経済成長
Dear Client, We are sending you our Quarterly Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of the year and beyond. We will also be hosting a webcast on Thursday, October 1st at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where we will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: Global growth faces near-term challenges from a resurgence in the pandemic and the failure of the US Congress to pass a stimulus deal. However, growth should revive next year as a vaccine becomes available and fiscal policy turns stimulative again. Global asset allocation: Favor equities over bonds on a 12-month horizon, while maintaining somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Equities: Prepare to pivot from the “Pandemic trade” to the “Reopening trade.” Vaccine optimism should pave the way for cyclicals to outperform defensives, international stocks to outperform their US peers, and for value to outperform growth. Fixed income: Bond yields will rise modestly, suggesting that investors should maintain below average duration exposure. Favor inflation-protected securities over nominal bonds. Spread product will outperform safe government bonds. Currencies: The US dollar will weaken over the next 12 months. The collapse in interest rate differentials, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Rising demand and constrained supply will support oil prices, while Chinese stimulus will buoy industrial metals. Investors should buy gold and other real assets as a hedge against long-term inflation risk. I. Macroeconomic Outlook Policy And The Pandemic Will Continue To Drive Markets Going into the fourth quarter of 2020, we are tactically neutral on global equities but remain overweight stocks and other risk assets on a 12-month horizon. As has been the case for much of the year, both the virus and the policy response to the pandemic will continue to be key drivers of market returns. Coronavirus: Still Spreading Fast, But Less Deadly On the virus front, the global number of daily new cases continues to trend higher, with the 7-day average reaching a record high of nearly 300,000 this week (Chart 1). Chart 1Globally, The Number Of Daily New Cases Continues To Trend Higher The number of daily new cases in the EU has risen above its April peak. Spain and France have been particularly hard hit. Canada is also seeing a pronounced rise in new cases. In the US, the number of new cases peaked in July. However, the 7-day average has been creeping up since early September, raising the risk of a third wave. On the positive side, mortality rates in most countries remain well below their spring levels. There is no clear consensus as to why the virus has become less lethal. Better medical treatments, including the use of low-cost steroids, have certainly helped. A shift in the incidence of cases towards younger, healthier people has also lowered the overall mortality rate. In addition, there is some evidence that the virus may be evolving to be more contagious but less deadly.1 It would not be surprising if that were the case. After all, a virus that kills its host will also kill itself. Lastly, pervasive mask wearing may be mitigating the severity of the disease by reducing the initial viral load that infected individuals receive.2 A smaller initial dose gives the immune system more time to launch an effective counterattack. It has even been speculated that the widespread use of masks may be acting as a form of “variolation.” Prior to the invention of vaccines, variolation was used to engender natural immunity. Perhaps most famously, upon taking command of the Continental Army in 1775, George Washington had all his troops exposed to small amounts of smallpox.3 The gamble worked. The US ended up winning the Revolutionary War, making Washington the first president of the new republic. Waiting For A Vaccine Despite the decline in mortality rates, there is still much that remains unknown about Covid-19, including the extent to which the disease will lead to long-term damage to the vascular and nervous systems. Thus, while governments are unlikely to impose the same sort of severe lockdown measures that they implemented in March, rising case counts will delay reopening plans, and in many cases, lead to the reintroduction of stricter social distancing rules. Chart 2Some States Have Started To Relax Lockdown Measures This has already happened in a number of countries. The UK reinstated more stringent regulations over social gatherings last week, including ordering pubs and restaurants to close by 10pm. Spain has introduced tougher mobility restrictions in Madrid and surrounding municipalities. France ordered gyms and restaurants to close for two weeks. Canada has also tightened regulations, with the government of Quebec raising the alert level to maximum “red alert” in several regions of the province. In the US, the share of the population living in states that were in the process of relaxing lockdown measures has risen above 50% for the first time since July (Chart 2). A third wave would almost certainly forestall the recent reopening trend. Ultimately, a safe and effective vaccine will be necessary to defeat the virus. Fortunately, about half of experts polled by the Good Judgment Project expect a vaccine to become available by the first quarter of 2021. Only 2% expect there to be no vaccine available by April 2022, down from over 50% in May (Chart 3). Chart 3When Will A Vaccine Become Available? Premature Fiscal Tightening And The Risk of Second-Round Effects Even if a vaccine becomes available early next year, there is a danger that the global economy will have suffered enough damage over the intervening months to forestall a rapid recovery. Whenever an economy suffers an adverse shock, a feedback loop can develop where rising joblessness leads to less spending, leading to even more joblessness. Fiscal stimulus can short-circuit this vicious circle by providing households with adequate income to maintain spending. Fiscal policy in the major economies turned expansionary within weeks of the onset of the pandemic (Chart 4). In the US, real personal income growth actually accelerated in the spring because transfers from the government more than offset the loss in wage and salary compensation (Chart 5). Chart 4Fiscal Policy Has Been Very Stimulative This Year Chart 5Personal Income Accelerated Earlier This Year Chart 6Drastic Drop In Weekly Unemployment Insurance Payments Starting in August, US fiscal policy turned less accommodative. Chart 6 shows that regular weekly unemployment payments have fallen from around $25 billion to $8 billion since the end of July. At an annualized rate, this amounts to over 4% of GDP in fiscal tightening. While President Trump signed an executive order redirecting some of the money that had been earmarked for the Federal Emergency Management Agency (FEMA) to be given to unemployed workers, the available funding will run out within the next month or so. On top of that, the funds in the small business Paycheck Protection Program have been used up, while many state and local governments face a severe cash crunch. US households saved a lot going into the autumn, so a sudden stop in spending is unlikely. Nevertheless, fissures in the economy are widening. Core retail sales contracted in August for the first time since April. Consumer expectations of future income growth remain weak (Chart 7). Permanent job losses are rising faster than they did during the Great Recession (Chart 8). Both corporate bankruptcy and mortgage delinquency rates are moving up, while bank lending standards have tightened significantly (Chart 9). Chart 7Consumer Expectations Of Future Income Growth Remain Weak Chart 8Permanent Job Losses Are Rising Faster Than They Did During The Great Recession Chart 9Corporate Bankruptcy And Mortgage Delinquency Rates Are Moving Up … While Bank Lending Standards Have Tightened Significantly Fiscal Stimulus Will Return We ultimately expect US fiscal policy to turn accommodative again. There is no appetite for fiscal austerity. Both political parties are moving in a more populist direction, which usually signals larger budget deficits. Even among Republicans, more registered voters support extending emergency federal unemployment insurance payments than oppose it (Chart 10). Chart 10There Is Much Public Support For Fiscal Stimulus As long as interest rates stay low, there will be little market pressure to trim budget deficits. US real rates remain in negative territory. Despite a rising debt stock, the Congressional Budget Office expects net interest payments to decline towards 1% of GDP over the span of the next couple of years, thus reaching the lowest level in six decades (Chart 11). Outside the US, there has been little movement towards tightening fiscal policy. The UK government unveiled last week a fresh round of economic and fiscal measures to help ease the burden on both employees, by subsidizing part-time work for example, and firms, by extending government-guaranteed loan programs. At the beginning of the month, the Macron government announced a 100 billion euro stimulus plan in France. Meanwhile, European leaders are moving forward on a euro area-wide 750 billion euro stimulus package that was announced this summer. In Japan, the new Prime Minister Yoshihide Suga has indicated that he will pursue a third budget to fight the economic downturn, adding that “there is no limit to the amount of bonds the government can issue to support an economy battered by the coronavirus pandemic.” The Japanese government now earns more interest than it pays because two-thirds of all Japanese debt bears negative yields (Chart 12). At least for now, a big debt burden is actually good for the Japanese government’s finances! Chart 11Low Interest Payments Amid Skyrocketing Debt In The US Chart 12Japan: Ballooning Debt And Declining Interest Payments China also continues to stimulate its economy. Jing Sima, BCA’s chief China strategist, expects the broad-measure fiscal deficit to reach a record 8% of GDP this year and remain elevated into next year. The annual change in total social financing – a broad measure of Chinese credit formation – is expected to hit 35% of GDP, just shy of its GFC peak (Chart 13). Not surprisingly, the Chinese economy is responding well to all this stimulus. Sales of floor space rose 40% year-over-year in August, driven by a close to 60% jump in Tier-1 cities. Excavator sales, a leading indicator for construction spending, are up 51% over last year’s levels, while industrial profits have jumped 19%. A resurgent Chinese economy has historically been closely associated with rising global trade (Chart 14). Chart 13China Continues To Stimulate Its Economy Chart 14Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Biden Or Trump: How Will Financial Markets React? Betting markets expect former Vice President Joe Biden to become president and for the Democrats to gain control of the Senate (Chart 15). A “blue wave” would produce more fiscal spending in the next few years. Recall that House Democrats passed a $3.5 trillion stimulus bill in May that was quickly rejected by Senate Republicans. More recently, Democratic leaders have suggested they would approve a stimulus deal in the range of $2-to-$2.5 trillion. Chart 15Betting Markets Putting Their Money On The Democrats In addition to more pandemic-related stimulus, Joe Biden has also proposed a variety of longer-term spending initiatives. These include $2 trillion in infrastructure spending spread over four years, a $700 billion “Made in America” plan that would increase federal procurement of domestically produced goods and services, and new spending proposals worth about 1.7% of GDP per annum centered on health care, housing, education, and child and elder care. As president, Joe Biden would likely take a less confrontational stance towards relations with China. While rolling back tariffs would not be an immediate priority for a Biden administration, it could happen later in 2021. Less welcome for investors would be an increase in taxes. Joe Biden has proposed raising taxes by $4 trillion over ten years (about 1.5% of cumulative GDP). Slightly less than half of that consists of higher personal taxes on both regular income (for taxpayers earning more than $400,000 per year) and capital gains (for tax filers with over $1 million in income). The other half consists of increased business taxes, mainly in the form of a hike in the corporate tax rate from 21% to 28% and the introduction of a minimum 15% tax on the global book income of US-based companies. Netting it out, a blue sweep in November would probably be neutral-to-slightly negative for equities. What about government bonds? Our guess is that Treasury yields would rise modestly in response to a blue wave, particularly at the longer end of the yield curve. Additional fiscal support would boost aggregate demand, implying that it would take less time for the economy to reach full employment. That said, interest rate expectations are unlikely to rise as sharply as they did in late 2016 following Donald Trump‘s victory. Back then, the Fed was primed to raise rates – it hiked rates nine times starting in December 2015, ultimately bringing the fed funds rate to 2.5% by end-2018. This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023. The Fed’s New Tune In two important respects, the Fed’s new Monetary Policy Framework (MPF) represents a sharp break with the past. Chart 16The Mechanics Of Price-Level Targeting First, the MPF abandons the Fed’s historic reliance on a Taylor Rule-style framework, which prescribes lifting rates whenever the unemployment rate declines towards its equilibrium level. Second, the MPF eschews the “let bygones be bygones” approach of past monetary policymaking. Going forward, the Fed will try to maintain an average level of inflation of 2% over the course of the business cycle. This means that if inflation falls below 2%, the Fed will try to engineer a temporary inflation overshoot in order to bring the price level back up to its 2%-per-year upward trend (Chart 16). Some aspects of the Fed’s new strategy are both timely and laudable. A Taylor rule approach makes sense when there is a clear relationship between inflation and the unemployment rate, as governed by the so-called Phillips curve. However, if inflation fails to rise in response to declining economic slack – as has been the case in recent years – central banks may find themselves at a loss in determining where the neutral rate of interest lies. In this case, it might be preferable to keep interest rates at very low levels until the economy begins to overheat. Such a strategy would avoid the risk of raising rates prematurely, only to discover that they are too high for what the economy can handle. Targeting an average rate of inflation also has significant merit. When investors purchase long-term bonds, they run the risk that the real value of those bonds will deviate significantly from initial expectations when the bonds mature. If inflation surprises on the upside, the bonds will end up being worth less to the lender as measured by the quantity of goods and services that they can be exchanged for. If inflation surprises on the downside, borrowers could find themselves facing a larger real debt burden than they had anticipated. An inflation targeting system that corrects for past inflation surprises could give both borrowers and lenders greater certainty about the future price level. This, in turn, could reduce the inflation risk premium embedded in long-term bond yields, leading to a more efficient allocation of economic resources. In addition, an average inflation targeting system could make the zero lower bound constraint less vexing by keeping long-term inflation expectations from slipping below the central bank’s target. This would give the central bank more traction over monetary policy. A Bias Towards Higher Inflation Despite the advantages of the Fed’s new approach, it faces a number of hurdles, some practical and some political. On the practical side, it may turn out that the Phillips curve, rather than being flat, is kinked at a fairly low level of unemployment. Theoretically, that would not be too surprising. If I have 100 apples for sale and you want to buy 60, I have no incentive to raise prices. Even if you wanted to buy 80 apples, I would have no incentive to raise prices. However, if you wanted to buy 105 apples, then I would have an incentive to raise my selling price. The point is that inflation could remain stubbornly dormant as slack slowly disappears, only to rocket higher once full employment has been reached. Since changes in monetary policy only affect the economy with a lag, the central bank could find itself woefully behind the curve, scrambling to contain rising inflation. This is precisely what happened during the 1960s (Chart 17). Chart 17Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Chart 18Something Has Always Happened To Preempt Overheating Over the past three decades, something always happened that kept the US economy from overheating (Chart 18). The unemployment rate reached a 50-year low in 2019. Inflation may have moved higher this year had it not been for the fact that the global economy was clotheslined by the pandemic. In 2007, the economy was heating up only to be sandbagged by the housing bust. In 2000, the bursting of the dotcom bubble helped reverse incipient inflationary pressures. But just because the economy did not have a chance to overheat at any time over the past 30 years does not mean it cannot happen in the future. The Political Economy Of Higher Inflation On the political side, average inflation targeting assumes that central banks will be just as willing to tolerate inflation undershoots as overshoots. This could be a faulty assumption. Generating an inflation overshoot requires that interest rates be kept low enough to enable