pressing upward, the HIRs are delivering productivity gains (third panel). This should amplify the operating leverage of a surge in same-store sales, driving margins higher. Relative valuations are lagging the solid operating performance (bottom panel). In fact, HIR stocks have not been this cheap since the GFC. This looks like an excellent buying opportunity; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.
Highlights Washington must establish a "credible threat" if it is to convince Pyongyang that negotiations offer the superior outcome; The process of establishing such a credible threat is volatile; U.S. Treasurys, along with Swiss and Japanese government bonds have been consistent safe haven assets; The risk of a U.S. attack against North Korea is a red herring, while the crisis itself is not; We suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Feature Brinkmanship between Pyongyang and Washington, D.C. has roiled markets over the past week. The uptick in rhetoric has not come as a surprise. Since last year, BCA's Geopolitical Strategy has stressed that souring Sino-American relations were the premier geopolitical risk to investors and that China's periphery, especially the Korean peninsula, would be the "decisive" factor for markets.1 North Korea's nuclear ambitions - which could be snuffed out immediately by a concerted and coordinated effort by China and the U.S. - are a derivative of the broader U.S.-China dynamic. The U.S. is unlikely to use military force to resolve its standoff with North Korea. There are long-standing constraints to war, ones that all of the interested parties know only too well from their experience in the Korean War of 1950-53. The first of these is that war is likely to bring a high death toll: Pyongyang can inflict massive civilian casualties in Seoul with a conventional artillery barrage; U.S. troops and Japanese troops and civilians would also likely suffer. Second, China is unlikely to remain neutral, given its behavior in the 1950s, its persistent strategic interest in the peninsula, and its huge increase in military strength relative to both the past and to the United States. However, the process by which the U.S. establishes a "credible threat" of military action is volatile.2 Such a credible threat is necessary if Washington is to convince Pyongyang that negotiations offer a superior outcome to the belligerent status quo. Viewed from this perspective - which is informed by game theory -President Donald Trump has not committed any grave mistakes so far, but has rather shrewdly manipulated the world's perception that he is mentally unhinged in order to enhance his negotiating leverage. It is unclear how long it will take Trump to convince North Korea that the threat of a U.S. preemptive strike is "credible." As such, it is unclear how long the current standoff will persist. From an investor perspective, it will be difficult to gauge whether the brinkmanship and military posturing are part of this "territorial threat display" or evidence of real preparations for an actual attack. As such, further volatility is likely. The ongoing crisis in North Korea is neither the first nor the last geopolitical crisis the world will face in today's era of paradigm shifts.3 We have long identified East Asia as the cauldron of investment-relevant geopolitical risks.4 This is a dynamic produced by the multipolar global context and the geopolitical disequilibrium in the Sino-American relationship. For now, investors have been able to ignore the rising global tensions (Chart 1) due to the ample liquidity emanating from central banks, but the day of reckoning is nigh (Chart 2). Chart 1Multipolarity Increases Conflict Frequency Chart 2Day Of Reckoning? Q&A On North Korea Back on April 19, we wrote a Special Report, "North Korea: Beyond Satire," which argued that North Korea had at last become a market-relevant geopolitical risk after decades of limited impact (Chart 3).5 Chart 3North Korean Provocations Rarely Affect Markets For Long Looking to the next steps, we introduced the "arc of diplomacy," a framework comparable to the U.S.-Iran nuclear negotiations from 2010-15 (Chart 4). We predicted that the U.S. would ultimately ramp up threats for the purpose of achieving a diplomatic solution. The U.S. was constrained and would only go to war if an act of war were committed, or appeared imminent.6 Chart 4Arc Of Diplomacy: Tensions Ramp Up As Nuclear Negotiations Begin This assessment is now playing out. But not all clients are convinced of our logic, as we have found in our travels throughout Asia Pacific and elsewhere this month. Below we offer a short Q&A based on questions we have received from clients: Q: Diplomacy has already been tried, so why won't the U.S. attack? A: The U.S. public has less appetite for war, especially a preemptive strike, in the wake of the Iraq War, and has not suffered a 9/11 or Pearl Harbor-type catalyst. The U.S. will exhaust diplomatic options before joining a catastrophic second Korean War. And the diplomatic options are far from exhausted. The latest round of sanctions are tighter and more serious than past ones, but still leave categories untouched (like fuel supplies to the North) and are still very hard to enforce (like cutting illegal North Korean labor remittances). Enforcement is always difficult, and the U.S. is currently attempting to ensure that its allies enforce the sanctions strictly, not to mention its rivals (i.e. Russia and China). While we do not think China will ever impose crippling sanctions, we do think it can tighten them up considerably, which could be enough to change the North's behavior. Q: Why doesn't China just take North Korea out? A: China is a formal political, military, and ideological ally of North Korea, and has a strategic interest in maintaining a buffer space on the Korean peninsula - which it defended at enormous human cost in the Korean War. This interest remains in place. China is far more likely to aid and abet a nuclear-armed ally in North Korea than it is to endorse (much less participate in) regime change. The fallout from a new war, such as North Korean refugees flooding into China, is extremely undesirable for China, though it could handle the problem ruthlessly. China would also prefer not