Recession-Hard/Soft Landing
Highlights Financial markets are in a state of upheaval, and no one knows where or when they’ll bottom: We reiterate that it’s too early to dive back into equities or spread product. The policy path is not nearly as clear as it was during the last crisis, and central banks and legislatures may be hard-pressed to blunt the effects of a pandemic until it’s contained: Developed-world central banks and legislatures are committed to doing whatever they can to aid their economies, but their measures won’t gain full traction until the coronavirus is bottled up. Uncertainty breeds opportunities, however, … : There’s a good chance that the baby will be thrown out with the bathwater as the selling accentuates and turns indiscriminate. … so we’re seeking out the most attractive risk-reward profiles: Those with cash who keep their head may find multiple opportunities to earn outsized profits. We’re actively trying to insulate ourselves from the current surge of emotion. Feature We don’t know. We don’t know where stocks will bottom, or when. We don’t know how much the economy will contract, or how long second-round effects will extend the recession. We don’t know how many businesses will go bust, or how many people will lose jobs and default on mortgages and other loans. But no one ever does in the midst of crashes, or when a sudden-stop economic tsunami looms, and only the foolish, naïve or arrogant think they do. Investing is never a sure thing, and its difficulty is a feature, not a bug. Alpha is earned by correctly intuiting securities’ future direction from a limited number of data points. We were slow to grasp the global health ramifications of the coronavirus outbreak in Wuhan, and the probability of a 2020 recession turned out to be considerably larger than we judged. We were also off the mark when we said the economy would likely bottom swiftly, roughly tracing the course of a V. We did not foresee the economically crippling strictures that would be imposed to slow COVID-19’s spread. We now recognize that the recession will be quite severe and that the market rout has further to go for as long as the self-reinforcing adverse consequences from quarantine-like conditions continue unabated. We suspect that markets are giving short shrift to the idea that something could short-circuit the vicious circle, however, and on that basis we think the outlook may not be as unrelentingly gloomy as market action is making it out to be. To be clear, we do not think risk assets have bottomed. We do not think investors should be in any rush whatsoever to buy stocks or spread product. Investors with cash should not lose sight of the fact that they are in control right now, and they should strike a hard bargain before parting with it. We still have a constructive 12-month view, however, and we do think investors should be making lists of assets they find attractive and the prices where they’d happily own them. We sketch out the reasons why across the following pages, but the nature of the analysis departs from our typical data-driven process. Market action has left the data far behind as investors have rushed to apply valuation haircuts in advance of economic releases that are sure to be dreadful. We are therefore pulling our focus out to 30,000 feet in this report, and highlighting the mindset we’re trying to bring to the task of navigating markets caught in the throes of peak fear. Crises Happen [W]hen the crisis began, governments around the world were too slow to act. When action came, it was late and inadequate. Policy was always behind the curve, always chasing an escalating crisis. And as the crisis intensified and more dramatic government action was required, the emergency actions meant to provide confidence and reassurance too often added to public anxiety and to investor uncertainty. The force of government support was not comprehensive or quick enough to withstand the deepening pressure brought on by a weakening economy. … We believe that the policy response has to be comprehensive, and forceful. There is more risk and greater cost in gradualism than in aggressive action. We believe that action has to be sustained until recovery is firmly established.1 Monetary and fiscal policy measures can still move markets, but their full effect won't be felt until the coronavirus is contained. Here we go again. Confronted with freefalling markets and the prospect of widespread business failures, Congress is preparing a gigantic fiscal stimulus package aimed at limiting the second-order effects of the crippling measures implemented to stem COVID-19’s spread and the Fed has already raided its 2008-9 playbook (Table 1). Officials could lift much of Treasury Secretary Geithner’s 2009 remarks announcing the stress tests to explain the rationale for the measures they’re proposing now. The difference is that policymakers in 2008 and 2009 could directly wield their monetary and fiscal tools to backstop a wobbling banking system, whereas now, the potent resources they’ve marshaled to spur the economy won’t be able to take full effect until the pandemic recedes. Table 1Borrowing From The 2008-09 Playbook As much as investors pine for a policy measure that puts a firewall around markets, and the cumulative global monetary and fiscal responses become truly substantial, the selloff may continue to rage until withering deleveraging pressure abates. The pattern may be very similar to 2009, when the S&P 500 didn’t bottom until four weeks after the financial crisis effectively ended upon Secretary Geithner’s pledge that the Treasury would provide sufficient capital to any of the largest 19 banks that failed the stress tests (Chart 1). Chart 1Deleveraging Pressure Might Drag On Stocks Even After Policymakers Fire Their Bazookas One Damn Thing After Another As we noted at the outset, investors are currently bedeviled by a multitude of significant unknowns about the coronavirus. Even epidemiologists don’t know if social distancing measures will be enough to arrest its spread within the US, how severe the mortality rate will be, or how long it will take to develop more effective treatment protocols. The current plunge was triggered by a pandemic that hadn’t occurred on a similar scale since the 1918-19 Spanish influenza outbreak, but significant unknowns are at the heart of every financial market panic. We were in the audience at the Economic Club of New York in October 2007, during the early stages of the subprime crisis, when Fed Chair Bernanke, asked what market and economic information he would like to have to improve the Fed’s decision-making process, replied, “I’d like to know what those damn things [securitized credit products] are worth.”2 Markets’ Outstanding Characteristic As Benjamin Graham pointed out repeatedly in The Intelligent Investor, markets have a deeply entrenched tendency to overreact. “The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.”3 “[W]hen an individual company … begins to lose ground in the economy, Wall Street is quick to assume that its future is entirely hopeless and it should be avoided at any price.”4 “[T]he outstanding characteristic of the stock market is its tendency to react excessively to favorable and unfavorable influences.”5 In times of severe stress, the market tendency to overreact at the individual-stock level radiates out to the entire market. As the buzzards circle, and the margin calls arrive, investors