unemployment to fall below its full employment level. That is likely to be politically popular. Generating an inflation undershoot, in contrast, requires restrictive monetary policy and rising unemployment. More joblessness would not sit well with workers. High interest rates could also damage the stock market and depress home prices, while forcing debt-saddled governments to shift more spending from social programs to bondholders. None of that will be politically popular. If central banks are quick to allow inflation overshoots but slow to engineer inflation undershoots, the result could be structurally higher inflation. Markets are not pricing in such an outcome (Chart 19). Chart 19Markets Are Not Pricing In Structurally Higher Inflation II. Financial Markets Global Asset Allocation: Despite Near-Term Dangers, Overweight Equities On A 12-Month Horizon An acceleration in the number of COVID-19 cases and the rising probability that the US Congress will fail to pass a stimulus bill before the November election could push equities and other risk assets lower in the near term. Investors should maintain somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Chart 20The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices Provided that progress continues to be made towards developing a vaccine and US fiscal policy eventually turns stimulative again, stocks will regain their footing, rising about 15% from current levels over a 12-month horizon. Negative real bond yields will continue to support stocks (Chart 20). The 30-year TIPS yield has fallen by over 90 basis points in 2020. Even if one assumes that it will take the rest of the decade for S&P 500 earnings to return to their pre-pandemic trend, the deep drop in the risk-free component of the discount rate has still raised the present value of future S&P 500 cash flows by nearly 20% since the start of the year (Chart 21). Chart 21The Present Value Of Earnings: A Scenario Analysis Thanks to these exceptionally low real bond yields, equity risk premia remain elevated (Chart 22). The TINA mantra reverberates throughout the investment world: There Is No Alternative to stocks. To get a sense of just how powerful TINA is, consider the fact that the dividend yield on the S&P 500 currently stands at 1.67%. That may not sound like much, but it is still a full percentage point higher than the paltry 0.67% yield on the 10-year Treasury note (Chart 23). Chart 22Equity Risk Premia Remain Elevated Chart 23S&P 500 Dividend Yield Is Above The Treasury Yield Imagine having to decide whether to place your money either in an S&P 500 index fund or a 10-year Treasury note. Dividends-per-share paid by S&P 500 companies have almost always increased over time. However, even if we make the pessimistic assumption that dividends-per-share remain unchanged for the next ten years, the value of the S&P 500 would still have to fall by 10% over the next decade to equal the return on the 10-year note. Assuming that inflation averages around 1.9% over this period, the real value of the S&P 500 would need to drop by 25%. The picture is even more dramatic outside the US. In the euro area, the index would have to fall by over 30% in real terms for investors to make more money in bonds than stocks. In the UK, it would need to fall by over 50% (Chart 24). Chart 24 (I)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Chart 24 (II)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds A Weaker US Dollar Favors International Stocks Outside the US, price-earnings ratios are lower, while equity risk premia are higher. Cheap valuations are usually not enough to justify a high-conviction investment call, however. One also needs a catalyst. Three potential catalysts could help propel international stocks higher over the next 12 months, while also giving value stocks and economically-sensitive equity sectors a boost: A weaker US dollar; the end of the pandemic; and a recovery in bank shares. Let’s start with the dollar. The US dollar faces a number of headwinds over the coming months. First, interest rate differentials have moved sharply against the greenback (Chart 25). Second, as a countercyclical currency, the dollar is likely to weaken as the global economy improves (Chart 26). Third, the current account deficit is rising again. It jumped over 50% from $112 billion in Q1 to $170 billion in Q2. According to the Atlanta Fed GDPNow model, the trade balance is set to widened further in Q3. This deterioration in the dollar’s fundamentals is occurring against a backdrop where the currency remains 11% overvalued based on purchasing power parity exchange rates (Chart 27). Chart 25Interest Rate Differentials Have Moved Sharply Against The Greenback A weaker dollar is usually good for commodity prices and cyclical stocks (Chart 28). In general, commodity producers and cyclical stocks are overrepresented outside the US. Chart 26The Dollar Is Likely To Weaken As The Global Economy Improves Chart 27USD Remains Overvalued Chart 28A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks BCA’s chief energy strategist Bob Ryan expects Brent to average $65/bbl in 2021, $21/bbl above what the market is anticipating. Ongoing Chinese stimulus should also buoy metal prices. A falling greenback helps overseas borrowers – many of whom are in emerging markets – whose loans are denominated in dollars but whose revenues are denominated in the local currency. It is thus no surprise that non-US stocks tend to outperform their US peers when global growth is strengthening and the dollar is weakening (Chart 29). Chart 29Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening The outperformance of non-US stocks in soft dollar environments is particularly pronounced when returns are measured in common-currency terms. From the perspective of US-based investors, a weaker dollar raises the dollar value of overseas sales and profits, justifying higher valuations for international stocks. From the perspective of overseas investors, a weaker dollar reduces the local currency value of US sales and profits, implying a lower valuation for US stocks. This helps explain why European stocks tend to outperform their US counterparts when the euro is rising, even though a stronger euro hurts the European economy. It’s Value’s Turn To Shine Value stocks have often outperformed growth stocks when the US dollar has been weakening and global growth strengthening. Recall that value stocks did poorly during the late 1990s, a period of dollar strength and economic turbulence throughout the EM world. In contrast, value stocks did well between 2001 and 2007, a period during which the dollar was generally on the back foot. The relationship between value stocks, the dollar, and global growth broke down this summer. Growth stocks continued to pull ahead, even though global growth turned a corner and the dollar began to weaken. There are two reasons why this happened. First, investors were too slow to price in the windfall that growth stocks in the tech and health care sectors would end up receiving from the pandemic. Second, rather than rising in response to better economic growth data, real rates fell during the summer months. A falling discount rate benefits growth stocks more than value stocks because the former generate more of their earnings farther into the future. The tentative outperformance of value stocks in September suggests that the tables may have turned for the value/growth trade. Retail sales at physical stores are rebounding, while online sales growth is coming down from highly elevated levels (Chart 30). Bank of America estimates that US e-commerce penetration doubled in just a few short months earlier this year. Some “reversion to the trend” is likely, even if that trend does favor online stores over the long haul. Chart 30Are Brick-And Mortar Retailers Coming Back To Life? Chart 31The Pandemic Has Caused Global Server And PC Shipments To Surge Meanwhile, PC shipments soared during the pandemic as companies and workers rushed out to buy computer gear to allow them to work from home (Chart 31). To the extent that this caused some spending to be brought forward, it could create an air pocket in tech demand over the next few quarters. A third wave of the virus in the US and ongoing second waves elsewhere could give growth stocks a boost once more, but the benefits are likely to be short-lived. If a vaccine becomes available early next year, investors will pivot from the “pandemic trade” to the “reopening trade.” The “reopening trade” will support companies such as banks, hotels, and transports that were crushed by lockdown measures and which are overrepresented in value indices. From a valuation perspective, value stocks are cheaper now compared to growth stocks than at any point in history – even cheaper than at the height of the dotcom bubble (Chart 32). Chart 32Value Stocks Are Extremely Cheap Relative To Growth Stocks The lofty valuations that growth stocks enjoy can be justified if the mega-cap tech companies that dominate the growth indices continue to increase earnings for many years to come. However, it is far from clear that this will happen. Close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, sites owned by Google and Facebook generate about 60% of all online advertising revenue. While all of these companies dominate their markets, this could change. At one point during the dotcom bubble, Palm’s market capitalization was over six times greater than Apple’s. The Blackberry superseded the PalmPilot; the iPhone, in turn, superseded the Blackberry. History suggests that many of today’s technological leaders will end up as laggards. Investors looking to find the next tech leader can focus on smaller, fast growing companies. Unfortunately, picking winners in this space is easier said than done. History suggests that investors tend to overpay for growth, especially among small caps. Based on data compiled by Eugene Fama and Kenneth French, small cap growth stocks have lagged small cap value stocks by an average of 6.4% per year on a market-cap weighted basis, and by 10.4% on an equal-weighted basis, since 1970 (Table 1). Table 1Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns Bank On Banks Financial stocks are heavily overrepresented in value indices (Table 2). Banks have made significant provisions against bad loans this year. If global growth recovers in 2021 once a vaccine becomes available, some of these provisions will end up being released, boosting profits in the process. Table 2Breaking Down Growth And Value By Sector Chart 33Modestly Higher Bond Yields Will Benefit Bank Shares A stabilization in bond yields should also help bank shares. Chart 33 shows that a fall in bank stocks vis-à-vis the overall market has closely matched the decline in bond yields. While we do not think that central banks will tighten monetary policy in the next few years, nominal bond yields should still drift modestly higher as output gaps narrow. What about the outlook for bank earnings? A massive new credit boom is not in the cards in any major economy. Nevertheless, it should be noted that global bank EPS was able to return to its long-term trend in 2019, until being slammed again this year by the pandemic (Chart 34). Global bank book value-per-share was 30% higher in 2019 compared to GFC highs (even though price-per-share was 30% lower). Chart 34Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Chart 35European Bank Earnings Estimates Have Lagged Credit Growth Admittedly, the global numbers disguise a lot of regional variation. While US banks were able to bring EPS back to its prior peak, and Canadian banks were able to easily surpass it, European bank EPS was still 70% below its pre-GFC highs in 2019. The launch of the common currency in 1999 set off a massive credit boom across much of Europe, leaving European banks dangerously overleveraged. The GFC and the subsequent European sovereign debt crisis led to a spike in bad loans, necessitating numerous rounds of dilutive capital raises. At this point, however, European bank balance sheets are in much better shape. If EPS simply returns to its 2019 levels, European banks will trade at a generous earnings yield of close to 20%. That may not be such a hurdle to cross. Chart 35 shows that European bank earnings estimates have fallen far short of what would be expected from current credit growth. If, on top of all this, European banks are able to muster some sustained earnings growth thanks to somewhat steeper yield curves and further cost-cutting and consolidation, investors who buy banks today will be rewarded with outsized returns over the long haul. Fixed Income: What Is Least Ugly? As noted above, a rebound in global growth should push up both equity prices and bond yields. As such, we would underweight fixed income within a global asset allocation framework. Within the fixed income bracket, investors should favor inflation-protected securities over nominal bonds. They should underweight government bonds in favor of a modest overweight to spread product. Spreads are quite low but could sink further if economic activity revives faster than anticipated. The upper quality tranche of high-yield corporates, which are benefiting from central bank purchases, have an especially attractive risk-reward profile. EM debt should also fare well in a weaker dollar, stronger growth environment (Chart 36). Chart 36BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles Given that some investors have no choice but to own developed economy government bonds, which countries or regions should they buy from within this category? Chart 37 shows the 3-year trailing yield betas for several major developed bond markets. In general, the highest-yielding currencies (US and Canada) also have the highest betas, implying that their yields rise the most when global bond yields are rising and vice versa. Chart 37High-Yielding Bond Markets Are The Most Cyclical In economies such as Europe and Japan where the neutral rate of interest is stuck deep below the zero bound, better economic news is unlikely to lift policy rate expectations by very much. After all, the optimal policy rate would still be above its neutral level even if better economic data brought the neutral rate from say, -4% to -3%. In contrast, when the neutral rate is close to zero or even positive, better economic data can lift medium-to-long-term interest rate expectations more meaningfully. As such, we would underweight US Treasurys and Canadian bonds, while overweighting Japanese government bonds (JGBs) over a 12-month horizon. On a currency-hedged basis, which is what most bond investors focus on, 10-year JGBs yield only 20 basis points less than US Treasurys (Table 3). This lower yield is more than offset by the risk that Treasury yields will rise more than yields on JGBs. Table 3Bond Markets Across The Developed World The End Game What will end the bull market in stocks? As is often the case, the answer is tighter monetary policy. The good news is tight money is not an imminent risk. The Fed will not hike rates at least until 2023, and it will take even longer than that for interest rates to rise elsewhere in the world. The bad news is that the day of reckoning will eventually arrive and when it does, bond yields will soar and stocks will tumble. Investors who want to hedge against this risk should consider owning more real assets. As was the case during the 1970s, farmland will do well from rising inflation. Suburban real estate will also benefit from more people working from home and, if recent trends persist, rising crime in urban areas. Gold should also do well. The yellow metal has come down from its August highs, but should benefit from a weaker dollar over the coming months, and ultimately, from a more stagflationary environment later this decade. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 “More infectious coronavirus mutation may be 'a good thing', says disease expert,” Reuters, August 17, 2020. 2 Nina Bai, ”One More Reason to Wear a Mask: You’ll Get Less Sick From COVID-19,” University of California San Francisco, July 31, 2020. 3 Dave Roos, “How Crude Smallpox Inoculations Helped George Washington Win the War,” History.com, May 18, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights Bank credit 6-month impulses are plunging, and the pandemic is resurging. Maintain an overweight to growth defensives (technology and healthcare). In the short term, profits will be more resilient in a resurgent pandemic. In the long term, profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. The European stock market’s massive underweighting to growth defensives will weigh on its relative performance. Go underweight China economy plays. Fractal trade: Fractal analysis confirms that basic resources are vulnerable to a reversal. Within value cyclicals, tactically overweight financials versus basic resources. Feature Chart of the WeekThe Greatest Ever Monetary Stimulus Is Over... For Now Monetary stimulus, as measured by the increase in banks’ six-month credit flows, reached an all-time high during the summer months. But now, the greatest ever monetary stimulus is fading (Chart of the Week). In the US and China, the increase in banks’ six-month credit flows peaked at $700 billion and $800 billion respectively during May. In the euro area, the increase peaked at over $1 trillion during July. The combination constituted the greatest ever global monetary stimulus, trumping even the stimulus that followed the 2008 financial crisis (Charts I-2 - I-4). Chart I-2US Monetary Stimulus Is Fading Chart I-3China Monetary Stimulus Is Fading Chart I-4Euro Area Monetary Stimulus To Fade However, the increase in six-month credit flows has recently slumped to around $200 billion in both the US and China. The euro area has yet to update its data beyond July, but we expect it to fade too. The upshot is that the greatest ever monetary stimulus is over… for now. Bond Yields Are No Longer Stimulating Our preferred metric for assessing the transmission of monetary stimulus on an economy is the increase in the banks’ six-month credit flows. In turn, this depends on the six-month deceleration in the bond yield – meaning, the bond yield decline in the most recent six months must be greater than the decline in the previous six months. At first glance, this seems counterintuitive. Why focus on the bond yield’s deceleration rather than its plain vanilla decline? Box 1 explains how it follows from a fundamental accounting identity of GDP statistics. Box 1 Why The Bond Yield’s Deceleration Matters GDP is a flow statistic. It measures the flow of goods and services produced in a period. Hence, the GDP flow receives a contribution from the bank credit flow in that period. In turn, the bank credit flow is established by the decline in the bond yield (Chart I-5). Chart I-5The Decline In The Bond Yield Establishes The Bank Credit Flow It follows that GDP growth receives a contribution from bank credit flow growth. Which, in turn, receives a contribution from the bond yield deceleration. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Finally, our preferred period is six months because it empirically equals the time to fully spend a bank credit flow. A quarter is too short: a year is much too long. Admittedly, during this year’s pandemic recession and rebound, the link between monetary stimulus and the real economy has weakened. Fiscal stimulus has played a more important role. Even when it comes to bank credit, much of the recent increase was not due to new loans. It was due to firms tapping pre-arranged credit lines, which they used to reinforce cash buffers, rather than to spend. Nevertheless, some impact of monetary stimulus will reach the real economy. This means that while this year’s earlier deceleration of bond yields was good news for the economy, the more recent acceleration of bond yields is bad news (Chart I-6). Chart I-6The Recent Acceleration Of Bond Yields Is Bad News Tactically Underweight China Plays Through the summer months, 10-year bond yields flipped from sharp six-month decelerations to sharp accelerations. But the reversals were much more extreme in China and the US than in the euro area. Seen in this light, it is hardly surprising that the increase in six-month bank credit flows has already slumped in China and the US, and could soon turn negative. If so, they would be a contractionary force on the economy. One tactical investment conclusion is to underweight China economy plays. Specifically, with China’s bank credit six-month impulse in freefall, the 40 percent outperformance of basic resources versus financials is vulnerable to a sharp reversal (Chart I-7). This is also confirmed by fractal analysis (see later section). Chart I-7With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable Stay underweight cyclicals. But within cyclicals, tactically overweight financials versus basic resources. A Resurgent Pandemic Will Force People Back Into Their Shells A resurgence of the pandemic will create a further headwind to the economy, irrespective of whether governments impose fresh lockdowns or not. This is because most of us have an instinct for self-preservation as well as protecting our loved ones. In response to a resurgent pandemic, we will go back into our shells. Shunning public transport, shopping, and other crowded places, some might even think twice about letting their children go to school. But if this cautious behaviour is voluntary, then why do governments need to impose lockdowns? The answer is that while the majority behaves responsibly, a minority behaves irresponsibly. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all Covid-19 infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. At first glance, it appears that the lockdown is causing the recession. In fact, this is a classic confusion between correlation and causation. The true cause of the recession is the pandemic, which forces people into their shells. But to the extent that severity of the lockdown correlates with the severity of the pandemic, many people confuse the correlated lockdown with the underlying cause, the pandemic. The ultimate proof comes from Scandinavia. Sweden imposed no lockdown, while its neighbour Denmark imposed the most extreme lockdown in Europe. If it was the lockdown that caused the recession, then the economy of no-lockdown Sweden should have fared much better than that of lockdown Denmark. In fact, the two Scandinavian economies suffered identical 9 percent recessions (Chart I-8). Chart I-8No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark Focus On Sectors That Can Thrive In The New World Tactically we have recommended an underweight to stocks versus bonds since July 9, and this tactical position is broadly flat. Stick with it for now.1 A crucial question is: can bond yields go significantly lower? It is a crucial question because it was the collapse in bond yields earlier this year that saved the aggregate stock market. As long-duration bond yields plunged by 1 percent, the forward earnings yield of long-duration technology and healthcare stocks also plunged by 1 percent (Chart I-9). This surge in the valuation of the growth defensive sectors compensated for the collapsed profits of the value cyclical sectors – banks, basic resources, and oil and gas (Chart I-10). A resurgent pandemic combined with the end of the greatest ever monetary stimulus means that this playbook may get a rerun in the coming months. Chart I-9The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare Chart I-10Tech And Healthcare Saved The Aggregate Stock Market The worry is that, from current levels, long-duration bond yields will struggle to plunge by another 1 percent and provide the same boost to valuations that they did in the first wave of the pandemic. In which case, the outlook for stocks and sectors will hinge more on their profits. On this basis, we still favour the growth defensives – which we define as technology and healthcare – both for the short term and the long term. In the short term, their profits will be more resilient in a resurgent pandemic. In the long term, their profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. One unfortunate consequence is that the European stock market’s massive underweighting to the growth defensives sectors will weigh on its relative performance, both in the short term and in the long term. Fractal Trading System* Supporting the fundamental analysis in the main body of this report, fractal analysis confirms that basic resources are vulnerable to a reversal versus financials. Hence, this week’s recommended trade is to go long financials versus basic resources. One way of implementing this is: long XLF, short XLB. Set the profit target and symmetrical stop-loss at 3.5 percent. In other trades, long ZAR/CLP reached the end of its holding period flat, and is now closed. The rolling 1-year win ratio now stands at 58 percent. 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. * 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 Expressed as short DAX versus 10-year T-bond. 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 Bond Yields & Growth: Developed market bond yields have ignored improving cyclical economic data over the past few months, remaining stuck in narrow trading ranges at low levels. That broken correlation will persist until central banks become less concerned about supporting pandemic-ravaged economies and begin worrying more about rising inflation, financial stability or the size of their balance sheets. That shift will not happen anytime soon. Inflation-Linked Trades: Our models suggest US TIPS breakevens are now at fair value. We are taking profits on our tactical long US 10-year inflation breakevens trade for a return of 2.88%. Stay long 10-year breakevens in Italy and Canada until we see further shrinkage in the gap between inflation breakevens and model-implied fair value and watch for a selling opportunity in UK 10-year breakevens. Feature Do bond investors even care about economic growth anymore? This is a valid question to ask, given how government bond yields in the developed markets have stayed in very narrow trading ranges over the past few months, even as economic data has rebounded from the global COVID-19 recession in the first half of 2020. Investors should get used to the current backdrop of rock-bottom interest rates and bond yields, which is unlikely to change anytime soon. Chart of the WeekBond Yields Are Responding To Inflation, Not Growth For example, the benchmark 10-year US Treasury yield has stayed between 0.65% and 0.75% since June 11, even though the US ISM Manufacturing index rose from 43 in May to 56 in August. Yields are also ignoring the ups and downs of the equity market. The 10-year Treasury yield now sits at 0.66% - the same level as on September 2 even though the NASDAQ equity index has fallen 12% from the all-time peak seen on that day. Our own Global Duration Indicator, comprised of cyclical measures like the global ZEW index and our global leading economic indicator, has surged to the highest level since 2008 (Chart of the Week). Given the usual lead time between broad turns in the Duration Indicator and the level of global bond yields (around 6-9 months), this suggests that yields have bottomed and should soon begin rising. Yet the reality is that the usual factors that typically drive yields higher during a cyclical upturn – namely, rising inflation expectations and a clearly understood signal from central banks that such a move would lead to tighter monetary policy – are not currently in place. Investors should get used to the current backdrop of rock-bottom interest rates and bond yields, which is unlikely to change anytime soon. Four Potential Triggers For A Rise In Bond Yields Chart 2A Breakdown Of The PMI/Yield correlation The breakdown of the positive correlation between growth and bond yields is not just visible in the US. For example, yields on German Bunds and UK Gilts also remain stuck at low levels despite sharp improvements in the German and UK manufacturing PMIs (Chart 2). Yet in China – where there is no zero interest rate policy (ZIRP) or large-scale quantitative easing (QE) programs - bond yields have steadily risen since the China manufacturing PMI bottomed back in April (bottom panel). What could change this backdrop? We see four potential catalysts, ranked below in our own subjective order of importance: Inflation Sustainably Returning Back To Central Bank Targets It may seem obvious, but it still needs to be said – dovish central bank policies are the biggest reason why developed market bond yields have de-linked from economic growth. That includes not only ZIRP or QE, but also forward guidance on future changes in interest rates. Central banks are telling markets they will not raise rates for a period measured in years, and will continue to expand their balance sheets to purchase assets and support bank lending, all in an effort to push undershooting inflation back to policy targets. This is a different message than bond investors have grown accustomed to hearing from central banks, most notably in the US. The Fed is trying to do something that it has never intentionally done before – erode some of its hard-earned inflation fighting credibility. The Fed is trying to do something that it has never intentionally done before – erode some of its hard-earned inflation fighting credibility. The recent shift by the Fed to an Average Inflation Targeting framework – where above-target inflation would be tolerated if inflation was below target for an extended period – is intended to change the perception that the Fed will hike rates preemptively based on a forecast of inflation, as they have done in the past. Chart 3Latest FOMC Projections Justify Years Of 0% Rates The latest set of Fed economic projections is consistent with this new framework (Chart 3): the unemployment rate is forecasted to fall back to the FOMC median estimate of full employment (4.1%) by 2023; headline PCE inflation is also projected to climb back to 2% by 2023; the fed funds rate is projected to stay unchanged near 0% until at least 2023. In many ways, the Fed is trying to atone for the mistakes made while normalizing policy after the extraordinary easing measures taken after the 2008 crisis. From signaling a slowing of QE bond purchases in 2013, to the 250bps of rate hikes and tapering of its balance sheet during 2016-18, the Fed moved aggressively relative to what was actually happening with US inflation. Core PCE inflation only inched above 2% for a few months in 2018 – towards the end of the normalization process - as did market-based inflation measures like TIPS breakevens (Chart 4). The Fed ended up raising the real fed funds rate during that tightening cycle to above its own estimate of neutral (r-star), even with inflation still not close to its target. Unsurprisingly, real US bond yields also rose during that same period, which tightened monetary conditions even further by boosting the value of the US dollar. No wonder US inflation could not stay at the 2% target for very long. This time around, the Fed is sending a much different signal to markets – that it wants to see inflation rise before raising rates, thus keeping real policy rates in negative territory for an extended period. If the Fed is looking for a real world case study of such an approach, it can look across the Atlantic to the Bank of England (BoE). On the surface, the BoE has been acting like a typical inflation-targeting central bank over the past several years, turning more hawkish in its commentary when the UK economy was improving and becoming more dovish when the economy was languishing. Yet since the 2008 crisis, the BoE has kept the Bank Rate in a range of 0.1% to 0.75%, well below realized UK inflation. While it has been difficult for the BoE to attempt to raise rates given the Brexit uncertainty since 2016 – which has also weakened the British pound, helping boost UK inflation - real UK policy rates have now been negative for 12 years (Chart 5). The result: steadily declining UK real bond yields with inflation expectations rising to levels well above the BoE 2% inflation target. Chart 4The Fed Is Trying To Erode Its Hard-Earned Credibility Chart 5Lessons From The BoE On How To Not Be Credible The experience of the ECB provides a cautionary tale for central banks not appearing dovish enough, even when policy settings are already extraordinarily accommodative. The message from central banks on future rate increases – namely, that there will not be any without sustainably higher inflation – must change before bond yields can have any hope of climbing higher. Chart 6Does The ECB Have Any Credibility Left? Inflation expectations have stayed below the ECB’s “just below 2%” target since 2013 (Chart 6), which forced the central bank into cutting nominal rates into negative territory while aggressively expanding its balance sheet through QE and long-term bank liquidity provision (i.e. LTROs). Yet the ECB has always put an expiration date on each of these programs, which sent a message to the markets that the central bank was not fully committed to keeping policy easy until inflation was back to target – however long that would take. In sum, the message from central banks on future rate increases – namely, that there will not be any without sustainably higher inflation – must change before bond yields can have any hope of climbing higher. A Shift From Central Banks To Concerns About Asset Price Bubbles Chart 7When Will CBs Start Worrying About Financial Market Valuations? Policymakers are paying lip service to the notion of the “financial stability” risks inherent in their new promises to keep rates low for a lot longer while intervening in financial markets more aggressively through asset purchase programs. Given the signs of froth in many important asset classes like US equities or global corporate debt, policymakers should at least be somewhat concerned that easy money policies are fueling asset bubbles (Chart 7). A big enough decline could erode confidence and spill over into the real economy, defeating the original purpose of easy money policies. However, given the still fragile state of much of the global economy that remains dependent on fiscal support amid ongoing COVID-19 restrictions, concerns over asset values will take a backseat to maintaining adequate monetary stimulus. Asset bubbles would have to become much larger before a central bank would even consider turning more hawkish to prick them through higher policy rates that would push up bond yields. The Announcement Of A Trustworthy COVID-19 Vaccine That Is Ready For Widespread Distribution Markets have already begun to worry about the “second wave” of the coronavirus that health officials had warned would happen in the cooler autumn months. The development of an effective, and safe, vaccine would thus be a game-changer for financial markets, particularly after the recent surge in new COVID-19 cases in Europe and the still elevated level of new cases in the US (Chart 8). Chart 8A Second Wave Of COVID-19 BCA Research’s Chief Global Strategist, Peter Berezin (a big fan of interesting data sets!), noted in his most recent report that, according to The Good Judgement Project, around 60% of “superforecasters” now expect a vaccine ready for mass distribution to be available by Q1/2021 (Chart 9).1 A vaccine appearing that rapidly – much faster than the usual multi-year process leading to a vaccine declared safe for use – would help boost business and consumer confidence and raise the odds of a return to pre-virus levels of economic activity. Bond yields would likely get a lift, as well, as markets would price in a shorter period of super low policy rates and a faster return of inflation to central bank targets. Yet even if a vaccine is presented