to have to occupy a collapsing North, which would be an extensive and dangerous entanglement. Therefore, expect China to twist Pyongyang's arm but not to break its legs. On a more topical note, China is consumed with domestic politics ahead of the nineteenth National Party Congress. It is perhaps more likely to take action after the congress in October-November. Q: Will U.S. allies cooperate with Trump? Why not bandwagon with China to gain economic benefit? A: South Korea is the best litmus test for whether Trump is causing U.S. allies to drift. The new South Korean President Moon Jae-In, who is politically left-of-center, has played his cards very carefully and started out on good footing with President Trump. A disagreement appears to be a likely consequence of Moon's agenda, which calls for extensive engagement with the North and a review of the U.S. THAAD missile defense deployment in Korea. So far, however, Moon is reaffirming the alliance, in his own way, and Trump has not (yet) expressed misgivings about him. If this changes significantly - as in, South Korea joining with China to give North Korea significant economic aid in defiance of U.S. sanctions efforts - then it would be a sign of division among the allies that would benefit North Korea and could even increase the risk of the U.S. taking unilateral action. The odds of that are still low, however. We have been short the Korean won versus the Thai baht since March 1, and the trade is up 6.03%. We also expect greater volatility and higher prices of credit default swaps to plague South Korea while the crisis continues over the coming months. We are closing our long Korean consumer stocks trade versus Taiwanese exporters for a loss of 4.24%. Q: What is Japan's role in the current crisis? What is the impact on Japan? A: Japan is one of the few countries whose relations with the U.S. have benefited under the Trump administration. The Japanese are in lock-step so far in reacting to North Korea. The government has been sounding louder alarms about North Korea for the past year, including by conducting evacuation drills in the case of attack. Japan has long been within range of North Korea's missiles, but its successes in nuclear miniaturization pose a much greater threat. Not only does North Korea pose a legitimate security risk, but Japanese Prime Minister Shinzo Abe also stands to benefit at least marginally in terms of popular support and support for his controversial constitutional revision. This will, in turn, feed into the region's insecurities. Yen strength as a result of the crisis, however, would be a headwind to Japan's economic growth. Thus Abe has a tightrope to walk. We expect him to take actions to ensure the economy continues to reflate. Q: Is Trump rational? How do we know he won't push the nuclear button? A: Ultimately this is unknowable. It also involves one's philosophical outlook. Josef Stalin and Mao Zedong both committed atrocities by the tens of millions but did not use nuclear weapons. Nikita Khrushchev practically wrote the playbook that North Korea's Kim dynasty has used in making its belligerent nuclear threats. Yet Khrushchev ultimately agreed to détente. Kim Jong Un makes Trump look calm. The combination of Kim and Trump is worrisome; but so was the combination of Eisenhower and Khrushchev, one believing nuclear weapons should be used if needed, the other threatening wildly to use them. It may be the case that the threat of an atrocity, or (in Kim's case) of total annihilation, is enough to keep decisions restrained. As we go to press, Kim has ostensibly suspended his plan to fire missiles around Guam and U.S. officials have repeatedly stated that they would not attack unless attacked. Stairway To (Safe) Haven Revisited In expectation of increased frequency of geopolitical risks, BCA's Geopolitical Strategy has produced two quantitative analyses of safe haven assets over the past two years. The first, "Geopolitics And Safe Havens," unequivocally crowned gold as the ultimate safe haven (Table 1), while showing that the USD is not much of a defense against geopolitical events (Chart 5).7 Table 1Safe-Haven Demand Rises During Crises Table 1Safe-Haven Demand Rises During Crises As such, investors should fade the narrative that the failure of the USD to appreciate amidst the latest North Korean imbroglio is a sign of some structural weakness. The greenback continues to underperform due to weak inflation in the U.S., a fleeting condition that our macro-economist colleagues expect to reverse. Mathieu Savary, BCA's currency strategist, believes that more upside exists for the USD regardless of the geopolitical outcome: Chart 5Gold Loves Geopolitical Crises Chart 6DXY Is Cheap... Chart 7...But The Euro Is Not First, the dollar is currently trading at its deepest discount to the BCA Foreign Exchange Service augmented interest rate parity model since 2010 (Chart 6). The euro, which accounts for 58% of the DXY index, is its mirror image, being now overvalued by two sigma, the most since 2010 (Chart 7). Second, bullish euro bets will dissipate as Europe's economic outperformance versus the U.S. fades. Financial conditions have massively eased in the U.S., while they have tightened in Europe, resulting in the biggest upswing on euro area growth relative to the U.S. in over two years (Chart 8). Such an economic outperformance by the U.S. should lead to a strengthening greenback (Chart 9).8 Chart 8Easing Versus Tightening FCI Chart 9PMIs Point To USD Rally Our second attempt to quantify safe-haven assets, "Stairway To (Safe) Haven: Investing In Times Of Crisis," concluded that U.S. Treasurys, Swiss bonds, and Japanese bonds are the best performers in times of crisis.9 We considered 65 assets10 (Table 2) with five different methodologies and back-tested them empirically within the context of 25 financial and geopolitical events since January 1988. Some of these assets have been proven to perform as safe havens by previous academic research, some are commonly utilized in investment strategies, and others could provide alternatives (see Box 1 for further details). Table 2Scrutinizing The World For Safe Havens This report demystifies four key issues related to safe havens: Part I identifies what qualifies as a safe-haven