scramble to sell stocks that have managed to dodge the brunt of the decline, and therefore bring something closer to their perceived fair value than the stocks that have already been savaged. In Dennis Gartman’s memorable phrasing, “when the cops raid the house of ill repute, they take away the good girls and the piano player, too.” The indiscriminate selling that draws better stocks into the vortex creates opportunities, and it seems to us that there must be many sound issues that are being tarred with the same brush as companies in the travel, hospitality, restaurant and brick-and-mortar retail industries, and the oil producers who are caught in the Russia-Saudi Arabia crossfire. Outstanding Investors’ Characteristics About 25 years ago, we read the Market Wizards profiles of elite traders before interviewing for trading positions with broker-dealers. We distilled them into seven characteristics of successful traders that were at the heart of our pitch: Competitiveness, Humility, Ability to Psychologically Handle Losses, Patience, Discipline, Emotional Detachment and Willingness to Be a Contrarian. We haven’t worked on a trading desk in a while, but those qualities would suit all investors, and we think they’re especially apropos at times of peak emotion. No one can manufacture them out of nothing, but by keeping them in mind, and trying to live up to them, we can draw on the reserves we do possess to make better decisions in the midst of the rout (Table 2). Cash is precious right now, and investors should part with it only when they're certain they're getting quite a bit in return. Table 2Honing One's Mental Edge What Now? We reiterate that it is too early to re-risk portfolios. Markets in the throes of daily convulsions are not healthy markets, and we do not expect that stocks will bottom until there is evidence that the global virus infection curve is flattening. Investors should always prune or exit positions that have become poor fits as the backdrop changes, but we would not dramatically alter asset allocation strategies now. Take a deep breath, and focus on the internal aspects you can control. Cash is precious during major selloffs, because it stabilizes portfolios while the storm rages and provides valuable optionality when it inevitably ends. We would deploy it slowly, via limit orders below the market in selected stocks that have been unfairly lumped in with the most vulnerable issues. We continue to embrace the idea of writing out-of-the-money puts in stocks we would happily own at lower levels. When the VIX spent most of last week in the 70s and 80s (Chart 2), implied volatilities on single-stock options soared into the triple digits. In the four largest banks, it was possible to earn an annualized return exceeding 100% by writing an April put between 12 and 15% below last sale (Box, page 8). Similar opportunities must be available in other besieged industries. Chart 2Implied Volatility On S&P 500 Index Options Made A New All-Time High These are unquestionably trying times for investors of all stripes, but they are especially hard on those with long-only mandates. Professional investors add much of their value by saving their clients from themselves – by keeping them from succumbing to the temptation to go all-in near market tops and run screaming from risk assets near market bottoms. We all need to make a conscious effort to overcome counterproductive emotions and impulses when markets plunge; reminders that the general pattern is similar, even if the specific circumstances change, help us to keep our eye on the ball. Trying to live up to the seven items we memorized 25 years ago when trying to secure a junior seat on a trading desk does, too. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Box: Extreme Volatility In SIFI Bank Options There are two possible outcomes for an investor who writes a put option. The option will expire without being exercised, in which case the writer will pocket the premium, or the holder will exercise it, compelling the writer to purchase the stock at the strike price. The writer keeps the premium in that case, too, so that his/her basis in the stock is equivalent to the strike price less the premium. The top panel in Table 3 shows the pricing data for April puts on the four largest banks with strike prices 12 to 15% below Thursday’s closing prices. The bottom panel uses that data to calculate the implied annualized return for each put option in the event that it is not exercised, and the option writer’s basis in the stock as a share of its tangible book value in the event that it is. Table 3Insuring SIFI Equities Is Tremendously Expensive We understand that banks are on the credit front lines, and that defaults will impair their book value. We further understand that their net interest margins, and therefore their revenues, are pressured by declines in longer-term interest rates, though it is our long-held conviction that markets overestimate the largest banks’ exposure to a flattening yield curve. The decision to own them is hardly a slam dunk, but the cost of insuring against further declines is staggering. We recognize that not every investor has discretion to write puts, and it is not something to be done lightly in any event. Writers of puts on SIFI banks are being paid annualized returns of 100% because equity prices are plunging, and investors are especially worried about banks’ exposure to the spreading pain. The compensation is so high, however, that we think the risk-reward proposition merits careful consideration. It may not be a no-brainer to write puts on the SIFI banks right now, but we certainly wouldn’t buy them at these prices. Footnotes 1 Prepared Remarks by Treasury Secretary Timothy Geithner Introducing the Financial Stability Plan, February 10, 2009. Accessed from https://www.treasury.gov/press-center/press-releases/Pages/tg18.aspx on March 18, 2020. 2https://www.econclubny.org/legacyarchive/-/blogs/2007-ben-bernanke Accessed on March 18, 2020. The referenced Q&A exchange begins at the 51:49 mark. 3 Graham, Benjamin, The Intelligent Investor, HarperCollins: New York, 2005, p. 97. 4Ibid, p. 15 5Ibid, p. 18
Highlights Policy Responses: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Fixed Income Strategy: With a global recession now a certainty, bond yields will remain under downward pressure and credit spreads should widen further. Given how far yields have already fallen, we recommend emphasizing country and credit allocation in global bond portfolios, while keeping overall duration exposure around benchmark levels. Model Portfolio Changes: Following up on our tactical changes last week, we continue to recommend overweighting government debt versus spread product. Specifically, overweighting US & Canadian government bonds versus Japan and core Europe, and underweighting US high-yield and all euro area and EM credit. Feature In stunning fashion, the sudden stop in the global economy due to the COVID-19 pandemic has triggered a rapid return to crisis-era monetary and fiscal policies. The battle has now shifted to trying to fill the massive hole in global private sector demand left by efforts to contain the spread of the virus. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. Fiscal policy, combined with efforts to boost market liquidity and ease the coming collapse of cash flows for the majority of global businesses, are the only plausible options remaining. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. While the speed of these dramatic policy moves is unprecedented, the reason for them is obvious. Plunging equities and surging corporate bond credit spreads are signaling a global recession, but one of uncertain depth and duration given the uncertainties surrounding the spread of COVID-19 (Chart of the Week). Chart of the WeekCan Crisis-Era Monetary Policies Be Effective During A Pandemic? Chart 2Risk Assets Will Not Bottom Until New COVID-19 Cases Ex-China Peak The ability for policymakers to calibrate stimulus measures is pure guesswork at this point. The same thing goes for investors who see zero visibility on global growth, with the full extent of the virus yet to be felt in large economies like the United States and Germany – even as new cases in China, where the epidemic began, approach zero. The response from central bankers has been swift and bold – rapid rate cuts, increased liquidity programs for bank funding and increased asset purchases. The fact that global financial markets have remained volatile, even after what is a clear coordinated effort from policymakers, highlights how the unique threats to growth from the COVID-19 pandemic may be beyond fighting with traditional demand-side stimulus measures. We continue to recommend a cautious near-term investment stance, particular with regards to corporate bond exposure, until there is clear evidence that the growth rate of new COVID-19 cases outside China has peaked (Chart 2). Policymakers Throw The Kitchen Sink At The Problem The market moves and policy announcements have come fast and furious this past week, from virtually all major economies. We summarize some of the moves below: United States The Fed cut rates by -100bps in a Sunday night emergency move, taking the funds rate back to the effective lower bound of 0% - 0.25%. Importantly, Fed Chair Powell made it clear at his press conference that negative rates are not on the table, suggesting that we may have seen the last of the rate cuts for this cycle. A new round of quantitative easing (QE) was also announced, with purchases of $500 billion of Treasury securities and $200 billion of agency MBS that will occur in the “coming months”; Powell hinted that those amounts could be increased, if necessary (Chart 3). The MBS purchases are a clear effort to help bring down mortgage rates, which have not declined anywhere near as rapidly as US Treasury yields during the market rout (bottom panel). The Fed also cut the discount window rate – the rate at which banks can borrow from the Fed for periods of up to 90 days – by -150bps, bringing it down to 0.25%. The Fed said it is “encouraging banks to use their capital and liquidity buffers” – essentially telling banks to hold less cash for regulatory purposes. The Fed also reduced the rate on its US dollar swap lines with other central banks. The new rate is OIS +25bps. Coming on top of the massive increase in existing repo lines last week, the Fed is attempting to ensure that banks, both in the US and globally, that need USD funding have more liquidity available to support lending. Already, there are signs of worsening liquidity in the bank funding markets, like widening FRA-OIS spreads, but also evidence of illiquidity in financial markets like wide bid-ask spreads on longer-maturity US Treasuries and the growing basis between high-yield bonds and equivalent credit default swaps (Chart 4). Chart 3A Return To Fed QE Chart 4Market Liquidity Issues Forced The Fed's Hand Turning to fiscal policy, the full response of the Trump administration is still being formed, but a major $850bn spending package has been proposed that would provide tax relief for American households and businesses while also including a $50bn bailout of the US airline industry. This comes on top of previously announced plans to offer free testing for the virus, paid sick leave, business tax credits and a temporary suspension of student loan interest payments. Chart 5The ECB Has Limited Policy Options Euro Area The European Central Bank (ECB) unexpectedly made no changes to policy interest rates last week. It opted instead to increase asset purchases by €120bn until the end of 2020 (both for government bonds and investment grade corporates), while introducing more long-term refinancing operations (LTROs) to “provide a bridge” to the targeted LTRO (TLTRO-3) that is set to begin in June. The terms of TLTRO-3 were improved, as well; banks that accessed the liquidity to maintain existing lending could do so at a rate up to -25bps below the current ECB deposit rate of -0.5%, for up to 50% of the existing stock of bank loans. The ECB obviously had to do something, given the coordinated nature of the global monetary policy response to COVID-19. Yet the decisions taken show that the ECB is much more limited in its ability to ease policy further, with interest rates already negative, asset purchases approaching self-imposed country limits and, most worryingly, inflation expectations falling to fresh lows (Chart 5). The bigger responses to date have come on the fiscal front, with stimulus packages proposed by France (€45bn), Italy (€25bn), Spain (€3bn) and the European Commission (€37bn). The biggest news, however, came from Germany which has offered affected businesses tax breaks and cheap loans through the state development bank, KfW – the latter with an planned upper limit of €550bn (and with the German government assuming a greater share of risk on those new KfW loans). The German government has also vaguely promised to temporarily suspend its so-called “debt brake” to allow deficit financing of virus-related stimulus programs, if necessary. Other Countries The Bank of England cut interest rates by -50bps last week, while also lowering capital requirements for UK banks by allowing use of counter-cyclical buffers for lending. On the fiscal side, a £30bn package was introduced last week that included a tax cut for retailers, cash grants to small business, sick pay for those with COVID-19 and extended unemployment benefits. The Bank of Japan held an emergency meeting this past Sunday night, announcing no changes in policy rates but doubling the size of its ETF purchase program to $56 billion a year to $112 billion, while also increasing purchases of corporate bonds and commercial paper. The central bank also announced a new program of 0% interest loans to increase lending to businesses hurt by the virus. The Bank of Canada delivered an emergency -50bps cut in its policy rate last Friday, coming soon after the -50bp reduction from the previous week. The central bank also introduced operations to boost the liquidity of Canadian financial markets. The Canadian government also announced a fiscal package of up to C$20bn, including increased money for the state business funding agencies. The Reserve Bank of Australia did not cut its Cash Rate last week, which was already at a record-low 0.5%. It did, however, signal that it would begin a quantitative easing program for the first time, and introduce Fed-like repo operations, to provide more liquidity to the economy and local financial markets. The Australian government has also announced A$17bn of fiscal stimulus. Fiscal packages have also been introduced in New Zealand (where the Reserve Bank of New Zealand just cut its policy rate by -75bps), Sweden, Switzerland, Norway, and South Korea. To date, China has leaned more on monetary and liquidity measures – lowering interest rates and cutting reserve requirements – rather than a big fiscal stimulus package. Will all these policy measures be enough to offset the hit to global growth from COVID-19 and help stabilize financial markets? It is certainly a good start, particularly in countries with low government and deficit levels that have the fiscal space for even more stimulus, like Germany, Australia and Canada (Chart 6). Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. The ability to calibrate the necessary policy response is impossible to assess without knowing the full impact of COVID-19 pandemic on the global economy – including the size of related job losses and corporate defaults/bankruptcies. Policymakers are likely to listen to the combined message of financial markets – equity prices, credit spreads and government bond yields. The low level of yields and flat yield curves, despite near-0% policy rates across the developed world (Chart 7), suggests that investors see monetary policy as “tapped out”, leaving fiscal stimulus as the only way to fight the economic war against COVID-19. Chart 6At Global ZIRP, The Policy Focus Shifts To Fiscal Chart 7Are Bond Yields Discounting A Global Liquidity Trap? Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. Bottom Line: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Corporate Bonds In The US & Europe – Stay Tactically Defensive Chart 8This Crisis Is Different Than 2008 The COVID-19 global market rout has generated levels of market volatility not seen since the 2008 Global Financial Crisis. The US VIX index of option-implied equity volatility spiked to a high of 84, while the equivalent German VDAX measure reached a shocking high of 93. Equity valuations in both the US and Europe remain much higher on a forward price/earnings ratio basis compared to the troughs seen in 2008, even after the COVID-19 bear market. Yet even though volatility has returned to crisis-era extremes, and corporate credit has sold off hard in both the US and Europe, credit spreads remain well below the 2008 highs (Chart 8). Nonetheless, the credit selloff seen over the past few weeks has still been intense. Both investment grade and high-yield spreads have blown out, and across all credit tiers in both the US (Chart 9) and euro area (Chart 10). Even the highest-rated segments of the corporate bond universe have seen spreads explode, with AAA-rated investment grade spreads having doubled in both the US and Europe. Chart 9Broad-Based Spread Widening For Both Investment Grade... Chart 10...And High-Yield With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis. With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis. One of our favorite metrics to value corporate bonds is to look at option-adjusted spreads, adjusted for interest rate duration risk. We call this the 12-month breakeven spread, as it measures the amount of spread widening over one year that would leave corporate bond returns equal to those of duration-matched US Treasuries. We then look at the percentile rankings of those breakeven spreads versus their history as one indicator of corporate bond value. Chart 11US Corporates Look Cheaper On A Duration-Adjusted Basis For the US, the 12-month breakeven spreads for the overall Bloomberg Barclays investment grade and high-yield indices are in the 82nd and 97th percentiles, respectively (Chart 11). This suggests that the latest credit selloff has made corporate debt quite cheap, although only looking through the prism of spread risk rather than potential default losses. Another of our preferred valuation metrics for high-yield debt is the duration-adjusted spread, or the high-yield index option-adjusted spread minus default losses. We then look at that default-adjusted spread versus its long-run average (+250bps) as a measure of high-yield value. To assess the current level of spreads, we use a one-year ahead forecast of the expected default rate using our own macro model. Over the past 12 months, the high-yield default rate was 4.5% and our macro model is currently calling for a rise to 6.2%. That estimate, however, does not yet include the certain hit to corporate profits from the COVID-19 recession. By way of comparison, the default rate peaked at 11.2% during the 2001/02 default cycle and at 14.6% during the 2008 financial crisis. In Chart 12, we show the historical default rate, our macro model for the default rate, and the history of the default-adjusted spread. We also show what the default-adjusted spread would look like in four different scenarios for the default rate over the next 12 months: 6%, 9%, 11% and 15%. The placement of these numbers in the bottom panel of Chart 12 indicates where the Default-Adjusted Spread will be if each scenario is realized. Chart 12US High-Yield Is Not Cheap On A Default-Adjusted Basis Right now, our expectation is that there will be a virus driven US recession, but it will be shorter in magnitude than past recessions; this suggests a peak default rate closer to 9%. Such a scenario would still be consistent with a positive default-adjusted spread and likely positive excess returns for US high-yield relative to US Treasuries on a 12-month horizon. However, if a default rate similar to that seen during past recessions (11% or 15%) is realized, that would lead to a negative default-adjusted spread. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect. Thus, we recommend a tactical underweight position in US high-yield until we see better visibility on the severity, and duration, of the US recession. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect. As for euro area corporates, spreads for both investment grade and high-yield do look relatively wide on a breakeven spread basis, although less so than US credit (Chart 13). However, with the World Health Organization declaring Europe as the new epicenter of the COVID-19 pandemic, the harsh containment measures seen in Italy, Germany, France and elsewhere – coming from a starting point of weak overall economic growth – suggest that euro area spreads need to be wider to fully reflect downgrade and default risks. Chart 13Euro Area Corporates Look A Bit Cheaper On A Duration-Adjusted Basis We recommend a tactical underweight allocation to both euro area corporate debt and Italian sovereign debt, as spreads have room to reprice wider to reflect a deeper recession (Chart 14). Chart 14Stay Underweight Euro Area Spread Product Bottom Line: Corporate bond spreads on both sides of the Atlantic discount a sharp economic slowdown, but the odds of a deeper recession – and more spread widening - are greater in Europe relative to the US. A Quick Note On Recent Changes To Our Model Bond Portfolio In last week’s report, we made several adjustments to our model bond portfolio recommended allocations on a tactical (0-6 months) basis.1 Specifically, we downgraded our overall recommended exposure to global spread product to underweight, while increasing the overall allocation to government debt to overweight. The specific changes made to the model bond portfolio are presented in tables on pages 14 & 15. Within the country allocation of the government bond side of the portfolio, we upgraded US and Canada (markets more sensitive to changes in global bond yields, and with central banks that still had room to ease policy) to overweight, while downgrading core Europe to underweight and Japan to maximum underweight (both