to the world by next spring, there is no guarantee that a large enough share of the population will deem the vaccine safe enough to take to ensure “herd immunity”. A recent Economist/YouGuv survey noted that only 36% of American adults would choose to get vaccinated when a COVID-19 vaccine becomes available, 32% would not get vaccinated, while 32% were unsure (Chart 10). Thus, a vaccine would be a bond-bearish development only if it is trusted to be safe to use – the mere announcement of a vaccine will not be enough to declare an “end” to the pandemic. Chart 9High Odds Of A Vaccine In 6-To-12 Months Chart 10Will Enough People Take The Vaccine? Central Banks Slowing QE Purchases Relative To Increased Fiscal Issuance Chart 11Still Room For The Fed, ECB and BoE To Expand QE Right now, it is easy for the major central banks to aggressively expand their balance sheets and provide additional monetary stimulus through asset purchases. Yet there may come a point where a capacity constraint is reached on buying government bonds if it impairs market functionality. That is currently the case in Japan, where the Bank of Japan now owns 49% of the Japanese government bond (JGB) market after years of aggressive QE purchases of JGBs. This has damaged the day-to-day liquidity of JGBs, where there have been instances of days where no single JGB has traded in the secondary market. A move by central banks to buy fewer bonds because they own too many of them could potentially push bond yields higher by worsening the demand/supply balance for government bonds - assuming private investors do not pick up the slack and buy more bonds, of course. Currently, the Fed only owns 22% of the US Treasury market with little evidence suggesting that its purchases are impairing the trading of Treasuries (Chart 11). The BoE and ECB own much larger shares of the UK and euro area government bond markets – 37% and 38%, respectively – suggesting that those central banks are closer to a BoJ-like capacity constraint. However, given the rising budget deficits and surging government bond issuance seen in Europe (and the US) so far in 2020, the odds of a capacity constraint soon being reached that could result in slower QE purchases are low. Bottom Line: Developed market bond yields have ignored improving cyclical economic data over the past few months, remaining stuck in narrow trading ranges at low levels. That broken correlation will persist until central banks become less concerned about supporting pandemic-ravaged economies and begin worrying more about rising inflation, financial stability or the size of their balance sheets. That shift will not happen anytime soon. Reviewing Our Tactical Inflation Breakeven Trades Back in June, we initiated a series of recommended inflation-focused trades in our Tactical Overlay portfolio. Specifically, we went long 10-year inflation breakevens in the US, Italy, and Canada by buying on-the-run inflation-linked bonds and selling government bond futures.2 We chose those trades based on the output of our fundamental valuation models for 10-year inflation breakevens in eight inflation-linked bond (ILB) markets: the US, UK, France, Italy, Japan, Germany, Canada, and Australia. Our fair value models use two inputs for all regions: a) a long-run moving average of headline inflation, representing the medium-term trend that anchors inflation expectations; and b) the annual percentage change of the Brent oil price in local currency terms, which creates shorter-term deviations from the trend to account for moves in oil and currencies. There looks to be little remaining upside to our tactical long TIPS breakeven position. The past few months have seen a sharp rise in global inflation expectations, owing to the extraordinary monetary policy actions taken by the major developed market central banks and recovering growth prospects coming out of the COVID-19 recession. This has led to a convergence between 10-year inflation breakevens and their model-implied fair values in the aforementioned ILB markets (Chart 12). Most notably, breakevens in the US are now at fair value, while breakevens in the UK and Australia are trading above fair value. In the US, 10-year breakeven inflation rates are now back to the long-run average of realized headline inflation, while the -8% decline in the Brent oil price so far this month has lowered the model-implied fair value (Chart 13). Therefore, there looks to be little remaining upside to our tactical long TIPS breakeven position with most of the easy gains following the pandemic-induced collapse having already been realized. Chart 12Global Inflation Breakevens Have Moved Higher Our colleagues over at BCA Research US Bond Strategy have reached a similar conclusion, noting that the Fed’s Jackson Hole announcement of the move to Average Inflation Targeting supercharged the rising trend in TIPS breakevens.3 Chart 13US Breakevens Are At Fair Value Although they also note the likelihood of stronger US CPI prints over the next few months should keep US breakevens well supported heading into year-end. The time horizon for trades that enter our Tactical Overlay portfolio is limited to no longer than six months. Thus, with TIPS breakevens reverting back to fair value after just three months in the trade, we are choosing to take profits on our long 10-year US inflation breakeven trade for a total return of 2.88%. Chart 14UK Breakevens Are Above Fair Value In other ILB markets, UK breakevens are now an intriguing case, and not only for the monetary policy driven interplay between UK real yields and breakevens discussed earlier in this report. The overshoot of UK breakevens relative to our fair value model may be related to growing market speculation that the BoE will move to negative interest rates – an outcome we deem to be unlikely, as we discussed in a recent report.4 Alternatively, the higher breakevens may be a reflection of UK political uncertainty. The risk of a hard Brexit has resurfaced as UK Prime Minister Boris Johnson’s Conservatives have now backed a bill that includes powers for the government to override its withdrawal agreement with the European Union; understandably, this has caused a sell-off in the pound. Within our fundamental fair value framework, the UK 10-year breakeven inflation rate has overshot both the 3-year moving average of headline inflation and the growth of GBP-denominated oil prices, leaving breakevens 0.72 standard deviations expensive (Chart 14). One possible explanation is that markets are pricing in a significant further depreciation in the pound given this resurfacing of Brexit risk. Within our model, GBP/USD impacts the fair value of breakeven inflation via Brent oil prices, which are denominated in local currency terms. Thus, we can back out an implied change in GBP/USD that would make the model-derived fair value breakeven rate equal to the actual 10-year UK inflation breakeven rate, holding all other variables in the model constant. This does produce some extreme results during periods of very rapid moves in UK breakevens, but we can standardize the data to use as an indicator of ILB market-implied views on the currency (Chart 15). With that in mind, pound bearishness in ILB markets is nearing levels where it has historically troughed. A favorable development in Brexit negotiations could cause a reversal in this pound-bearish trend and a sharp downward correction in UK inflation breakevens. We see a potential opportunity to play for narrower UK breakevens if our view on Brexit and negative rates in the UK prove to be correct. On that front, BCA Research’s Chief Geopolitical Strategist, Matt Gertken, sees a no-deal Brexit by year-end as the less likely outcome, with odds of only 35%, given the political calculus that PM Johnson faces with the decision.5 Polls show that the UK public does not support a no-deal Brexit (Chart 16), which would severely hurt a UK economy that remains fragile due to the coronavirus, and would raise the odds of a new independence referendum in Scotland in 2021. Chart 15UK Breakevens Already Discount A Big Fall In GBP Chart 16Only 25% In The UK Think A No-Deal Brexit Is A Good Outcome We will monitor the situation closely in the coming weeks, but we see a potential opportunity to play for narrower UK breakevens if our view on Brexit and negative rates in the UK prove to be correct. Finally, although the majority of the gains from our long inflation breakeven trades in Canada and Italy have likely been realized, there are still some chips left on the table. Canadian breakeven inflation rates have risen in lockstep with Brent prices but have yet to converge with the long-run moving average of inflation (Chart 17). In Italy, the increases in oil prices in euro terms has outstripped the rise in breakevens, pushing up the model-implied fair value and leaving breakevens remain more than one standard deviation under fair value (Chart 18). We will look for the gap between breakevens and fair values to shrink further in these two countries before closing these trades, even though we are substantially in the green on both (see the Tactical Overlay table on page 19). Chart 17Canadian Breakevens Are Just Below Fair Value Chart 18Italian Breakevens Are Well Below Fair Value Bottom Line: Our models suggest US TIPS breakevens are now at fair value. We are taking profit on our tactical long US 10-year inflation breakeven trade for a return of 2.88%. Stay long 10-year breakevens in Italy and Canada until we see further shrinkage in the gap between inflation breakevens and model-implied fair value and watch for a selling opportunity in UK 10-year breakevens. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Global Investment Strategy Weekly Report, "Pivot To Value", dated September 18, 2020, available at gis.bcaresearch.com. You can also learn more about The Good Judgement Project here: https://goodjudgment.com/about/ 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research US Bond Strategy Portfolio Allocation Summary, "The Fed’s New Framework Is Bond Bearish…But Not Yet", dated September 8, 2020, available at usbs.bcaresearch.com. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Assessing The Leading Candidates To Join The Negative Rate Club", dated August 26, 2020, available at gfis.bcaresearch.com. 5 Please see BCA Research Geopolitical Strategy Weekly Report, "The End-Game For Trump And Brexit", dated September 18, 2020, available at gis.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
China: The Recovery And Equity Dichotomy China’s economic recovery has been gathering steam, and policymakers have become reasonably confident about the growth outlook. In fact, transaction activity in the property market has recovered to year-ago levels, auto sales and construction starts have bottomed following a 18 to 20-month contraction (Chart I-1). In line with this economic revival, authorities issued a statement following last week’s Politburo meeting contending that monetary policy should aim “to maintain adequate growth of money supply and credit.” This statement is a change in the monetary policy stance in May when the stated objective was to “significantly accelerate the growth rate of broad money supply and total social financing relative to last year.” This change in language highlights that authorities have become more comfortable with the recovery and are now becoming a bit concerned about amplifying credit and property market excesses. There will be no additional stimulus forthcoming, but policy tightening is not in the cards. In short, there will be no additional stimulus forthcoming, but policy tightening is not in the cards. Policymakers will therefore be in a wait-and-see mode for now, monitoring how economic conditions improve as the enacted stimulus works its way into the economy. Odds are high that the business cycle recovery will continue in China for now. Chart I-2 shows that the amount of credit and fiscal stimulus has been considerable, and that broad money and bank assets impulses remain in uptrend. All these should support the recovery into early next year. Chart I-1China: A Cyclical Recovery Is Underway Chart I-2China: The Stimulus Will Continue Working Its Way Into Economy As to the risks to Chinese growth emanating from depressed demand in the rest of the world, they are not substantial. First, global demand has already bottomed. Second, China’s total exports account for 17% of GDP, while investment expenditures and consumer spending account for 42% and 38% of GDP, respectively (Chart I-3). Hence, rising capital expenditures and household spending will offset the drag from exports. Finally, China exports many household and medical goods that are currently in very high demand worldwide due to the lockdowns and the pandemic. As a result, Chinese exports have recently done a bit better than global shipments in volume terms (Chart I-4). Chart I-3China Is Not Very Reliant On Exports Chart I-4Chinese Exports Are Doing A Better Than Global Shipments As to domestic growth drivers, output has been rising faster than consumer demand. Furthermore, capital spending and production by state-owned enterprises has been much stronger than that of private enterprises. However, with the stimulus in full force, both consumer demand and private investment will pick up in the second half of this year. An Equity Market Dichotomy Chart I-5Dichotomy Between Old And New Economy Stocks On the surface, the strong rally in Chinese equity indexes has validated the economic recovery thesis. However, a closer examination of the equity performance of various equity sectors reveals that the rebound in cyclical sectors has been rather tame and that the large gains in the equity indexes have been primarily due to tech and new economy businesses, benefiting from working and shopping from home, and to health care stocks (Chart I-5). Chart I-6 illustrates that industrials, materials, autos and real estate stocks are only modestly above their March lows. More importantly, large bank stocks trading in Hong Kong are reaching new lows in absolute terms (Chart I-6, bottom panel). Chart I-6China: Cyclicals Stocks And Banks Is such lackluster performance by Chinese cyclical stocks a warning sign to its business cycle recovery? Not necessarily. In our opinion, poor performance of cyclical stocks and banks in China reflects the long-term ramifications of repeated episodes of credit frenzy. A credit-driven growth recovery is always a double-edged sword for both borrowers and creditors. Companies that borrow and invest in new projects accumulate debt. Critically, it is unclear whether these investments will produce new recurring cash flows that would allow the debtors to service their debt. Hence, many companies that take on more debt and invest in financially non-viable projects undermine shareholder value. China has again doubled down on the same policies it has been deploying since the 2008 Lehman crisis. Namely, it has encouraged another boom in money and credit creation, as well as in infrastructure investment. Another outcome of this is that excess money creation leaks into the property market, further fueling the real estate bubble. As for banks, if debtors are unable to service their debt, bank shareholders will be at risk too. This does not mean that banks will be liquidated, but that their shareholders will be diluted. It is critical to put this round of stimulus into perspective: it comes amid already elevated debt levels, following a decade-long credit frenzy and a two decade-long capital spending boom (Chart I-7). Therefore, we doubt that the latest round of investments will be able to substantially increase shareholder value. On the whole, we believe the rally in Chinese stocks outside secular growth plays – such as Alibaba, Tencent – is cyclical not structural. The basis is that while more credit produces a cyclical recovery, it often undermines shareholder value. Chart I-6 on page 4 illustrates that Chinese cyclical stocks and bank share prices have been flat-to-down in the past 10 years despite recurring stimulus. Finally, the near-term risks for Chinese stocks do not stem from the domestic economy, but from geopolitics and a correction in US FAANG stocks. President Trump may escalate the confrontation with China in order to “rally the nation behind the flag” if his polling does not improve ahead of the November elections. Chart I-8 illustrates that the Americans’ view of China has deteriorated significantly in recent years. This might be exploited by President Trump to boost his re-election chances. A heightened confrontation could produce a correction in Chinese stocks. Chart I-7China Credit Excesses Are Getting Larger Chart I-8Americans’ Perception Of China Has Deteriorated In Recent Years Also, if the FAANG mania is either paused or reversed, then Chinese tech and mega-cap stocks will correct, pulling down the broad Chinese equity indexes. Bottom Line: The current round of stimulus in China has made the credit, money and property excesses even larger. As we have written over the years, easy money and credit generally fuel a misallocation of capital. Ultimately, this slows productivity growth on the macro level and destroys shareholder value on the company level. Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Nevertheless, given that the cyclical recovery in China will endure for now, we continue overweighting Chinese investable stocks within an EM equity portfolio. Finally, we are closing our short CNY/long USD position given the change in our USD outlook on July 9. This position has produced a 4.2% loss since its initiation on December 9, 2015. A Stress Test For Bank Stocks Chart I-9China: Small and Medium Banks Versus Large 5 Ones Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Chart I-9 demonstrates that the risk-weighted assets of smaller banks have risen much faster, and are presently larger, than those of large banks. We have performed a new stress test for both the Big Five and small & medium listed banks. Concerning large banks, our base-case scenario calls for risk-weighted non-performing assets to rise to 13% of total. Accordingly, their equity will be diluted by 46% if they were to provision for these losses (Table I-1). Consequently, the true (adjusted) price-to-book (PBV) ratio will be 1.1. Assuming that the fair value of these large banks corresponds to a PBV ratio of one, then Big Five banks remain moderately (10%) overpriced. For small banks, our baseline scenario assumes a risk-weighted non-performing asset ratio of 13%. If these banks were to provision for these write offs, their equity will be diluted by 61%, pushing the adjusted PBV ratio to 2 (Table I-2). If we use a PBV fair value ratio of 1.3, then small and medium listed banks are substantially overpriced. Table I-1Stress Test Of 5 Large Banks Table I-2Stress Test Of The Other 25 Listed Medium & Small Banks Chart I-10Favor Large 5 Banks Over Small And Medium Ones Bottom Line: Chinese banks stocks could rebound, but their structural outlook has deteriorated further following another round of credit binge. Among banks stocks, we reiterate our strategy of favoring large banks over smaller ones (Chart I-10). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, CFA Research Analyst linx@bcaresearch.com Indonesia: Struggling To Recover Indonesian stocks and the rupiah have rebounded in line with global risk assets. However, the rebound might be waning. The rupiah has begun weakening anew against the US dollar despite a major weakness in the latter. Relative to EM, Indonesian equities are underperforming again (Chart II-1). Chart II-1Indonesian Stocks Are Underperforming EM Again Crumbling Economic Activity And Insufficient Stimulus Indonesia is experiencing its worst recession since the Asian Crisis in 1997. Consumer income has dwindled and consumer confidence collapsed (Chart II-2, top panel). In turn, passenger car and truck sales have contracted by 90% and 84%, respectively, from a year ago (Chart II-2, second and third panel). Meanwhile, domestic cement consumption plunged by 17% (Chart II-2, bottom panel). In the meantime, the Coronavirus pandemic is not subsiding and will continue weighing on the Indonesian economy. The authorities have been attempting to prop up domestic demand. Yet the total fiscal stimulus announced so far – which amounts to $48 billion or 4.3% of GDP – is unlikely to be enough, given the harsh nature of this recession. For instance, the commercial banks loan impulse has already dipped to -2.7% of GDP (Chart II-3, top panel). Provided that demand for credit stays weak and banks continue to be reluctant to lend, the credit impulse will drop even further. As a result, the negative credit impulse will offset the fiscal thrust. Chart II-2Indonesia: Domestic Demand Collapsed Chart II-3Indonesia: Lending Rates Are High On the monetary policy front, Bank Indonesia (BI) has been aggressively cutting its policy rate and injecting banking system liquidity into the market. The BI has been also purchasing government bonds on the secondary and primary markets, de facto conducting quantitative easing. Still, the ongoing monetary easing has not translated into lower lending rates for the real economy. In particular, although the BI lowered its policy rate by 200 basis points since July 2019, bank lending rates have only fallen by 100 basis points (Chart II-3, middle panel). This is a major sign that the monetary transmission mechanism is broken. Furthermore, the commercial banks’ lending rate, in real (inflation-adjusted) terms, remains elevated (Chart II-3, bottom panel). This is severely hurting credit demand (Chart II-3, top panel). The deflationary pressures on the Indonesian economy are intensifying. As a result, the deflationary pressures on the Indonesian economy are intensifying. The top panel of Chart II-4 shows that the GDP deflator is flirting with deflation. Meanwhile, both core and headline inflation have undershot the central bank’s target (Chart II-4, bottom panel). Bottom Line: Very low inflation and crumbling real growth have caused nominal GDP growth to drop below borrowing rates (Chart II-5). This is hitting borrowers’ ability to service their debt and is leading to swelling non-performing loans (NPLs). Chart II-4Indonesia Is Facing Very Low Inflation Chart II-5Indonesia: Nominal GDP Growth Is Well Below Lending Rates Bank Stocks Remain At Risk The outlook for bank stocks that make up 48% of the Indonesia MSCI equity index is bleak. Chart II-6 shows that non-performing loans and special-mention loans (which are composed of doubtful loans) were rising before the pandemic shock. This has forced commercial banks to boost their bad loans provisioning, which has hurt their profitability. Additionally, Indonesian commercial banks’ net interest margins (NIM) have been falling sharply (Chart II-7). This has occurred because, on the revenues side, interest earnings have mushroomed as debtors have halted their interest payments while, on the expenditures side, commercial banks were forced to keep on paying interests to depositors. To protect their profitability, commercial banks have kept their lending rates stubbornly high. However, doing so will end up backfiring – as elevated lending rates punish borrowers and end up causing NPLs to rise, leading to more profit weakness. Chart II-6Indonesia: Bad Loans Are On The Rise Chart II-7Indonesia: Banks' Net Interest Margins Are Falling Crucially, Bank Central Asia and Bank Rakyat – which now account for a whopping 37% of the Indonesia MSCI market cap – are vulnerable. Both commercial banks are heavily exposed to state-owned enterprises (SOE) and small and medium (SME) companies. Particularly, 40% of Bank Central Asia’s loan book is linked to SOEs and government-led projects across electricity, ports, airports and cement among other sectors. Meanwhile, 68% of Bank Rakyat’s loan book is leveraged to the SME sector and 20% to large companies, including SOEs. Worryingly, both SOEs and SMEs have been undergoing stress. Their profitability and debt servicing ability were questionable even before the COVID-19 pandemic. State-Owned Enterprises (SOEs): The debt servicing ability for these companies has deteriorated. The debt-to-EBITDA ratio has risen considerably while the EBITDA coverage of interest expenses is set to fall from already low levels (Chart II-8). Small & Medium Enterprises (SME): The debt serviceability of the top 40% of the MSCI-listed small cap stocks is also deteriorating. The top panel of Chart II-9 shows that these companies’ debt-to-EBITDA has risen substantially, and that the EBITDA-to-interest expense ratio has plunged (Chart II-9, bottom panel). Chart II-8Indonesian SOEs: Weak Debt Servicing Capacity Chart II-9Indonesian SMEs: Weak Debt Servicing Capacity Chart II-10Indonesia Equities: Banks, Non-Financials And Small Caps All in all, both Bank Central Asia and Bank Rakyat are set to experience a considerable new NPL cycle emanating from the poor profitability of SOEs and SMEs. Importantly, Bank Central Asia and Bank Rakyat’s respective NPLs at 1.3% and 2.6% were relatively low at the start of this year and have much room to rise. Neither are their valuations appealing. At a price-to-book value of 4.4 Bank Central Asia is expensive. As for Bank Rakyat while its multiples are not as high as Bank Central Asia’s (which is trading at a price-to-book value of 1.8), it is not particularly cheap either, considering its enormous exposure to Indonesia’s struggling SME sector. Bottom Line: The outlook for bank stocks is murky (Chart II-10). Apart from banks, the rest of the Indonesian stock market has been performing very poorly and there is no obvious evidence that this will change (Chart II-10, bottom two panels). Investment Conclusions Continue underweighting the Indonesian stock market. Bank stocks remain at risk. Moreover, there is evidence that retail investors have been active in the stock market as of late. When the stock market does relapse, retail investors will likely rush to sell their holdings, thereby magnifying the equity selloff. Dedicated EM local currency bonds and credit portfolios should continue underweighting Indonesia. Investors in Indonesia’s corporate US dollar bonds should tread carefully as the largest issuers are those SOEs that have experienced deteriorating creditworthiness. Chart II-11Return On Capital Drives EM Currencies If the US dollar continues to depreciate, the rupiah could stabilize and rebound but it will underperform other EM and DM currencies. Return on capital (ROC) is the ultimate driver of EM currencies. Given the magnitude of the recession Indonesia is in and the slow recovery it will experience, its ROC will remain weak. This will weigh on the rupiah (Chart II-11). We continue shorting the rupiah against an equally weighted basket of the euro, Swiss franc and Japanese yen. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Turkey: The Ramifications Of A Money Plethora Turkey is facing another currency turmoil. At the core of significant currency depreciation pressures is an overflow of money. Chart III-1 demonstrates that narrow money (M1) and broad money (M3) are booming at 90% and 50%, respectively, from a year ago. These measures exclude foreign currency deposits. Bank loan annual growth has surged to 45% and commercial bank purchases of government bonds are skyrocketing (Chart III-2). Chart III-1Turkey's Money Overflow Chart III-2Rampant Credit Creation By Commercial Banks In turn, the Central Bank of Turkey’s (CBRT) funding of commercial banks has surged (Chart III-3). By providing ample liquidity the CBRT has enabled commercial banks to engage in a credit frenzy and levy of government debt. The latter has capped local currency bond yields at a time when the private sector and foreign investors have been reluctant to finance the government bond given its current yields. At the core of significant currency depreciation pressures is an overflow of money. Consistent with this expanding money bubble, inflation in Turkey remains in a structural uptrend (Chart III-4). Core and service sector consumer price inflation is close to 12% and will rise even further due to the overflow of money in the economy. Besides, residential property prices are already soaring, in local currency terms, as residents are fleeing from liras. Chart III-3Central Bank's Funding Of Banks Chart III-4Structurally Rising Inflation Still, the central bank refuses to acknowledge these inflationary pressures and to tighten its policy stance. Monetary authorities remain well behind the inflation curve. The policy rate, in real terms (deflated by core CPI), is -2%. In the past, when real policy rates have dropped to this level, the exchange rate has often tumbled, as in 2011, 2013, 2015 and 2018 (Chart III-5). Chart III-5Numerous Headwinds For The Lira In regard to balance of payments, the current account deficit is widening again due to the plunge in exports and tourism revenues and the recovering imports (Chart III-5, bottom panel). Historically, a widening current account deficit has weighed on the currency. Lastly, the central bank is not in the position to defend the exchange rate much longer. Not only has it depleted its own reserves but it has also used up $70 billion of commercial banks deposits and entered a $55 billion foreign exchange swap. Hence, its is massively short on US dollars. Bottom Line: As part of our broader currency strategy, on July 9, we replaced our short Turkish lira versus the US dollar position with a short in TRY versus a basket of the euro, CHF and JPY. This switch has proved to be very profitable and we continue recommending it. Consequently, investors should continue underweighting Turkish stocks, local currency bonds and credit markets relative to their EM counterparts. Fixed-income investors should consider betting on higher inflation expectations, i.e. going long domestic inflation adjusted yields and shorting nominal yields. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Global Bond Yields: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Currency-hedged spread product: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK. Feature Global bond yields are testing the downside of the narrow trading ranges that have persisted since May. As of last Friday, the yield on the Bloomberg Barclays Global Treasury index was at 0.41%, only 3 basis points (bps) above the 2020 low seen back in March. The 10-year US Treasury yield closed yesterday at 0.56%, only 6bps above the year-to-date low. Chart of the Week Concerns about global growth, with the number of new COVID-19 cases still surging in the US and new breakouts occurring in countries like Spain and Australia, would seem to be the logical culprit for the decline in yields. The first reads on global GDP data for the 2nd quarter released last week were historically miserable, with declines of -33% (annualized) in the US and -10% in the euro area (non-annualized). That represents a very deep hole of lost output, literally wiping out several years of growth. Even with the sharp improvements seen recently in cyclical indicators like global manufacturing PMIs, especially in China and Europe, a return to pre-pandemic levels of global economic output is many years away. Central banks will have no choice but to keep policy rates near 0% for at last the next couple of years, as is the current forward guidance provided by the Fed, ECB and others. Lower global bond yields may simply be reflecting the reality that it will take a long time to heal the economic wounds from the pandemic. However, there may be a more insidious reason why bond yields are falling. Investors may be permanently marking down their expectations for long-term potential economic growth, and equilibrium interest rates, in response to the devastation caused by the COVID-19 recession. Last week, Fitch Ratings lowered its estimates for long-term potential GDP growth, used to determine sovereign credit ratings, by 0.5 percentage points for the US (now 1.4%), 0.5 percentage points for the euro area (now 0.7%) and 0.7 percentage points in the UK (now 0.7%).1 These are declines similar in magnitude to the plunge in the OECD’s potential growth rate estimates seen after the 2009 Great Recession (Chart of the Week). Bond yields in the US and Europe witnessed a fundamental repricing in response, with nominal 5-year yields, 5-years forward breaking 200bps below the 4-6% range that prevailed in the US and Europe during the decade prior to the Great Recession. A similar re-rating of global bond yields to structurally lower levels may now be happening, with investors now believing that central banks will have difficulty raising rates much (if at all) in the future - even after the pandemic has ended. The Message From Declining Negative Real Bond Yields Chart 2The Real Rate/Breakevens Divergence Continues The typical signals about economic growth from government bond yields are now less clear because of the aggressive policy responses to the COVID-19 crisis. 0% policy rates, dovish forward guidance on the timing of any future rate increases, large scale asset purchases (QE), and more extreme measures like yield curve control to peg bond yields, have all acted to suppress the level and volatility of nominal global bond yields. Within those calm nominal yields, however, the dynamic that has been in place since May - rising inflation breakevens and falling real bond yields – is growing in intensity. The 10-year US TIPS real yield is now at a new all-time low of -1.02%, while the 10-year TIPS breakeven is now up to 1.58%, the highest since February before the pandemic began to roil financial markets (Chart 2). Similar trends are evident in most other major developed economy bond markets, with the gap between falling real yields and widening breakevens growing at a notably faster pace in Canada and Australia. More often than not, longer-term real yields tend to move in the same direction as inflation expectations when economic growth is improving. The former responds to faster economic activity, often with an associated pick up in private sector credit demand. At the same time, rising inflation expectations discount higher economic resource utilization (i.e. lower unemployment) and confidence that inflation will start to pick up. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. In Chart 3, we show the range of rolling three-year correlations between 10-year inflation-linked (real) government bond yields and 10-year inflation breakevens in the US, Germany, France, Italy, the UK, Japan, Canada and Australia for the post-crisis period. The triangles in the chart are the latest three-year correlation, while the diamonds are a more recent measure showing the 13-week correlation. There are a few key takeaways from this chart: Chart 3Negative Real Yield/Breakevens Correlations Are Not Unprecedented All countries shown have experienced a sustained period of negative correlation between real yields and inflation breakevens; The correlation has mostly been positive in Australia and has always been negative in Japan; Most importantly, the deeply negative correlations seen over the past three months – with rising breakevens all but fully offsetting falling real yields – are at or below the range of historical experience for all countries shown. Chart 4TIPS Yields May Stay Negative For Some Time In the current virus-stricken world, where many businesses that have closed during the pandemic may never reopen, there will be abundant spare global economic capacity for several years. In the US, measures of spare capacity like the unemployment gap (the unemployment rate minus the full-employment NAIRU rate) have been a reliable leading directional indicator of the long-run correlation between real TIPS yields and TIPS breakevens over the past decade (Chart 4). The surge in US unemployment seen since the spring, which has pushed the jobless rate into double-digit territory, suggests that the current deeply negative correlation between US real yields and inflation breakevens can persist over the next 6-12 months. Given the large increases in unemployment seen in other countries, the negative correlations between real yields and inflation breakevens should also continue outside the US. As for inflation expectations, those remain correlated in the short-run to changes in oil prices and exchange rates in all countries. On that front, there is still some room for breakevens to widen to reach the fair value levels implied by our models.2 A good conceptual way to think about inflation breakevens on a more fundamental level, however, is as a “vote of confidence” in a central bank’s monetary policy stance. If investors perceive policy settings to be too tight, markets will price in slower growth and lower inflation expectations, and vice versa. Every developed market central bank is now setting policy rates near or below 0% - and promising to keep them there until at least the end of 2022. Thus, the trend of rising global inflation breakevens can continue as a reflection of very dovish central banks that will be more tolerant of increases in inflation and not tighten policy pre-emptively. Currently, real 10-year inflation-linked bond yields are below the New York Fed’s estimates of the neutral real short-term rate, or “r-star”, in the US and the UK (Chart 5), as well as in the euro area and Canada (Chart 6).3 In the US and euro area, real yields have followed the broad trend of r-star, but the gap between the two is relatively moderate with r-star estimated to be only 0.5% in the US and 0.2% in the euro zone (where the ECB is setting a negative nominal interest rate on European bank deposits at the central bank – a policy choice that the Fed has been very reluctant to consider). Chart 5Negative Real Bond Yields Are Below R* In The US & UK ... Chart 6... As Well As In The Euro Area & Canada A more interesting study is in the UK where 10yr inflation-linked Gilt yields have fallen below -2.5%, but without the Bank of England implementing any negative nominal policy rates. In the UK, inflation expectations have been relatively high – running in the 2.5-3% range prior to the COVID-19 recession – as the Bank of England has consistently kept overnight interest rates below actual CPI inflation since the 2008 financial crisis. Thus, nominal Gilt yields have stayed relatively low for longer, as real yields and inflation expectations have remained negatively correlated for a long period with the Bank of England maintaining a consistently negative real policy rate. Chart 7Spillovers From Negative TIPS Yields Into Other Assets If the Fed were to do the same in the US, keeping the funds rate very low even as inflation rises, then a similar dynamic could take place where real TIPS yields continue to fall and TIPS breakevens continue to rise as the market prices in a sustained negative real fed funds rate. That may already be happening, with Fed Chair Jerome Powell hinting last week that the Fed is in the process of completing its inflation strategy review – with a shift towards rate hikes occurring only after realized inflation has sustainably increased to the Fed’s 2% target. A forecast of inflation heading to 2% because of falling unemployment will no longer be enough.4 Other factors may be at work depressing real bond yields while boosting inflation expectations, such as the massive QE bond buying programs of the Fed, ECB and other central banks. Yet even QE programs are essentially an aggressive form of forward guidance designed to drive down longer-term bond yields by lowering expectations of future interest rates. In sum, it is increasingly likely that the current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bond investors will expect central banks to sit on their hands and do nothing in that environment, even if inflation starts to increase. This not only has implications for bond markets, but other asset classes as well based on what is happening in the US. The steady decline in the in the 10-year US TIPS yield has boosted the valuation of assets that typically have been considered inflation hedges, like equities and gold (Chart 7). The fall in TIPS yields also suggests that more weakness in the US dollar is likely to come over the next 6-12 months – another reflationary factor that should help lift global inflation expectations and boost the attractiveness of inflation-linked bonds. The current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bottom Line: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Searching For Value In Global Spread Product Last week, we looked at the impact of currency hedging on the attractiveness of government bond yields across the developed markets.5 We concluded that US Treasuries still offered superior yields to most other countries’ sovereign bonds, even with the US dollar in a weakening trend and after hedging out currency risk. We also presented a cursory look at the relative attractiveness of the major global spread product categories in that report, but without factoring in any considerations on the relative credit quality or volatility between sectors. This week, we will look at the relative value of global spread products hedged into USD, GBP, EUR and JPY, but after controlling for those credit and volatility risks. We conducted a similar analysis in early 2018,6 ranking the currency-hedged yields for a wide variety of global spread products by the ratio of yields to trailing volatility. This time, instead of looking at the just that simple valuation metric, we use regression models to make a judgment on how under- or over-valued spread products are relative to their “fair value”. To recap the methodology of this analysis, we take the Bloomberg Barclays index yield-to-maturity (YTM) for each spread product category, hedged into the four currencies used in this analysis, and divide it by the annualized trailing volatility of those yields over both short-term (1-year) and long-term (3-year) windows. In order to hedge the yields into each currency, we used the annualized differentials between spot and 3-month forward exchange rates, which is the all-in cost of hedging. We then compare those currency-hedged, volatility-adjusted yields to two measures of risk: the index credit rating and duration times spread (DTS) for each spread product. Table 1 summarizes the attractiveness of each product when hedged into different currencies. The rank is based on the average of four different valuation measures.7 The higher the rank, the more attractive the sector is in terms of yield relative to risk measures such as both short-term and long-term volatilities, credit ratings, and DTS. Table 1Ranking Currency-Hedged, Risk-Adjusted Global Spread Product Yields A few interesting points come from the table: Emerging market (EM) USD-denominated investment grade (IG) corporate debt ranks at or near the top of the rankings, for all currencies; the opposite holds true for EM USD-denominated sovereign bonds Almost all European spread products rank poorly for non-euro denominated investors US & UK high-yield (HY) rank highly for all currencies US real estate related assets (MBS and CMBS) also rank well for all investor groups In general, US products are more attractive than European credit sectors. This is mainly because US spread products offer higher yields than European ones even after accounting for volatility and the weakening US dollar. Almost all European spread products rank poorly for non-euro denominated investors. Chart 8 shows the unhedged YTM on the x-axis and the option-adjusted spread (OAS) on the y-axis (Table 2 contains the abbreviations used in this chart and all remaining charts in this report). Unsurprisingly, the YTM and OAS follow a very tight linear relationship. However, when yields are hedged into different currencies and risk measures are factored in, the result changes. Chart 8Global Spread Product Yields & Spreads Charts 9A to 12B show the details of spread product analysis with different currency hedges and risk factors. To limit the number of charts shown, we show only currency-hedged yields adjusted by long-term trailing volatility (the rankings do not change significantly when using a shorter-term volatility measure). The y-axis in all charts shows the volatility-adjusted yields, while the x-axis shows credit ratings and DTS. Sectors that are close to upper-right in each chart are more attractive (undervalued), while spread products that are close to bottom-left are less attractive (overvalued). Chart 9AGlobal Spread Product Yields, Hedged Into USD, Adjusted For Credit Quality Chart 9BGlobal Spread Product Yields, Hedged Into USD, Adjusted For Duration-Times-Spread Chart 10AGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Credit Quality Chart 10BGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Duration-Times-Spread Chart 11AGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Credit Quality Chart 11BGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Duration-Times-Spread Chart 12AGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Credit Quality Chart 12BGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Duration-Times-Spread Table 2Global Spread Products In Our Analysis An interesting result is that when comparing the three major high-yield products (US-HY, EMU-HY and UK-HY), US-HY is the most attractive in USD terms, but UK-HY is more attractive when hedged into GBP, EUR, and JPY. Another observation is that higher quality bonds such as government-related and agency debt in the US and euro area are overvalued and less attractive given how low their yields are, regardless of their low volatility. The results from this analysis may differ from our current recommendations. For example, we currently only have a neutral recommendation on EM corporates, but based on this analysis, EM corporates offer the most attractive return in USD terms. This analysis is purely based on YTM and traditional risk factors without considering other concerns that could make EM assets riskier such as the spread of COVID-19 in major EM countries. However, these rankings do line up with our major spread product call of overweighting US IG and HY corporate debt versus euro area equivalents. Based on this analysis, EM corporates offer the most attractive return in USD terms. Bottom Line: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.fitchratings.com/research/sovereigns/coronavirus-impact-on-gdp-will-be-felt-for-years-to-come-27-07-2020 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresarch.com. 3 We use the French 10-year inflation-linked bond as the proxy for the entire euro area, as this is the oldest inflation-linked bond market in the region and thus has the most data history. 4https://www.wsj.com/articles/fed-weighs-abandoning-pre-emptive-rate-moves-to-curb-inflation-11596360600?mod=hp_lead_pos6 5 Please see BCA Research Weekly Report, “What A Weaker US Dollar Means For Global Bond Investors”, dated July 28, 2020, available at gfis.bcaresarch.com. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6, 2018, available at gfis.bcareseach.com. 7 Hedged YTM/Short-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Duration; Hedged YTM/Long-term trailing volatility vs. Duration. 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 Equities and other risk assets face near-term headwinds from the surge in Covid cases in the US Sun Belt and the looming fiscal cliff. We think these problems will be resolved, but the next few weeks could be rough sledding for markets. Government bond yields have moved sideways-to-down since late March even though inflation expectations have rebounded. The resulting decline in real yields has been an important, if rather overlooked, driver of higher equity prices. The failure of government bond yields to rise in line with higher inflation expectations can be attributed to the ongoing dovish shift in monetary policy. Nominal yields are likely to increase modestly over the next two years as growth recovers. However, inflation expectations should rise even more. Hence, real yields may fall further, justifying an overweight position in TIPS and a generally positive medium-term view on equities. As long as there is spare capacity in the economy, fiscal stimulus will not push up real yields. This is because bigger budget deficits tend to raise overall savings, thus creating the resources with which to finance the deficits. Once economies return to full employment in about three years, the fiscal free lunch will end. At that point, the combination of easy monetary and fiscal policies could cause inflation to accelerate. Central banks will welcome higher inflation initially. However, they will eventually be forced to hike rates aggressively if inflation continues to march upwards. When this happens, bond yields will rise sharply, while stocks will tumble. A Curious Divergence Government bond yields have moved sideways-to-down in most developed economies since stocks bottomed in late March (Chart 1). In contrast, inflation expectations have risen. As a result, real yields have declined. In the US, TIPS yields have fallen into negative territory across all maturities (Chart 2). Chart 1Nominal Yields Have Moved Sideways-To-Down, Inflation Expectations Have Risen, And Real Yields Have Declined Chart 2TIPS Yields Have Fallen Into Negative Territory Across The Board The decline in real yields has been one of the unsung drivers of higher equity prices this year. The forward P/E ratios of the major US indices have moved closely in line with real yields (Chart 3). Gold prices have also risen, as they are often wont to do when real yields go down (Chart 4). Chart 3Lower Real Yields Have Lifted Stock Multiple Chart 4Gold Prices Have Risen On The Back Of Falling Real Yields It is fairly uncommon for inflation expectations to rise without a commensurate increase in nominal bond yields (Chart 5). As a rule of thumb, when the economic data surprise to the upside, as has occurred over the past few months, bond yields go up (Chart 6). Chart 5It Is Unusual For Inflation Expectations To Rise Without A Corresponding Increase In Nominal Bond Yields Chart 6Bond Yields Usually Rise When Economic Data Surprise To The Upside An important exception to this rule occurs when monetary policy is becoming more expansionary. Bond yields tend to follow the path of expected policy rates (Chart 7). When central banks guide rate expectations lower, bond yields can fall, even as the reflationary impulse from lower yields delivers an upward kick to inflation projections. Chart 7ABond Yields Tend To Follow The Path Of Expected Policy Rates Chart 7BBond Yields Tend To Follow The Path Of Expected Policy Rates The last time such a divergence between yields and inflation expectations occurred was in early 2019. The stock market crash in late 2018 forced the Fed to abandon its plans to hike rates. Jay Powell’s dovish pivot occurred just three months after he said that rates were “a long way” from neutral. The Fed would go on to cut rates by 75 bps over the course of 2019. Real Yields Could Fall Further Chart 8Inflation Expectations Are Still Quite Depressed In Most Countries The key question for investors is how much longer the pattern of rising inflation expectations and stable bond yields can persist. Our sense is that nominal bond yields will rise modestly over the next few years as growth recovers. However, inflation expectations are likely to rise even more, justifying an overweight position in TIPS relative to nominal bonds. Inflation expectations are still quite depressed in most countries (Chart 8). If global growth rebounds, both actual and expected inflation should edge higher. Chart 9 shows that the US ISM manufacturing index leads core inflation by about 12-to-18 months. Higher oil prices should also lift inflation expectations (Chart 10). Will global growth recover? The answer is “yes” if we are talking about a horizon of 12 months or so. That said, as we discuss below, there are some near-term risks to growth. This implies that equities and other risk assets could trade nervously over the next few weeks. Chart 9Global Growth Recovery Will Lead To Higher Inflation Down The Line Chart 10Inflation Expectations And Oil Prices Move In Lockstep Near-Term Risks To Global Growth The two biggest threats to global growth over the coming months are the Covid outbreaks in a number of countries and the possibility that fiscal stimulus will be rolled back, especially in the US, where a “fiscal cliff” is looming. Despite progress in suppressing the virus in Europe, Japan, and most of East Asia, the number of reported daily infections continues to rise globally (Chart 11). In the developed world, the US remains a major hotspot. Although the number of cases appears to have peaked in Arizona, it is still rising in the other Sun Belt states (Chart 12). Among emerging markets, the epicenter has moved from Brazil and Russia to India (Chart 13). Chart 11Despite Progress In Europe, Japan, And Most Of East Asia, The Number Of Covid Infections Continues To Rise Globally Chart 12A Second Wave Is A Key Macro Risk Chart 13BRICs: Covid Leaving No Stone Unturned While efforts to contain the virus will boost growth in the long run, they will weigh on economic activity in the near term. Over half of the US population lives in states that have either reversed or suspended reopening plans (Chart 14). Chart 14Not So Fast Google data on visits to shopping malls, recreation centers, public transport facilities, and office destinations have dipped in recent weeks. The decline in visits has occurred alongside a decrease in the New York Fed’s high-frequency economic activity indicator (Chart 15). Initial unemployment claims also rose this week. At this point, it looks likely that the recovery in US consumer