asset. Unsurprisingly, the best performers are U.S. Treasurys along with Swiss and Japanese bonds due to their currency effects. Part II examines if safe havens change over time. We find that gold and Treasurys have changed places as safe havens, and that JGBs and Swiss bonds have a long history as portfolio protectors. Part III breaks down safe havens through an event analysis. We look at the country of origin, the nature of the crisis, and whether the risk is a "black swan" or "red herring" - two classifications of events that BCA's Geopolitical Strategy has established - all of which have an impact on their performance. But red herrings or black swans are only defined after the fact, thus requiring geopolitical analysis or market timing indicators to be able to act on them. Part IV demonstrates that timing plays a crucial part when investing in safe havens as their performance is coincident with that of equities. Box 1 Safe Havens - A Literature Review In a previous Geopolitical Strategy Special Report published in November 2015, it was established that shifts in economic and political regimes alter investors' preferences for safe-haven assets, and that Swiss bonds and U.S. 10-year Treasurys were at the top of that list.11 Also, statistical methods were used to demonstrate that gold had acted as a safe haven from the 1970s to the early 90s, but has since lost its status due in part to a new era of looming deflationary risks. Li and Lucey (2013) have identified a pattern in precious metals, through a series of quarterly rolling regressions testing the significance of the 1st, 5th and 10th percentile movements in U.S. equity movements against safe-haven assets, catching extreme negative events. For instance, the 1st percentile captures the very worst corrections that have occurred, the one that represent the bottom 1% of the equity performances. The 5th and 10th percentiles represent the 5% and 10% lowest returns for equities, respectively. The authors demonstrated that silver, platinum and palladium act as safe havens when gold does not.12 Similarly, Bauer and McDermott (2013) examined the 1st, 5th and 10th percentile movements in U.S. equity movements and proved that both gold and U.S. Treasurys can serve as safe havens, but that gold has the best record in times of extreme financial stress.13 Baele et al. (2015) concentrated on flight-to-safety episodes, which they characterized as events in which the VIX, TED spreads and a basket of CHF, JPY, and USD all increased drastically.14 They found that during flight-to-safety episodes, large cap stocks outperform small caps, precious metal and gold prices (measured in dollars) increase slightly, while bond returns exceed those of the equity market by 2.5-4 percentage points. Baur and Glover (2012) provide further evidence that gold can no longer be utilized as a safe haven due to increased speculation and hedging. Their main finding is that gold cannot be both an investment and a safe-haven asset. That is, gold can only be effective as a safe haven if the periods prior to the event had not generated significant investment demand for gold.15 Using high-frequency exchange rate data, Ranaldo and Soederlind (2010) conclude that the CHF, EUR and JPY have significant safe-haven characteristics, but not the GBP.16 The strongest safe havens are identified as the CHF and JPY, but the returns are partly reversed after a day of safe-haven protection. They also find that the nature of the crisis has a significant effect on safe-haven properties. For instance, a financial crisis and a natural disaster produced drastically different outcomes for the yen. Part I - Safety In Numbers Our first step in identifying safe-haven assets was to review each asset's performance against equities in times of crisis. As such, we conducted a series of threshold regressions to generate a list of true safe-haven assets - assets that have a statistically significant positive performance in times of turmoil. Our method is explained as follows: Step 1 - Percentile Dummies: Following methods from Li and Lucey (2013) and Bauer and McDermott (2013), we created dummy variables for the 1st, 5th and 10th percentile of the S&P 500 daily total returns since 1988. We then multiplied each of these dummies by their corresponding stock returns (see Box 1 for further detail). Step 2 - Regressions: Using the 64 potential safe-haven assets, we ran a series of regressions both in USD and the local currency, testing each asset's returns explained by the three percentile dummies.17 Step 3 - Identifying Safe Havens: We then quantified strong safe-havens as assets having significant coefficients for all three return thresholds (1st, 5th and 10th percentile of the S&P 500 daily total returns). Results - Seek Refuge In Currencies And Government Bonds: Our quantitative results are mainly consistent with what others have found in the past: the Japanese yen and most G10 government bonds are safe havens. Table 3 shows the safe-haven assets that generated negative coefficients versus equities for all three threshold percentiles. Table 3Seeking Protection Against Corrections In our threshold regressions expressed in USD terms, we found that the Japanese yen, Quality Stocks,18 and Japanese, Swiss and U.S. bonds acted as strong safe havens. Currencies play a crucial part in the performance of safe havens. In fact, in local-currency terms, a series of G10 government bonds (U.S., Canada, Belgium, France, Germany, Netherlands, Sweden, Switzerland, and the U.K.) proved to be the most useful safe havens. In sum, true or strong safe havens are government bonds that have currencies that add to positive returns during times of crisis. Unsurprisingly, this select group of strong safe-haven assets is comprised of U.S., Japanese, and Swiss government bonds. Quality Stocks did provide positive and statistically significant results, but the returns were very low - for this reason, we excluded them from our basket of strong safe havens. While gold, the Swiss franc, and the U.S. dollar did generate positive returns during times of crisis, they failed to generate statistically significant results at all three thresholds. Bottom Line: Based on our econometric work, most G10 government bonds can act as safe havens. But due to strong