markets less sensitive to global yields and with no room to cut rates). On the credit side of the portfolio, we downgraded US high-yield to underweight (with a 0% allocation to Caa-rated debt), while also downgrading euro area investment grade and high-yield debt to underweight. We also lowered allocations to emerging market USD denominated debt, both sovereign and corporate, to underweight. We left the allocation to US investment grade debt at neutral, as the other reductions left our overall spread product allocation at the desired level (35% versus the 43% spread product weighting in our custom benchmark portfolio index). In terms of the specific weightings, the portfolio is now +11% overweight US fixed income versus the benchmark, coming most through US Treasury exposure. The portfolio is now -7% underweight euro area versus the benchmark, equally thorough government bond and corporate debt exposure. The portfolio is now also has a -7% weight in Japan versus the benchmark, entirely from government bonds. Note that these weightings represent a tactical allocation only, as we are recommending a defensive stance on spread product exposure given the near-term uncertainties over COVID-19 and global growth. On a strategic (6-12 months) horizon, however, we are neutral overall spread product exposure versus government bonds. Corporate bond spreads already discount a sharp economic slowdown and some increase in defaults. However, the rapid shift to aggressive monetary and fiscal easing by global policymakers to combat the virus will likely limit the duration and, potentially, the severity of the global slowdown currently discounted in wide credit spreads. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcarsearch.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
HighlightsPortfolio Strategy“There is blood in the streets”. Investors with higher risk tolerance should be buying into this weakness and start to deploy long-term oriented capital. S&P 500 futures fell to 2394 which is a whopping 1000 points below the February 19, 2020 high of 3393. We cannot time the bottom, but future returns will be handsome from current SPX levels.Stick with health care stocks as the coronavirus pandemic will boost demand for health care goods and services, at a time when investors will also seek the refuge of defensive equities as the economy is in recession.Surging demand for pharmaceuticals, firming operating metrics, cheap relative valuations, an appreciating greenback along with the drubbing in the global manufacturing PMI, all signal that an underweight stance is no longer warranted in pharma equities. Recent ChangesLift the S&P pharmaceuticals index to neutral today. Table 1 Feature"Be fearful when others are greedy, and greedy when others are fearful"- Warren Buffett"The time to buy is when there's blood in the streets"- Baron RothschildEquities were unhinged last week, as the trifecta of the corona virus becoming a pandemic, Saudi ripping the cord out of crude oil and the convulsing bond markets made for an explosive equity market cocktail. The result was two circuit breaker triggers at the -7% mark that (thankfully) worked as planned and brought some liquidity back into the markets.Our Complacency-Anxiety index plunged to a panic level that has marked previous equity market troughs (Chart 1A). CNN’s Fear & Greed Index fell from near 100 to 1. While it could fall further at least a reflex rebound is in order. The Monday and Thursday mini-crashes felt like a capitulation (Chart 1B). Whoever wanted to get out likely got out. Chart 1ATime To Buy Chart 1BThere’s Is Blood In the Streets Volumes in the SPX soared to the highest level since 2011 and the bullish percentage index1 fell to 1.4%2 below the low hit in 2008! Early last week six out of ten stocks in the broad-based Russell 3000 were down 30% or more from their 52-week highs. As a reminder, the SPX took the elevator down and erased 13 months of gains in a mere 13 trading days (Chart 2)! Chart 2Selling Is Overdone Chart 3Our Roadmap A big crack has now formed.Given the tremor we just experienced, we doubt a V-shaped recovery to fresh all-time highs is in store for stocks similar to the one following the 2018 Christmas Eve lows V-shaped advance. Instead, parallels with the early-2018, 2015/16, 2011 or 19873 market action are more apt (Chart 3).Historically, Table 2 shows that the median time it takes for the stock market to make fresh all-time highs following a minimum 20% bear market from the most recent highs is two years. Table 2Bear Markets Duration In other words, this will likely be a prolonged troughing phase and a retest near last Thursday’s lows is a high probability event, at which point we think the market will hold those lows, and this will serve as a catalyst to definitively put cyclical-oriented capital to work.Our purpose here is not to scare investors when a number of markets are in duress and already in a bear market. We have been sending these warning shots4 since last summer5 all the way until the recent SPX February peak. Now that we have reached the proverbial “riot point” we would recommend taking a cold shower and keeping calm and collected in order to put things into perspective as one of our mentors would always do in tumultuous times.Importantly, investors with higher risk tolerance should be buying into this weakness and start to deploy long-term oriented capital. We cannot time the bottom, but future returns will be handsome from current SPX levels. As a reminder, S&P 500 futures fell to 2394 which is a whopping 1000 points below the February 19, 2020 high of 3393.This drubbing blew past our most bearish SPX estimate of 2544,6 pushing the SPX from overvalued to undervalued overnight. In fact, the forward P/E has fallen to one standard deviation below the historical time trend (Chart 4). Chart 4From Overvalued To Undervalued Our sense is that we will avoid a GFC type collapse, and thus investors with higher risk tolerance should start putting long-term cash to work as “there is blood in the streets”.Recapping the sequence of recent events is instructive. Two Fed officials (Clarida and Evans) made a huge error in our view by relaying that the Fed should stand pat and refrain from cutting rates. This culminated in a Powell press release that the Fed is ready to act, basically canceling these misplaced statements from the two Fed officials.Following these communication whipsaws, G7 finance ministers and central bankers held a conference call and then, the Fed panicked and cut rates inter-meeting further fueling the blazing fire. Now the Fed is cornered and has to act anew and further cut the fed funds rate (FFR) on March 18 all the way down to the zero lower bound. As a reminder, the last time the markets fell roughly 20% in late-2018 it took the Fed seven months to cut rates, this time it happened a mere two trading days after the market had a near 16% decline from the February peak.All of this bred uncertainty and a bond market spasm. There is little doubt we are in recession. The 10-year US Treasury yield plunging below 0.4% has fully discounted a recession, 100bps of Fed cuts and QE5 in our view.Keep in mind that the bond market now knows the Fed will cut the FFR to zero and eventually resort to QE, so it really front runs the Fed. This is something the bond market never anticipated or discounted on the eve of the Great Financial Crisis.While it is definitely true that interest