spending will stall in July and August. Chart 15Covid Outbreak Is Weighing On Spending While it is difficult to know what will happen starting in September, our guess is that the pandemic will ebb in the southern states, just like it did in the northeast. This is partly because mask-wearing is becoming more widespread. Back in early March, when most mainstream news sources were tweeting out misinformation such as “Oh, and face masks? You can pass on them,” we noted that both logic and evidence suggest that masks are an effective tool against the virus. Increased testing should also help identify asymptomatic people before they have had the chance to spread the virus to many others. Meanwhile, improved medical care should also help reduce the mortality and morbidity rates from the disease. Just this week, scientists presented the results of a double-blind clinical trial showing that the inhalation of interferon beta, a cytokine used to treat multiple sclerosis, reduced the risk of developing severe Covid symptoms by nearly 80%. Fiscal Cliff Ahead? In addition to the pandemic, investors have to grapple with uncertainty over whether fiscal policy will remain sufficiently accommodative to reflate the economy. Unlike the EU, which managed to cobble together a framework for creating a 750 billion euro pandemic relief fund earlier this week, the US Congress remains deadlocked on the size and complexion of a new stimulus bill. Under current law, US households will stop receiving expanded unemployment benefits at the end of July. These benefits were legislated as part of the original CARES Act and currently total over 4% of GDP. The Paycheck Protection Program for small businesses is also nearly drained, while state and local governments are facing a major cash crunch due to evaporating tax revenues and higher pandemic-related spending needs. We estimate that about $2-to-$2.5 trillion in new stimulus will be necessary to keep fiscal policy from turning unduly restrictive. Senate Majority Leader Mitch McConnell has been floating a number of $1.3 trillion. If McConnell gets his way, risk assets will likely sell off. Our guess is that he will not prevail, however. President Trump favors a larger stimulus bill, as do the Democrats. Critically, more than four out of five voters, both nationwide and in swing states, support extending benefits (Table 1). Thus, there is a high probability that Senate Republicans will agree on a much larger package than what they are currently proposing. Table 1There Is Much Public Support For Fiscal Stimulus Fiscal Stimulus And Bond Yields Could continued fiscal stimulus deplete national savings, leading to significantly higher real yields? For the next few years, the answer is no. National savings depend not just on how much people spend, but on how much they earn. To the extent that fiscal stimulus raises GDP, it also raises national income. For the global economy as a whole, savings must equal investment. If fiscal stimulus in the major economies prompts firms to undertake more investment spending than they would have otherwise, overall savings will rise. How can that be? The answer is that fiscal stimulus raises private savings by more than it reduces government savings when an economy is operating below its full capacity. From the perspective of the bond market, this means that currently, large budget deficits are self-financing. Bigger budget deficits will produce an even bigger pool of private income, allowing the private sector to buy more government bonds. Indeed, a premature pullback in fiscal support would almost certainly raise real rates by depressing inflation expectations. If that sounds far-fetched, recall that this is precisely what happened in March. Full Employment And Beyond Chart 16Government Debt Levels Have Surged In The Wake Of The Pandemic The fiscal free lunch will end only when economies return to full employment. At that point, bigger budget deficits will no longer be able to raise output since everyone who wants to work will already have found a job. Rather, increased government borrowing will crowd out private-sector investment. National savings will decline. If monetary and fiscal policy stay accommodative, inflation could accelerate. Central banks will probably welcome the initial burst of inflation, since they have been lamenting below-target inflation for many years now. However, if inflation continues to march higher, central banks may get spooked and start talking up the prospect of rate hikes. Higher rates would create a lot of problems for debt-saddled governments (Chart 16). It would not be at all surprising if politicians leaned on central banks to keep rates low. Governments could also end up forcing central banks to buy more debt in order to keep long-term yields from rising. In the extreme case, governments could even force central banks to cap yields. While such measures would prevent bond prices from tumbling, this would be cold comfort for bondholders. If central banks were to keep bond yields below their equilibrium level, inflation would rise even further, thus eroding the purchasing power of the bonds. In the end, central banks would still have to raise rates, probably more than they would have had they acted more swiftly to quell inflation. Investment Conclusions To answer the question posed in the title of this report, yes, bond yields will eventually go up. However, they are not likely to rise very much until inflation reaches intolerably high levels. That point is at least three years away. Despite the near-term risks posed by the pandemic and the looming fiscal cliff, investors should remain overweight equities over a 12-month horizon. Given the run-up in some of the large cap US tech names, we suggest shifting equity exposure to other parts of the stock market. The cyclically-adjusted price-earnings ratio is significantly lower outside the US, implying that international stocks are well placed to outperform their US peers over the coming decade (Chart 17). A weaker dollar should also help non-US stocks as well as the more cyclical equity sectors (Chart 18). Chart 17Non-US Stocks: The Place To Be Over The Coming Decade Chart 18A Weaker Dollar Should Boost Non-US Stocks Along With The More Cyclical Equity Sectors Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights Money Supply Drivers: About 70% of the unprecedented increase in broad money supply is the result of the Fed’s asset purchase activity. The remaining 30% is due to an uptick in C&I loan growth, almost all of which is from nonfinancial firms tapping existing credit lines, an activity that will taper off in the coming months. Money Supply Impact: We don’t find broad money supply measures (M1 and M2) to be useful indicators of economic growth, inflation or financial asset performance. Bank Bonds: After viewing the results of the Fed’s stress tests, we still think the odds of bank ratings downgrades this year are low. Investors should stay overweight subordinate bank bonds. Feature The COVID-19 recession and associated policy response have led to unprecedented moves in a number of economic indicators. In this week’s report we focus on one such move that is particularly difficult to square with the rest of the economic landscape, at least judging by the large volume of client questions we’ve received on the topic. The move in question: Broad money supply growth (M1 & M2) is faster today than at any time since the mid-1940s (Chart 1). This week, we look at what has driven money growth to such heights and consider what it might mean for bond investors. We also update our call to overweight subordinate bank bonds based on last week’s release of the Fed’s bank stress tests. Chart 1Massive Money Growth! Money Supply Drivers The US economy’s broad money supply is more or less the sum total of all the money sitting in bank deposits at any point in time. More specifically, the M1 measure includes currency in circulation, demand deposits and traveler’s checks. The M2 measure includes all of M1 plus savings accounts, time deposits and retail money market funds. Fed asset purchases and bank lending are the two drivers of money supply growth. There are two ways for these broad money supply measures to grow. First, the Fed can purchase securities from the private market. Second, banks can lend money to the private sector. We consider both of these drivers in turn. The Federal Reserve’s Contribution To Money Growth The Fed influences the money supply by changing the amount of reserves in the banking system. To see how this works, Table 1 shows recent balance sheets for both the Fed and the aggregate US banking system. Table 1The Link Between The Fed’s Balance Sheet And The Aggregate US Banking System The largest line items on the Fed’s balance sheet are the securities it owns (on the asset side) and the reserves it supplies to the banking system (on the liability side). The Treasury Department’s General Account has also become a sizeable liability for the Fed during the past couple of months (see Box). Box 1: The Large Treasury General Account Is Not Stimulus Waiting To Be Deployed The Treasury General Account (TGA), aka the Treasury Department’s cash account at the Fed, has skyrocketed during the past couple of months and now totals $1.6 trillion (Chart 3). This has prompted more than a few client questions, mostly asking whether this large amount of money represents fiscal stimulus that is waiting to be deployed. Chart 3Treasury Holds A Huge Cash Buffer It does not. Any new fiscal stimulus must be authorized by Congress and with most of the funds from the CARES act having already been paid out, any further fiscal stimulus is contingent upon Congress passing a follow-up bill. So why is the TGA balance so large? The Treasury Department’s job is to finance the federal government’s deficit by issuing bonds. To do this, it must make estimates about what tax revenues and government spending will be in the future. To avoid a situation where it has not issued enough bonds to finance the deficit, it will typically err on the side of caution and issue some extra bonds, holding the proceeds in cash in its account at the Fed. Due to the heightened uncertainty of the current macro environment, it recently decided to target a larger-than-usual cash balance of $800 billion. It even overshot that target during the past couple of months, likely because tax revenues came in higher than expected. Going forward, heightened uncertainty about federal deficit projections will ensure that the Treasury continues to hold an elevated cash balance. However, it will probably try to bring the TGA balance down a bit in the second half of the year, closer to its stated $800 billion target. It will accomplish this by simply issuing fewer T-bills in the second half of the year. This will have the result of increasing the broad money supply through the same mechanism as Fed asset purchases. That is, any drawdown in the TGA increases the amount of reserves supplied on the liability side of the Fed’s balance sheet. When the Fed buys a Treasury security it removes that security from the private market and replaces it with cash in the form of a bank reserve. Those bank reserves are a liability for the Fed, but appear on the asset side of the banking sector’s aggregate balance sheet. Please note that the amount of reserves supplied on the Fed’s balance sheet in Table 1 doesn’t exactly match the amount of reserves shown on the banking sector’s balance sheet. This is only because the numbers were recorded on different days. Turning to the banking sector’s balance sheet, we see that when the amount of reserves increases there are only a few different things that can occur to keep the balance sheet in balance. Banks can accommodate the increase in reserves by reducing the amount of loans or securities they hold. Alternatively, banks can raise capital, borrow in private debt markets or show an increase in deposits. When banks accommodate the increase in reserves by raising deposits, the money supply rises. Charts 2A and 2B show the change in the main items on the aggregate banking system balance sheet since the end of February. First, we see that banks did not reduce their other asset holdings in response to the sharp increase in reserves. Neither did they raise capital or debt. Rather, deposit growth accommodated the entire increase in bank reserves. Chart 2AChange In Commercial Bank Assets: February 26 To June 17, 2020 Chart 2BChange In Commercial Bank Liabilities & Capital: February 26 To June 17, 2020 In fact, deposits have grown by about $2 trillion since February compared to reserve growth of $1.4 trillion. Roughly, we can say that Fed asset purchases are responsible for 70% of the growth in the money supply since then. The remaining 30% is attributable to the second driver of the money supply: bank lending. Bank Lending’s Contribution To Money Growth Looking again at Table 1, we see that an increase in bank loans must also lead to an increase in deposits, unless the bank raises debt and/or capital instead. Further, Chart 2A shows that increased bank lending since February accounts for about 30% of the growth in deposits. However, we expect bank loan growth to moderate in the coming months, easing some of the upward pressure on the money supply. This year's increase in bank loan growth has been driven entirely by C&I loans. A look at bank loan growth by category shows that this year’s increase has been driven entirely by Commercial & Industrial (C&I) loans (Chart 4). Growth in other major loan categories – commercial real estate, residential real estate and consumer – has flagged. Further, the increase in C&I lending has been mostly due to firms drawing on existing credit lines. Chart 4A Spike In C&I Lending The Fed’s Senior Loan Officer Survey for the first quarter of 2020 showed a small increase in C&I loan demand. But the survey also asked about potential reasons for the demand uptick (Chart 5). When faced with that question, 95% of respondents reported that “precautionary demand for cash” was a “very important” reason for increased C&I loan demand in Q1. 71% of respondents also pointed to a lack of internally generated funds as a “very important” reason. Importantly, no respondents reported increased C&I loan demand due to investment needs or M&A activity. Chart 5Possible Reasons For Greater C&I Loan Demand In Q1 2020 The distinction is important. Greater investment needs and M&A activity would suggest an improving economic back-drop, and would imply a more sustainable increase in bank lending. In contrast, there is a limit to how much firms can tap existing credit lines for immediate cash needs, and this activity should taper off during the next few months. Bottom Line: About 70% of the unprecedented increase in broad money supply is the result of the Fed’s asset purchase activity. The remaining 30% is due to an uptick in C&I loan growth, almost all of which is from nonfinancial firms tapping existing credit lines, an activity that will taper off in the coming months. The Implications Of Rapid Money Growth According to some theory and popular thought, there are three possible channels through which rapid money growth could impact the economy and financial markets: Fast money growth could lead to stronger economic growth in the future. Fast money growth could lead to rising inflationary pressures. A larger money supply could suggest that there are more funds available to deploy in financial markets. As such, it could lead to price appreciation in risky financial assets. We are inclined to downplay the importance of M1 and M2 as indicators in all three of these areas, for reasons discussed below. The Money Supply’s Impact On Economic Growth In the past, measures of the broad money supply (M1 and M2) did a good job of forecasting economic growth and were tracked closely (and at times targeted) by the Federal Reserve. But as the banking and monetary systems evolved, M1 and M2 became less important. As Fed Chairman Alan Greenspan explained in 1996:1 At different times in our history a varying set of simple indicators seemed successfully to summarize the state of monetary policy and its relationship to the economy. Thus, during the decades of the 1970s and 1980s, trends in money supply, first M1, then M2, were useful guides. […] Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy. Chairman Greenspan’s insight is backed up by the empirical data (Chart 6). Real M2 growth was an excellent leading indicator of economic growth until the early 1990s. The relationship has broken down since then, and in fact, the only reliable trend in Real M2 since the 1990s is that it tends to spike during recessions. Chart 6Broad Money Growth Has Been A Poor Indicator For Economic Activity Since The 1990s The Conference Board also noticed this trend and removed Real M2 from its Leading Economic Indicator in 2012. According to the Conference Board, Real M2 ceased to function as a leading economic indicator because (i) the Fed began targeting interest rates instead of monetary aggregates and (ii) the creation of interest-bearing checking accounts and money market funds increased safe haven demand for M2. The latter helps explain why money growth has surged during the last three recessions. All in all, broad money growth is now a poor indicator for GDP. The Money Supply’s Impact On Inflation Another popular theory is that money growth is a leading indicator of inflation. This stems from the following identity, aka the Equation of Exchange: MV = PY Where: M = money supply, V = velocity of money, P = price level and Y = real output The identity holds, but is of little practical value, mainly because there is no good way to measure (or model) velocity (V) without relying on money growth and nominal GDP (P*Y). This means that an increase in the money supply doesn’t necessarily tell us anything about inflation, because we have no idea how velocity will respond. In