currency effects, our models favor what are already commonly known as safe havens: U.S., Japanese, and Swiss government bonds. Simply put, the difference between this select group and other G10 bonds is that their currencies rise or are stable during turmoil, while the currencies of the other G10 bonds do not. Part II - Are Safe Havens Like Fine Wines? U.S., Japanese, and Swiss government bonds were not always the top assets providing protection against the downside in equities, however. To determine whether safe-haven properties change, we examined the evolution of the relationship between safe havens and U.S. equity markets over time with the following model: Step 1 - Rolling Regressions: Considering the results obtained in Part I, we restricted our sample to G10 governments in USD and local-currency terms, Quality Stocks, gold, JPY, EUR, and USD for this statistical procedure. We put these remaining assets, both in USD and local-currency terms, through a series of 1-year rolling regressions.19 Step 2 - Identifying Trends: Each regression generated a coefficient that explained the relationship between equities and safe havens (B1). We created a new time series by collecting the coefficients for each data point and smoothing them using a five-year moving average, thus depicting a long-term pattern in the evolution of safe havens. Results - A Regime Shift In Gold And Treasurys: Our findings show that safe-haven assets fall in and out of favor through time (Charts 10A, B & C). Most striking are the changes in U.S. Treasurys and gold. Only after 2000 did Treasurys start providing a good hedge for equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. That said, gold's coefficient has been falling closer to zero lately, illustrating that it could soon resurface as a proper safe haven, especially if deflation risks begin to dissipate. Given that this is precisely the conclusion stated by our colleague Peter Berezin - BCA's Chief Global Strategist - and our own political analysis, we suspect that gold may be resurrected as a safe haven very soon.20 Chart 10ASafe Havens Don't Necessarily Age Well Chart 10BSafe Havens Don't Necessarily Age Well Chart 10CSafe Havens Don't Necessarily Age Well Another important finding is that the currency effect plays a key role during recent risk-off periods (Charts 11A & B). The best protector currencies are the ones that are negatively correlated with equity returns. According to our results, the CHF and the JPY have generally been risk-off currencies, while the USD has only been one since 2007, switching places with the euro. This reinforces the case for U.S., Japanese, and Swiss government bonds, which are supported by risk-off currencies. Chart 11ACurrencies Are Difference Makers Chart 11BCurrencies Are Difference Makers Bottom Line: Safe havens change over time. Gold fell out of favor due to global deflationary dynamics. With inflation on the horizon, we will keep monitoring the relationship between gold and equities for a possible return of the yellow metal as a safe haven. Since the July 4 North Korean ICBM test, for example, gold has rallied 4.8%. Part III - Red Herrings And Black Swans Since 1988, we identified 25 economic and (geo)political events that generated instant panic or acute uncertainty in the media and financial markets.21 We analyzed the short-term reactions of the safe-haven assets, both in USD and local-currency terms. This methodology allowed for the deconstruction of the impact of the events by the following factors: Country of origin of the crisis, the nature of the crisis, and whether the event was a "red herring" or a "black swan." Generally speaking, a red herring event is a crisis of some sort with little lasting financial impact. A black swan, on the other hand, is an event that has a very low probability of occurring but has a pronounced market impact if it does. Quantitatively, our definition of a black swan is an event that produces an immediate negative response in the S&P 500 below -1%, while creating a rise in either U.S., Japanese, or Swiss government bonds above 0% (Table 4). Of course, determining which event is a red herring or a black swan is only obvious post-facto and thus requires thorough geopolitical analysis. Table 4Understanding The Crises Results - Red Herrings And Black Swans Matter: Our event analysis solidifies our findings with regards to U.S., Japanese, and Swiss government bonds, but also builds a case for some European bonds as well as gold during black swan events. Our main findings can be summarized as follows. Fade The Red Herrings: Out of the sixteen geopolitical events, ten were identified as red herrings, in which safe havens underperformed the equity market. This, then, suggests that it is not always beneficial to buy safe-haven assets when tensions are rising. What is interpreted as a major geopolitical crisis - say, Ukraine in 2014 or Greece in 2015 - often ends up being a "red herring." Geopolitical Risk = Gold: Geopolitical black swan events, on the other hand, have a significant, negative impact on the market. During these events, gold emerges as the strongest hedge against a downturn in equities. U.S. Treasurys And The Swiss Franc Provide A Baseline: Under all black swan events considered - geopolitical and non-geopolitical - U.S. Treasurys and the Swiss franc had the strongest performance, generating positive returns on the day of the stock market crash in 85% of the cases. G10 Government Bonds Will Also Do: German, Dutch, Swiss and Swedish government bonds also provided protection during black swan events in local and common-currency terms, albeit to a lesser extent. U.S. And Swiss Bonds Outperform During Financial Episodes: During black swan financial crises, Swiss and U.S. government bonds stand out as the best safe havens due to their capacity to generate positive returns both in USD and local-currency terms in eight out of the nine examined crashes. Other findings that are interesting, yet less robust due to a limited sample size, include: When the crisis originated on U.S. soil, U.S. Treasurys and the dollar performed relatively poorly compared to other safe-haven assets. This is a somewhat surprising finding, as most investors believe that U.S. assets rally even at a time of U.S.