rate cuts and further QE will neither cure COVID-19 nor reverse work-related disruptions, the Fed has to act and cut interest rates and restart QE for three reasons:a) to instill confidence that it is doing something and it is not a bystander,b) to loosen financial conditions as the VIX at a recent high near 76 and a more than doubling in junk spreads are screaming “help” (Chart 5), andc) to jawbone the US dollar lower.Our sense is that the fixed income market hit an inflection point for stocks when the 10-year US Treasury yield breeched the 1.5% mark: the correlation between stocks and bond yields quickly snapped from negative to positive. Based on recent empirical evidence, stocks cannot stomach a 10-year US Treasury yield above 3%, and suffer indigestion below 1.5% (Chart 2). Crudely put, while lower yields act as a shock absorber for equities (via lifting the forward P/E multiple), below a breaking point they warn of a deflationary shock. Thus, we would view an eventual return of the 10-year US Treasury yield near the 1.5% as a positive sign for stocks. Chart 5Watching Spreads The other shock two weekends ago was the deflationary oil market spiral out of the OPEC meeting in Vienna where a fight apparently erupted between the Saudis and the Russians with regard to rebalancing the oil markets and resulted in $30/bbl oil. The timing could not have been worse. Oil related capex will fall off a cliff given the looming bankruptcies in the US shale oil patch (bottom panel, Chart 5) and that makes a fiscal package from the US even more pressing.We deem that only a mega fiscal package comparable to the $750bn TARP will definitively stop the hemorrhaging. A comprehensive fiscal package close to $1tn in order to deal with the aftermath of the corona virus would mark a bottom in the equity market.Health care stocks will benefit both from a fiscal package and from the corona virus pandemic automatic rise in demand for health care services and goods. Thus, this week we reiterate our overweight stance in the health care sector and make a small shift to our sub-sector positioning.Continue To Hide In Health Care…We recommend investors continue to take refuge in health care stocks within the defensive universe as the coronavirus pandemic unfolds. The S&P health care sector relative share price ratio recently bounced off the one standard deviation below the historical time trend line and is primed to vault higher in coming quarter (Chart 6). Chart 6Health Care Shines In Recessions If severe government measures are a prerequisite to stop the spread of the virus then growth will suffer a massive setback. Were President Trump to take draconian measures similar to what the Italian Prime Minister imposed recently and effectively shut down the country, then PCE will collapse.In fact, PCE excluding health care will take a beating. Health care outlays will rise both in absolute terms and relative to overall spending (Chart 7). Given the safe haven status of the S&P health care index and the stable cash flows these businesses command, when growth is scarce, investors flock to any source of growth they can come by and health care stocks definitely fit that bill.Not only is firming demand reawakening health care stocks that have been trading at a discount to the broad market owing to political uncertainty, but also their defensive stature is a heavily sought after attribute during recessions (Chart 6). Chart 7Upbeat Demand Profile… Chart 8…Will Boost Selling Prices And Sales Inevitably, demand for health care goods and services will rise in the coming weeks straining the US health care system, as the number of infections increases. This will sustain industry selling price inflation and underpin revenue growth at a time when the world will be deflating (Chart 8).The implication is an earnings-led durable health care sector outperformance phase, a message that our relative macro EPS growth model is forecasting for the rest of the year (Chart 9).Importantly, such a rosy outlook is neither discounted in relative forward sales nor profit growth expectations for the coming year and we would lean against such pessimism (third panel, Chart 10). Chart 9Macro Profit Growth Model Says Buy Chart 10Unloved And Under-owned Finally, valuations and technicals are both flashing green. On a forward P/E basis health care stocks still trade at a 15% discount to the broad market and momentum is washed out offering a compelling entry point for fresh capital.In sum, in times of malaise investors flock to defensive health care stocks, that are currently direct prime beneficiaries of the ongoing coronavirus pandemic.Bottom Line: We reiterate our overweight recommendation in the largest market capitalization weighted defensive sector in the SPX, the S&P health care sector.Upgrade Pharma To NeutralLift the S&P pharmaceuticals index to neutral from underweight for a modest loss of -1% since inception.A structurally downbeat pricing power backdrop was the primary driver of our bearish call on the S&P pharma index as both sides of the political aisle were out to get Big Pharma (bottom panel, Chart 11). This portfolio position was up double digits since inception, but it has given back almost all the gains recently since the coronavirus pandemic took stage a few weeks ago.While our thesis has not changed, we do not want to be bearish any health care related equities in times of a health epidemic. In addition, there is a chance that one of these behemoths discovers a compound to beat the virus and could serve as a catalyst for a sharp reversal of the downtrend.Importantly, from an operating perspective, margins appear to have troughed following 15 years of declines (middle panel,Chart 11). Now that inadvertently demand for medicines will surge, sales and profits will expand smartly (third & bottom panels, Chart 12). Chart 11It No Longer Pays To Be Bearish Chart 12Firming Demand As a result of the coronavirus pandemic, we deem pharma factories will start to hum reversing the recent contraction in pharmaceutical industrial production (second panel, Chart 12).From a macro perspective, layoffs are inevitable from the coronavirus catalyzed recession and a softening labor market bodes well for defensive pharma profits (bottom panel, Chart 12).The collapse in the February global manufacturing PMI, primarily driven by China, is a window into what the future holds for developed market (DM) PMIs. DMs will feel the coronavirus aftermath in the current month and likely sustain downward pressure on the global manufacturing PMI print. Historically, relative forward profits and the global manufacturing PMI have been inversely correlated and the current message is to expect catch up phase in the former (global PMI shown inverted, middle panel, Chart 13).Moreover, the same rings true for the ultimate macro indicator, the US dollar. A rising greenback reflects global growth ills and a safe haven bid in times of duress as investors park their money in the reserve currency of the world. Therefore, defensive pharma relative forward EPS enjoy a positive correlation with the US dollar, and the path of least resistance remains higher (bottom panel, Chart 13).Finally, relative valuations are hovering near one standard deviation below the historical mean and technicals have returned back to the neutral zone underscoring that it no longer pays to be bearish pharma stocks (Chart 14). Chart 13Macro Backdrop Is Favorable Chart 