fact, many commentators have observed that the stronger empirical correlation is actually between money velocity (PY/M) and core inflation (Chart 7). When nominal GDP growth exceeds money growth, core inflation tends to rise 18 months later. However, this relationship also holds if we remove money supply from the equation entirely (Chart 7, bottom panel). What we’re actually observing is that core inflation tends to lag economic growth by about 18 months. Chart 7Inflation Lags Economic Growth, Not Broad Money Growth Since we’ve already seen that money supply does a poor job forecasting economic growth, it’s clear that indicators such as M1 and M2 don’t improve our ability to forecast inflation, and in fact probably only confuse the picture. The Money Supply’s Impact On Financial Markets BCA’s US Bond Strategy definitely subscribes to the notion that the stance of monetary policy is one of the most important drivers of financial market performance. If the Fed keeps interest rates low and signals to the market that rates will stay low for a long time, then we would expect investors to chase greater returns in riskier assets, driving up the prices of corporate bonds and equities. That being said, the appropriate way to measure the stance of monetary policy is with interest rates. Money supply measures like M1 and M2 are not helpful guides for risk asset performance. We have already seen that an increase in the money supply can only arise via (i) greater bank lending or (ii) the Fed’s purchase of securities and injection of reserves into the banking system. Both of these things are likely to occur when interest rates are low and monetary policy is accommodative. Low interest rates boost loan demand, and large-scale Fed asset purchases are more likely to occur when interest rates are already at the zero-lower-bound. We would argue that it is, in fact, low interest rates that influence both money growth and financial asset prices. The drivers of money supply growth – bank lending and Fed asset purchases – don’t offer any new information beyond what the interest rate already tells us. On loan growth, both loan demand and risk asset price appreciation are functions of low interest rates. In fact, financial markets will respond more quickly to changes in interest rates than will bank lending: Stock prices are included in the Conference Board’s Leading Economic Indicator, while C&I bank lending is included in the Lagging Economic Indicator.2 This means that, practically, any money supply growth that is driven by bank lending is not useful as an indicator for financial asset prices. What about money growth that is driven by Fed asset purchases? Here, we need to distinguish between the signaling impact of Fed asset purchases and any other potential impact that purchases might have on asset prices. In the first half of 2019, financial markets responded to the Fed's dovish interest rate policy, not to its shrinking balance sheet. Though the data are difficult to parse, our reading is that the only meaningful impact of Fed purchases on financial asset prices is through what the purchase announcements signal to markets about the future path of interest rates. To test this theory, we need to search for periods when the Fed’s signaling about its future interest rate policy diverges from its balance sheet policy. That is, we need to find periods when the balance sheet is shrinking and Fed rate guidance is becoming more dovish, or periods when the balance sheet is growing and rate policy is becoming more hawkish. Unfortunately, we can only identify one such period and that is the first half of 2019 when the Fed was simultaneously shrinking its balance sheet and signaling to markets that interest rate policy was becoming more dovish (Chart 8A). During that period, financial markets responded to the more dovish interest rate policy and not to the shrinking of the Fed’s balance sheet (Chart 8B). Bond yields fell, the dollar weakened and both corporate bonds and equities delivered strong returns. Chart 8ARates Policy Trumps Balance Sheet Part I Chart 8BRates Policy Trumps Balance Sheet Part II Bottom Line: We don’t find broad money supply measures (M1 and M2) to be useful indicators of economic growth, inflation or financial asset performance. Subordinate Bank Bonds: Still In The Sweet Spot Chart 9Still In The Sweet Spot Two months ago we made the case for owning subordinate bank bonds.3 The premise for this call is that subordinate bank bonds are a high-quality cyclical sector, exactly the sweet spot of the investment grade corporate bond market that we want to own in the current environment. We expect that extraordinary Fed support for the market will cause investment grade corporate bond spreads to tighten during the next 6-12 months. In that environment we want to focus on cyclical (or “high beta”) bond sectors, ones that outperform the index during periods of spread tightening. However, we also recognize that the Fed’s emergency lending facilities will not prevent a surge in ratings downgrades. Therefore, the sweet spot we want to own is cyclical bonds that are unlikely to be downgraded. High-quality Baa-rated securities, like subordinate bank bonds, fit the bill nicely. Chart 9 shows that the subordinate bank bond index has a duration-times-spread ratio above 1.0.4 This confirms that the sector will trade cyclically relative to the corporate benchmark. We also see that subordinate bank bonds have outperformed both the overall corporate index and other Baa-rated bonds since the start of the year (Chart 9, panel 2). Further, subordinate bank bonds offer a spread pick-up versus the corporate index in both option-adjusted spread terms (Chart 9, panel 3) and 12-month breakeven spread terms (Chart 9, bottom panel). What Did We Learn From The Stress Tests? Last week the Fed released the results of its 2020 bank stress tests. Results for individual banks were released for a “severely adverse scenario”, the details of which had been publicly available since February. However, because of concern that the “severely adverse scenario” wasn’t dire enough to capture the potential fallout from the pandemic, the Fed also stress tested three COVID-specific scenarios and released results only for the banking system in aggregate. The three scenarios are: A ‘V’-shaped recovery, where economic growth recovers in Q3 and Q4 of this year after contracting significantly in the first half. A ‘U’-shaped recovery, where the growth pick-up in the second half of 2020 is much milder. A ‘W’-shaped recovery, where economic growth recovers in Q3 but then dips again near the end of the year. Table 2 shows a few key assumptions of the three scenarios along with how the actual economy is tracking. It seems that, absent the re-imposition of lock-down measures, the economy is tracking to be in a slightly better place than in any of the three scenarios. Note that the unemployment rate has already peaked below 15%, lower than assumed by any of the three scenarios. Table 2Three Stress Test Scenarios* Chart 10Banks Have Huge Capital Buffers Chart 10 shows the Common Equity Tier 1 Capital Ratio for the aggregate banking sector, and the dashed horizontal lines show how far it would fall in the three different COVID scenarios. The results show that the ‘V’-shaped scenario is manageable for the banking system, but a significant number of banks would run into trouble in the ‘U’ and ‘W’ shaped scenarios. The good news for bank credit quality is that, based on how the economy is tracking and the prospects for further fiscal stimulus, the worst ‘U’ and ‘W’ shaped scenarios will probably be avoided. Further, the Fed has already suspended share buybacks and capped dividend payouts. It will also re-run the stress tests later this year. Another round of stress tests this year is credit positive, as it will encourage banks to strengthen their capital buffers during the next few months. Bottom Line: After viewing the results of the Fed’s stress tests, we still think the odds of bank ratings downgrades this year are low. Investors should stay overweight subordinate bank bonds. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Footnotes 1 https://www.federalreserve.gov/BOARDDOCS/SPEECHES/19961205.htm 2 https://www.conference-board.org/data/bci/index.cfm?id=2160 3 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 4 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights We conservatively estimate lost output from shutdowns and social distancing will equal $10 trillion, and we expect the jobs market to be permanently scarred. Inflation, even at 2 percent, is a pipe dream, which leads to three investment conclusions on a 1-year horizon: Overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs. Any high-quality bond yield that can decline will decline. Overweight CHF/USD. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities (technology and healthcare) versus cyclical equities (banks and energy). This implies underweight European equities versus other markets. Fractal trade: Short Germany versus the UK. The recent outperformance of German equities is technically extended. Feature Chart of the WeekCredit Impulses Are Large, But The Hole In Output Is Much Larger Big numbers befuddle us. Hardly a day passes without someone listing the unprecedented global stimulus unleashed to counter the coronavirus forced shutdowns – the trillions in government spending promises, tax relief, loan guarantees, money supply growth, and central bank asset-purchases. The most optimistic estimates quantify the total stimulus at $15 trillion. This includes $7 trillion of loan guarantees plus increases in central bank balance sheets which do not directly boost demand. So the direct stimulus is closer to $7 trillion.1 Yet the size of the stimulus is meaningless until we quantify the massive hole in economic output that needs to be filled. Assuming no further large-scale shutdowns, we conservatively estimate that the hole will amount to 12 percent of world output, or $10 trillion. A $10 Trillion Hole In Output Last week, the UK’s Office for National Statistics (ONS) helped us to estimate the hole in output, because unusually the ONS calculates UK GDP on a monthly basis. Between February and April, when the UK economy went from fully open to full shutdown, UK GDP collapsed by 25 percent. This despite the UK having an outsized number of jobs suitable for ‘working from home.’ For a more typical economy, we estimate that a full shutdown collapses output by 30 percent (Chart I-2). Chart I-2A Full Shutdown Collapses Output By 30 Percent The next question is: how long does the full shutdown last? Assuming it lasts for three months, output would suffer a hole amounting to 7.5 percent of annual GDP.2 But in practice, the economy will not fully re-open after three months. Social distancing will persist until people feel confident that the pandemic is under control. An effective vaccine against Covid-19 is unlikely to be available for a year. So, even without government policy to enforce social distancing, many people will choose to avoid crowds and congregations for fear of catching the virus. The size of the stimulus is meaningless until we quantify the massive hole in economic output. This means that the sectors that rely on crowds and congregations – leisure and hospitality and retail trade – will be operating at half-capacity, at best. Given that these sectors generate 9 percent of GDP, operating at half-capacity will create an additional hole amounting to 4.5 percent of output. More worryingly, these two sectors employ 21 percent of all workers, so operating at sub-par will leave the jobs market permanently scarred.3 Combining the 7.5 percent existing hole with the 4.5 percent future hole, the full hole in economic output will amount to around 12 percent of annual GDP. As global GDP is worth around $85 trillion, this equates to $10 trillion. Crucially though, our estimate assumes that a second wave of the pandemic will not force a new cycle of shutdowns. If it does, the hole will become even bigger. Don’t Be Fooled By Money Supply Growth The recent growth in broad money supply seems a big number. Since the start of the year, the outstanding stock of bank loans has increased by around $0.7 trillion in the euro area, and by $1 trillion in both the US and China (Chart I-3 and Chart I-4). This has boosted the 6-month credit impulses in all three economies. Indeed, the US 6-month credit impulse recently hit its highest value of all time, and the combined 6-month impulse across all three blocs equals around $2 trillion (Chart of the Week). Chart I-3Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Chart I-4...And In ##br##China This 6-month credit impulse quantifies the additional borrowing in the most recent six-month period compared to the previous period. Ordinarily, a $2 trillion impulse would create a huge boost to demand. After all, the private sector does not usually borrow just to hold the cash in a bank. Yet in the coronavirus crisis this is precisely what has happened. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers. Therefore, much of the money growth will not generate new demand. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers. To the extent that this cash is sitting idly in a firm’s bank account, the monetary velocity will decline. Meaning there will be a much-reduced transmission from credit impulses to spending growth. Furthermore, when the economy re-opens, many firms will relinquish the precautionary credit lines. There is no point holding cash in the bank when there are few investment opportunities. Hence, credit impulses will fall back – as seems to be the case right now in the US. QE: The Great Misunderstanding To repeat, big numbers befuddle us. They must always be put into context. No truer is this than when it comes to central bank asset-purchases. The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Central banks act as lenders of last resort to solvent but illiquid banks and sovereigns. If there is ample liquidity in these markets – as is the case now – then the primary function of central bank asset-purchases is to set the term-structure of interest rates. In turn, the term-structure of global interest rates establishes the prices of $500 trillion of global assets. The prices of these assets are inextricably inter-connected and inter-dependent4 (Chart I-5). Chart I-5The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Yet central banks set no price target for their asset-purchases. They leave that to the market. Moreover, in the context of the $500 trillion of inter-dependent asset prices, the $10-15 trillion or so of central bank asset-purchases to date constitutes chicken feed (Chart I-6). Hence, the mechanism by which asset-purchases work is through the signal they give to the $500 trillion market on the likely course of interest rate policy. This sets the term-structure of interest rates, which in turn sets the required return on all the $500 trillion of assets (Chart I-7). Chart I-6$10-15 Trillion Of QE Is Chicken Feed... Chart I-7...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates As the ECB’s former Chief Economist, Peter Praet, explains: “There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. This credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these asset purchases are a concrete demonstration of our desire (to keep policy rates at the lower bound.)” The credible commitment to keep policy rates near the lower bound for an extended period depresses bond yields towards the lower bound too. But once bond yields have reached their lower bound the effectiveness of central bank asset-purchases becomes exhausted. Three Investment Conclusions The main purpose of this report was to put the $7 trillion of direct stimulus dollars unleashed into the economy into a proper context. With lost output estimated at $10 trillion and the jobs market permanently scarred, inflation – even at 2 percent – is a pipe dream. Moreover, a second wave of the pandemic and a new cycle of shutdowns would inject a further disinflationary impulse. This leads to three investment conclusions on a 1-year horizon: Any high-quality bond yield that can decline – because it is not already near the -1 percent lower bound to yields – will decline. An excellent relative value trade is to overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs (Chart I-8). Long CHF/USD is a win-win. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities versus cyclical equities, with technology correctly defined as defensive, not cyclical. The performance of cyclicals (banks and energy) versus defensives (technology and healthcare) is now joined at the hip to the bond yield (Chart I-9). This implies underweight European equities versus other markets. Chart I-8Bond Yields That Can Decline Will Decline Chart I-9The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield Fractal Trading System* The recent outperformance of German equities is technically extended. Accordingly, this week’s recommended trade is to go short Germany versus the UK, expressed through the MSCI dollar indexes. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long euro area personal products versus healthcare achieved its 7 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 65 percent. 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. * 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. Footnotes 1 Source: Reuters estimate. 2 A 30 percent loss in output for a quarter of a year (3 months) amounts to a 30*0.25 = 7.5 percent loss in annual output. 3 Using the weights of leisure and hospitality and retail trade in the US economy as a proxy for the global weights. 4 The $500 trillion of assets comprises: real estate $300 trillion, public and private equity $100 trillion, corporate bonds and EM debt $50 trillion, and high-quality government bonds $50 trillion. 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