-based crises, such as the 2011 budget crisis. We show that they may perform well, but in USD, non-U.S. based assets do better. When the crisis originated in Europe, European bonds performed very well both in USD and local-currency terms. When the crisis originated in Europe, Swiss and U.K. government bonds performed poorly in USD terms, but offered strong protection in local-currency terms. When the crisis originated in Russia, precious metals acted as a poor hedge. Bottom Line: It is crucial to gain an understanding of the nature of any potential crisis. Red herrings should always be faded, not hedged against, as they produce poor results in safe-haven assets. U.S. Treasurys, Swiss and Japanese government bonds have been very consistent safe-haven assets during previous periods of acute risk. Part IV: Timing Is Everything As a final step in our quantitative approach, we put our results through numerous timing exercises to test how the assets would perform in real time. Based on our Risk Asset Spectrum (Diagram 1), which summarizes our findings, one could argue that investing in times of crisis simply boils down to buying an equal-weighted basket of U.S. Treasurys, Swiss, and Japanese government bonds. Although this is technically true, such a strategy would require perfect foresight, unparalleled timing, or dumb luck - since black swan events are, by definition, very difficult to predict. Diagram 1Risk Asset Spectrum Proof Of The Ultimate Safe Haven: The first experiment we conducted was to illustrate how powerful safe havens can be when timed perfectly in a trading strategy. We started off by comparing two baskets. The first was a benchmark portfolio comprised of 60% U.S. equities and 40% U.S. bonds. The other contained the same two assets, but with 100% allocated to a basket comprised of U.S. Treasurys, Swiss, and Japanese government bonds during times of negative returns for equities. Of course, this strategy is not realistic and would be impossible to implement, since the trading rule depends on future events. But as Chart 12 shows, if one were able to predict every single period of negative returns for global equities and hold safe-haven assets instead, the trading rule would outperform almost 10-fold. Chart 12Safe Havens Work Wonders With Perfect Information... One-Month Lag Is Already Too Late: Repeating the same exercise, but with a one-month lag in the execution, produces drastically different results. More specifically, whenever the previous month's equity return is negative (t=0), the portfolio allocates 100% to a single safe-haven asset for the current month (t=1), otherwise it keeps the allocation identical to that of the benchmark. The rationale for using such a simple rule is that average investors are generally late in identifying a crisis and only react once they have validation that the market is in a correction. Chart 13 shows that being late by one month changes the performance of the safe haven basket from astronomically outperforming the benchmark to underperforming it. Chart 13... But Timing Is Everything Reaction Is Key: As a final timing exercise, we analyzed the reaction function of our assets to see how quickly they react after the correction in equities begins (Chart 14). Unsurprisingly, the top assets that we identified start appreciating as soon as the crisis hits (t=0). Gold is, on average, the quickest asset to react from investors seeking refuge. Swiss bonds come in as a close second, almost mirroring gold during the first few days of the correction. But both assets start to flatten out and even roll over after a few days. Japanese bonds react slightly later than gold and Swiss bonds, but keep increasing for a longer period of time and start plateauing around the 30th day after the crisis. U.S. Treasurys and Quality Stocks, on the other hand, remain rather flat and constant over the short term. These results attest to the importance of timing the crisis using the best safe-haven assets. Chart 14Safe Havens React Instantly Bottom Line: Timing plays a crucial part in investing in safe-haven assets, as their performance is coincident to that of equities. Investment Implications: Is Pyongyang A Red Herring Or A Black Swan? The results of our quantitative analysis are clear: hedging geopolitical risk depends on whether it is persistent or fleeting. So, is Pyongyang a red herring or a black swan? From our geopolitical analysis we make three key conclusions: The U.S. is not likely to preemptively attack North Korea; However, the U.S. has an interest in signaling that it may conduct precisely such an attack; Brinkmanship could last for a long time. Even if the risk of a U.S. attack against North Korea itself is a red herring, the crisis itself is not. In fact, between now and when a negotiated solution emerges, investors may face several new crises, which may include limited military attacks or skirmishes. While markets have faded such North Korean provocations in the past, the current context is clearly different. As such, we would suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Even though a "buy and hold" strategy with such a "Doomsday Basket" will likely underperform the market if tensions with North Korea subside, we are betting that it may take time for the U.S. and North Korea to get to the negotiating table. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com David Boucher, Associate Vice President Quantitative Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 6, 2016, available at gis.bcaresearch.com. We upgraded North Korea to the status of a genuine market-relevant risk in "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2017 available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0," dated September 25, 2012, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. In particular, we argued, "the current saber-rattling is carefully orchestrated. But North Korea can no longer be consigned to the realm of satire. The very fact that the U.S. administration is adopting greater pressure tactics makes this year a heightened risk period. Investors should be especially wary of any missile tests that reveal North Korean long-range capabilities to be substantially better than is known to be the case today." Then, on May 13 and July 4, North Korea conducted its first ICBM launches; the UN Security Council agreed to a new round of even tighter economic sanctions on August 5; and the U.S. and North Korea engaged in an alarming war of words. 