14Value Has Been Restored Adding it all up, surging demand for pharmaceuticals, firming operating metrics, cheap relative valuations, an appreciating greenback along with the drubbing in the global manufacturing PMI, all signal that an underweight stance is no longer warranted in pharma equities.Bottom Line: Lift the heavyweight S&P pharma index to neutral today, for a modest loss of -1% since inception. The ticker symbols for the stocks in this index are: BLBG: BLBG: S5PHAR – JNJ, MRK, PFE, BMY, LLY, ZTS, AGN, MYL, PRGO. Anastasios Avgeriou US Equity Strategistanastasios@bcaresearch.com Footnotes1 https://school.stockcharts.com/doku.php?id=index_symbols:bpi_symbols2 https://schrts.co/IfrNQmIu3 Please see BCA US Equity Strategy Daily Report, “Gravitational Pull” dated March 12, 2020, available at uses.bcaresearch.com.4 Please see BCA US Equity Strategy Weekly Report, “A Recession Thought Experiment” dated June 10, 2019, available at uses.bcaresearch.com.5 Please see BCA US Equity Strategy Special Report, “What Goes On Between Those Walls? BCA’s Diverging Views In The Open” dated July 19, 2019, available at uses.bcaresearch.com.6 Please see BCA US Equity Strategy Weekly Report, “From "Stairway To Heaven" To "Highway To Hell"?” dated May 2, 2020, available at uses.bcaresearch.com.Current RecommendationsCurrent TradesStrategic (10-Year) Trade RecommendationsSize And Style ViewsJune 3, 2019Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018Favor value over growthMay 10, 2018Favor large over small caps (Stop 10%)June 11, 2018Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Highlights The S&P 500 is in a bear market, and a recession appears to be inevitable, … : The longest bull market in S&P 500 history succumbed last week to the Saudi-Russia oil war, the relentless drumbeat of spreading COVID-19 disruptions and the realization that it will take even worse market conditions to prompt a meaningful fiscal response. … but it is BCA’s view that the recession will be short, if sharp: Although our conviction level is low, and our view is subject to change as more information becomes available, we expect that the recession is much more likely to produce a V-bottom than a U-bottom. Pent-up demand will be unleashed once the coronavirus runs its course, stoked by monetary and fiscal stimulus initiatives around the world. Are central banks out of bullets?: We are not yet ready to embrace the most provocative idea that came up at our monthly View Meeting last week, but the question highlights the uncertainty that currently pervades markets. First, do no harm: What should an investor do now? Watch and wait. It is too early to re-risk a portfolio, but safe-haven assets are awfully overbought. Cash is worth its weight in gold right now, and those who have it should remember that they call the shots. Feature The S&P 500 entered a bear market last Thursday, bringing down the curtain on the longest US equity bull market in recorded history at just under 11 years.1 We are duly chastened by the misplaced bravado we expressed in last week’s report, which crumbled under the force of the ensuing weekend’s oil market hostilities between Saudi Arabia and Russia. We see the plunge in oil prices, and the looming spike in oil-patch defaults, bankruptcies and layoffs, as the straw that broke the camel’s back, ensuring a 2020 recession. Now that it has slid so far, we expect that the S&P 500 will generate double-digit returns over the next twelve months, but we do not believe that investors should be in any rush to buy. Wild oscillations are a sign of an unhealthy market, and stocks don’t establish a durable bottom while they are still experiencing daily spasms. The Fundamental Take (For What It’s Worth) We nonetheless believe that the recession will be fairly brief, even if it is sharp. The global economy was clearly turning around before the virus emerged, and the US economy was as fit as a fiddle. Data releases across February were decidedly positive, on balance, and the year-to-date data, as incorporated in the Atlanta Fed’s GDPNow model, pointed to robust first quarter growth in an economy that was firing on all cylinders (Chart 1). We continue to believe that most of the demand that goes missing across the first and the second quarters will not be lost for good, but will simply be deferred to the second half of this year and the beginning of next year. The coronavirus has brought an end to the expansion, but the US economy was in rude health before it was infected, and we expect it will make a full and swift recovery. Chart 1The First Quarter Had Been Shaping Up Really Well Chart 2Old Faithful That pent-up demand will be goosed by abundant monetary and fiscal stimulus. We expect that China and the US will take the lead, and will have the most impact on global aggregate demand, but that policymakers in other major economies will also lend a hand. Central banks in Australia, Canada and England have all cut rates in the last two weeks, and British policymakers took the boldest step, pairing last week’s rate cut with an immediate 30-billion-pound infusion of emergency spending, and a pledge to spend 600 billion pounds on infrastructure upgrades between now and 2025.2 Australia announced a plan to inject fiscal stimulus equivalent to about 1% of GDP Thursday morning, and Germany’s ruling party indicated a willingness to run a budget deficit to combat the virus.3 Our China Investment Strategy team notes that the Chinese authorities are already supporting domestic demand via aid to threatened businesses and out-of-work individuals, and are poised to open the infrastructure taps (Chart 2). Global aggregate demand is also set to receive a boost from the oil plunge, although it will arrive with a lag. Energy sector layoffs and the tightening in monetary conditions from wider bond spreads and marginally tighter bank lending standards will exert an immediate drag on activity. Once that drag fades, however, the positive supply-shock effects will take hold, helping households stretch their paychecks and non-energy businesses expand their profit margins. Although the effect of falling oil prices is mixed for the US now that fracking has made it a heavyweight oil producer, more economies are oil importers than exporters, and global growth is inversely related to oil price moves. We are keenly aware that markets are paying no attention whatsoever to economic data releases right now. They are backward-looking, after all, and fundamentals are not the driving force behind current market moves anyway. The data are useful, however, for evaluating the fundamental backdrop once the non-stop selling abates, as it eventually will. When it becomes important to take the measure of the economy and where it’s headed, investors will be able to make a more informed judgment if they have a good read on how the economy was doing before it was exposed to the virus (Chart 3). Chart 3Layoffs Are Coming, But They Hadn't Started By Early March Investment Strategy The near-term equity view was cautious when we held our View Meeting Wednesday morning before the open. No one thought investors should be in any hurry to buy, and while not everyone shared the bleakest S&P 500 downside estimate of 2,400 (well within sight now), no one suggested that the index had already bottomed. One participant made the case for a negative 10-year Treasury yield, but we still have little appetite for Treasuries as a