6 Specifically, we wrote: "Diplomacy is the only real option. And in fact it is already taking shape. The theatrics of the past few weeks mark the opening gestures. And theatrics are a crucial part of any foreign policy. The international context is looking remarkably similar to the lead-up to the new round of Iranian negotiations in 2012. The United States pounded the war drums and built up the potential for war before coordinating a large, multilateral sanctions-regime and then engaging in talks with real willingness to compromise." 7 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 8 Please see BCA Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen," dated August 11, 2017, available at fes.bcaresearch.com. 9 Please see BCA Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 10 Forty-one assets were denominated in USD only, while G10 bonds, Credit Suisse Swiss Real Estate Fund, and European 600 real estate were used both in local-currency terms and USD, for a total of 65 assets. 11 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 12 Sile Li and Brian M. Lucey, "What precious metals act as safe havens, and when? Some U.S. evidence," Applied Economic Letters, 2013. 13 Dirk G. Bauer and Thomas K.J. McDermott, "Financial Turmoil and Safe Haven Assets," 2013. 14 Lieven Baele, Geer Bekaert, Koen Inghelbrecht and Min Wei, "Flights to Safety," National Bank of Belgium Working Paper No. 230, 2015. 15 Dirk G. Baur and Kristoffer J. Glover, "The Destruction of Safe Haven Asset?,"2012. 16 Angelo Ranaldo and Paul Soederlind, "Safe Haven Currencies," Review of Finance, Vol. 10, pp. 385-407, 2010. 18 Quality stocks are defensive equity plays with high, steady earnings with an elevated return on investments. They are estimated by Deutsche Bank's Factor Index Equity Quality Excess Return in USD. 20 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com, and BCA Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017, available at gis.bcaresearch.com. 21 Since we were interested in the immediate, often unexpected, response to the event, we did not include economic recessions in our event analysis.
Highlights A number forward-looking indicators for EM corporate profits point to a major deceleration in the next several months, and potentially a contraction early next year. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth and they herald a bearish outlook for EM EPS. We continue deciphering the differences between China's various money and credit aggregates. Irrespective of which money measure we use, and regardless of their past track record, all of them are currently extremely weak and point to a major and imminent slump in China's growth in the next six to 12 months. We recommend shifting the underweight EM corporate and sovereign credit position versus U.S. high-yield to underweight versus U.S. investment-grade corporate credit. Feature Chart I-1Asian Exports And EM EPS The recovery in EM earnings per share (EPS) has been instrumental to the EM stock rally this year. As such, the equity strategy at the moment hinges on the outlook for corporate profits. In this report, we revisit coincident and leading indicators for EM profits. At the moment, EM corporate profit growth still appears robust, though several forward-looking indicators point to a major deceleration in the next several months, and potentially a contraction early next year. Korean and Taiwanese exports can be used as proxy for global trade. The latest data for July reveal that the sum of Taiwanese exports and Korean total exports excluding vessels has rolled over (Chart I-1). Historically, the U.S. dollar values of both economies' exports have correlated with EM EPS, and Chart I-1 entails that EM EPS growth will roll over very soon. The reason why we exclude vessel exports in the case of Korea is because vessel shipments are one-off occurrences and when they take place, they distort export growth. This was the case in the last several months - vessel (shipbuilding) exports surged by 75% from a year ago, distorting the annual growth rate of total exports. Overall, Korea's and Taiwan's overseas shipments in the past three months have averaged about 10%, which is lower than the mid-teen growth rates recorded earlier this year. In China, export growth is close to 9% in the past three months, and it is also rolling over. On a similar note, Korea's and Taiwanese shipments-to-inventory ratios lead EM EPS cycles, and they are presently sending a downbeat message (Chart I-2). China's import growth has relapsed, as suggested by both Chinese trade data and their counterparties export data to China (Chart I-3). Chart I-2Asia's Shipment-To-Inventory Ratios And EM EPS Chart I-3Exports To China And Chinese Imports The recovery in Chinese imports has been responsible for a considerable part of the recovery in global trade. Importantly, Chinese import cycles correlate very well with EM EPS growth (Chart I-4). The key pillar of our view remains that Chinese imports will contract going forward, which will depress both advanced and developing countries' shipments to China. Exports to China are much more important for EM than DM economies, and deteriorating sales to China will weigh considerably on EM profits and currencies. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth. Chart I-5A and Chart I-5B demonstrate that both EM narrow (M1) growth and China's broad money impulse (the second derivative) - herald a major slump in EM EPS. This is the main reason behind our negative stance on EM share prices and other risk assets. Chart I-4Chinese Imports And EM EPS Chart I-5AChina Broad Money Impulse And EM EPS Chart I-5BEM Narrow Money And EM EPS Both narrow and broad money growth in China have already relapsed, and it is a matter of time until economic growth and imports downshift enough to produce a major selloff in EM risk assets. We discuss China's monetary aggregates in the section below. Finally, if Chinese imports and commodities prices relapse, any reasonable strength in DM domestic demand will not be sufficient to preclude a meaningful EM slowdown. The basis is that exports to the U.S. and EU only make up 7% of GDP for China, 8% for Korea and 11% for Taiwan. While exports to China account for 10% of Korean GDP and 15% of Taiwanese GDP. The same holds true for most East Asian countries. With the exceptions of India and Turkey, non-Asian EM countries are primarily commodities producers. These two have their own idiosyncratic problems. Most of our analysis is not applicable to smaller central European economies that are leveraged to the EU business cycle. That said, neither Turkey, India, nor central European markets have large enough financial markets to make a difference in the EM benchmarks. The above is the primary reason behind our bearish view on EM growth and profits. That said, there are a few other interesting considerations regarding EM corporate profits dynamics. First, EM share prices lead EM EPS by six to nine months. Therefore, to be bullish on EM stocks, it is not sufficient to expect EM EPS growth to be robust over the next three months. Rather, to be bullish on EM stocks at the current juncture, one should have a bullish view on EM EPS by the end of this year and into the early part of 2018. Consistently, we believe that EM EPS growth will decelerate materially by the end of this year and shrink in the early part of 2018. Second, the top-line shrinkage in 2015 and the consequent recovery for EM exporters has been mostly driven by prices rather than volumes. Chart I-6A illustrate that Korean, Taiwanese and Chinese manufacturing production growth is rather muted. Chart I-6ACorporate Pricing Power Chart I-6BAsian Manufacturing Production Price fluctuations affect profits much more than output volume changes. Therefore, if global tradable goods prices deflate - at the moment they have rolled over (Chart I-6B) - EM EPS will contract materially. Third, in EM excluding China, Korea and Taiwan, there has been little economic recovery, as evidenced by Chart I-7. Along the same lines, the latest (July) manufacturing PMI for EM ex-China, Korea and Taiwan has dropped below the crucial 50 line (Chart I-7, bottom panel). This and the majority of other economic aggregates we use are equity market-cap weighted averages, so they are relevant to investors. This corroborates the fact that outside China, Korea and Taiwan there has been little genuine growth improvement in EM domestic demand - despite the decent recovery in global trade. This challenges the prevailing widespread consensus of a synchronized global economic recovery/expansion. This is also consistent with the fact that the overwhelming EM profit recovery has occurred in technology and resource sectors while domestic sectors have not seen much of corporate earnings recovery (Chart I-8). Chart I-7EM Ex-China, Korea And Taiwan: ##br##No Strong Recovery Chart I-8EM Sectors' EPS: Exporters ##br##Have Outperformed Domestic Finally, bottom-up equity analysts have recently downgraded their EPS estimates for listed EM companies (Chart I-9). Typically, analysts alter their forecasts simultaneously with swings in share prices. Hence, the latest decoupling is puzzling. Chart I-9EM EPS And Analysts' Net Revisions Notably, EM net EPS revisions have failed to move into positive territory in the past 7 years. This entails that analysts' expectations have been chronically high in recent years, and/or that companies have failed to deliver profits that match these projections. Bottom Line: The EM EPS outlook is downbeat, and listed companies profits will likely contract early next year. Deciphering China's Money Puzzle Based on our assessment of multiple measures, our conclusion with respect to Chinese broad money growth is as follows: Irrespective of which measure we use, and regardless of their individual past track records, all Chinese monetary growth aggregates are currently weak (Chart 10), and point to a major and imminent slump in China's growth in the next six to 12 months. In recent weeks, we have been working to understand differences among various measures of money growth in China. Our motivation is because neither M2 nor total social financing and fiscal spending - variables that we relied on last year - did a good job of forecasting the duration and magnitude of China's economic and profit revival in the past 12 months. In our July 26 report,1 we introduced the concept of broad money calculated using commercial banks' assets. We called it credit-money. This week, we discuss a different broad money calculation based on commercial banks' liabilities, and refer to it as deposit-money. Deposit-money is an aggregate of non-financial companies' time and demand deposits, household deposits, transferable and other deposits, other liabilities, bonds issued and liabilities to non-depository financial corporations. This measure is broader than official broad money (M2) because the latter includes only non-financial companies' time and demand deposits, household deposits and some of liabilities to non-depository financial corporations. In brief, our deposit-money calculation is more comprehensive than the official broad money figures (M2). In turn, banks' credit-money is the sum of commercial banks' claims on companies, households, non-bank financial institutions and all levels of government, as well as banks' foreign assets. Also, we deduct government deposits at the central bank (see July 26 Emerging Markets Strategy report1 for more details). Chart I-10 illustrates the differences between credit-money, deposit-money, total social financing and M2. Based on our calculations, deposit-money grew faster in 2015-'16 than both M2 and total social financing. Yet its current and ongoing slowdown is as bad as that of credit-money or M2. Chart I-10Dichotomy Among Various Money And Credit Aggregates In China The reason why M2 growth has lagged behind deposit-money growth since the middle of 2015 until now is the fact that the latter's components that are not included in the official M2 measure have outpaced M2 growth by a wide margin since late 2015. The main components of deposit-money are shown in Chart I-11. This is one of the main reasons why we missed the latest China-play rally - we relied on the official measure of money and credit published by the PBoC that has been much tamer than the broader money and credit, as banks have originated credit and hence money in a way that official monetary aggregates have not captured. In addition, banks' credit-money and deposit-money measures should theoretically be identical, but this has not been the case in China in recent years. Deposit-money is larger and it may well be more comprehensive than credit-money (Chart I-12). Chart I-11China: Components Of Deposit-Money Aggregate Chart I-12The Outstanding Stock And Flow Of Money Understanding these discrepancies is an ongoing work-in-progress for us, and we will be refining these measures going forward. For now, we would say that these differences are probably due to banks' efforts to misrepresent/hide their assets and liabilities to meet the regulatory ratios and avoid penalties, as well as maximize short-term profits. All that said, the gaps between M2 and deposit-money has recently narrowed: both deposit-money and M2 growth and their impulses are at all-time lows (Chart I-13). Furthermore, we expect deposit-money to slow further because of the lagged impact of higher interest rates and regulatory tightening that is intended to curb commercial banks' ability to originate more money via shadow banking activities. Finally, as can be seen from Chart I-14A, Chart I-14B and Chart I-15, deposit-money's impulse - its second derivative - leads many cyclical economic variables such as nominal GDP, producer prices, freight index, and imports. Chart I-13China: Two Measures Of Broad Money Chart I-14ADeposit-Money Leads Real Business Cycle Chart I-14BDeposit-Money Leads Real Business Cycle There are several other data points from China's real economy that portend developing weakness. Specifically, car sales growth has almost ground to a halt, real estate floor space sold and started are decelerating (Chart I-16). Chart I-15Deposit-Money Leads Metals Prices And Construction Chart I-16China: More Signs Of Slowdown Bottom Line: Regardless of which money measure we use, and regardless of their past track record, all of them are currently weak and point to a major and imminent slump in China's growth in the next six to 12 months. This gives us confidence in reiterating our negative view on China plays (including commodities) and EM. Credit Markets Strategy We have been recommending a strategy of shorting/underweighting EM sovereign and corporate credit versus U.S. high-yield (HY) credit and this strategy has shown strong performance, producing 15% gains with low volatility since August 2011 (Chart I-17). However, today we recommend shifting the underweight EM corporate and sovereign credit position from U.S. HY to U.S. investment grade (IG) corporate credit. The primary reason is that credit spreads are extremely tight and odds favor credit spreads widening in both U.S. and EM. Chart I-18 shows that when U.S. TIPS yields rise U.S. IG usually outperforms U.S. HY on an excess return basis. We expect U.S. Treasurys and TIPS yields to grind higher in the near term because U.S. growth and inflation are much stronger than the bond market is currently pricing in. Chart I-17Book Gains On This Strategy Chart I-18Higher U.S. Bond (TIPS) Yields Warrant Rotation Rising U.S. bond yields also warrants EM credit underperformance versus U.S. IG because the EM credit benchmark is riskier than U.S. IG. While the two segments have similar durations, the duration times spread measure of risk is greater for EM credit. Furthermore, U.S. HY spreads have narrowed versus both EM sovereign and corporate spreads since early 2016 (Chart I-19, top panel). Hence, there is little value favoring the former versus EM credit. In contrast, U.S. IG spreads versus both EM sovereign and corporate credit are appealing historically (Chart I-19, bottom panel). Therefore, there is a valuation aspect to this strategy change. Relative spread differences have historically correlated quite well with the subsequent 12-month return. Given where relative spreads are, the subsequent 12-month return for investing in U.S. IG relative EM credit is positive (Chart I-20, top panel) but it is negative for investing in U.S. HY versus EM credit (Chart I-20, bottom panel). Chart I-19EM Credit Offers Value Relative ##br##To U.S. HY But Not Versus U.S. IG Chart I-20Projected Returns Of EM Credit ##br##To Both U.S. IG And HY As to the rationale of favoring U.S. credit to EM credit, this is consistent with our theme that the growth outlook, corporate leverage, and health of the banking system are in much better shape in the U.S. than in EM. Bottom Line: Book profits on the short EM sovereign and corporate credit / long U.S. HY credit position. Institute a new position: short EM sovereign and corporate credit / long U.S. IG corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Follow The Money, Not The Crowd", dated July 26, 2017, link available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
U.S. equities, despite some geopolitically-imposed wobbles last week, remain very near all-time highs. Still, the trajectory for the S&P 500 is upward. A multiple expansion phase explains the bulk of equity returns in this bull market; now it is time for profits to shine (second panel). Three key factors drive our sanguine profit view: first, financials and energy will command a larger slice of the earnings pie, a backdrop not yet discounted in sell-side analysts' estimates (please see Table 2 from the July 24th Weekly Report). Second, irrespective of where the U.S. dollar heads in the coming months, SPX earnings will benefit from positive FX translation gains in Q3 and Q4. Finally, ramping sales and the accompanying operating leverage will drive profits higher; muted wage inflation should amplify near-term operating leverage (third panel). Our optimistic profit view is shared by the sell-side, who forecast record profit margins in the coming 12 months (bottom panel). Nevertheless, a straight line higher seems like an unlikely scenario for equity markets and investors may be wise to take advantage of extremely low pricing of risk insurance. Still, we would be buyers of any significant dips and remain comfortable with our overall early-cyclical portfolio exposure, while simultaneously maintaining a bit of defense in the form of our overweight consumer staples and underweight tech positions.