house. We expect the 10-year yield will be higher in twelve months than it is now, if perhaps only modestly. We like equities' 12-month prospects, but they may have to decline some more before Congress joins hands and puts a floor under them. For anyone expecting US fiscal stimulus to bail out the markets, our geopolitical team sounded a note of caution. A recession is kryptonite for incumbent presidential candidates, and the more the virus squeezes the economy, the greater the Democrats’ chances of capturing the White House and the Senate. Our Geopolitical Strategy service fully expects that Democrats will eventually agree to a sizable spending package, but only after allowing the situation to deteriorate some more. As long as they don’t look like they’re putting party concerns ahead of the nation’s welfare, they can dent the president’s re-election prospects by waiting to throw a lifeline to the economy and financial markets. The administration’s initial proposal, as alluded to in the president’s prime-time Oval Office address on Wednesday night, fell way short of what the market sought. Its small-bore items seemed woefully inadequate to stem the tide, and raised the unsettling prospect that the fiscal cavalry might fail to ride to the rescue because the administration didn’t think it needed to be summoned. The good news for markets is that governments get an almost unlimited number of do-overs.4 The first iteration’s failure ensures that the second will be more ambitious, and if that fails, the third iteration will be even bigger. Thank You, Sir, May I Have Another? News of disruptions to economic activity, and daily life, in the United States piled up last week. Colleges closed their gates en masse for what remains of the academic year; concerts and music festivals were cancelled; the NCAA basketball tournament was initially closed to fans, then cancelled altogether; and all of the major North American professional sports leagues have suspended their seasons. In many instances, city and state ordinances banning mass gatherings forced sports franchises’ and concert promoters’ hands. The relentless drumbeat of bad news did markets no favors, and it surely did not help business or consumer confidence as broadcasters, hotels, restaurants, bartenders, taxi drivers and arena staff totted up their lost income. Today’s pain may be tomorrow’s gain, however. While draconian measures weigh on peoples’ spirits and crimp economic activity in the immediate term, they increase the chances of limiting the virus’ spread and mitigating its ultimate effect. As our Global Investment Strategy colleagues have pointed out, there is a trade-off between health and growth. Bulking up health safeguards unfortunately involves some growth sacrifices. Are Central Banks Out Of Bullets? Chart 4If At First You Don't Succeed, ... The most provocative line of argument in last week’s firm-wide discussion was the idea that the coronavirus is a bit of a red herring, and that the true driver of the global market selloff is the failure of the policy put. That’s to say that the efficacy of, and the belief in, central banks’ ability to shore up markets and the economy has crumbled. So far, this round of emergency rate cuts has failed to stem the flow of red on Bloomberg terminals and television screens (Chart 4). Spending plans have underwhelmed as well, with British, Australian and Japanese equities all fizzling following the announcement of fiscal stimulus measures. The end of markets’ monetary policy era would mark a major inflection point, if not a full-on regime change. We are hesitant to make such a sweeping declaration now, however. As one of our colleagues put it in making the case for further declines in rates, the golden rule of investing is never to lean against a primary trend. Positioning for an end to central banks’ influence on markets would mean going against 33 years of history that began with the Fed’s post-Black Monday statement affirming its “readiness to serve as a source of liquidity to support the economic and financial system.” Central bankers are neither omniscient nor omnipotent, but there’s a reason why You can’t fight the Fed became a cherished truism. It affects the real economy when it turns its policy dials. If monetary stimulus is aligned with fiscal stimulus, as it just might be next week, it can make for a potent cocktail. A devotee of the Austrian School of Economics may grind his or her teeth to dust over the endless intervention in markets, but the results are popular with the public and elected officials, and we can expect that they’ll continue over most professional investors’ relevant timeframes. Public officials will let go of the Debt Supercycle controls only when they’re pried out of their cold, dead hands. What Now? It feels like it was a month ago, but just last week we were of the view that a correction was more likely than a bear market. As we wrote then: We remain constructive on risk assets because we think the selling has gotten overdone. There may well be more of it, and the S&P 500 could reach its 2,708.92 bear-market level before we can publish again next Monday, but we will be buying it in our own account all the way there. Compounding our embarrassment and regret, we actually did buy shares in a SIFI bank on Tuesday as they approached their tangible book value. Markets were unimpressed with the initial monetary salvo, but there's more where that came from (and some fiscal artillery, too). We have learned our lesson and will wait before committing any more capital. We have also learned our lesson about “overdone selling.” Despite the dramatic gap between the S&P 500 and its 200-day moving average (Chart 5), every single sale over the last three weeks has proven to be a good one. Cutting one’s losses is a deservedly celebrated portfolio management rule, and we cannot object to any client who wants to take some exposure off the table. Chart 5The Equity Selloff Has Become Extreme We have little love for the havens that have already spiked, like gold, Treasuries, utilities and makers and sellers of hand sanitizer, disinfectant wipes and surgical masks. Insurance in the form of index puts is bracingly expensive. Our preferred way of taking advantage of the massive market disruption (Chart 6 and Table 1) is to write out-of-the money puts on individual stocks at strike prices where we’d be happy to own them. With the VIX in the 50s, much less the 60s or 70s, an investor writing puts 10% out of the money on a range of S&P 500 constituents5 can get paid double-digit annualized returns in exchange for agreeing to get hit down 10% between now and March 20th or April 17th. Chart 6Selling Insurance Looks More Appealing Than Buying It Right Now Table 1One Week, Two Historic Declines We recognize that not every investor has discretion to write puts, and it is not something to be done lightly in any event. The compensation is so high because it is a contractual agreement to buy stock in a relentlessly falling market. (Options only confer a right to transact for their buyers; they’re an iron-clad obligation to transact for their sellers.) Our species’ cognitive biases being what they are, however, we like the strapped-to-the-mast feature of writing puts because it commits an investor to following through on a course of action s/he decided upon before price declines had a chance to shake his/her resolve. It is one thing to have said that one would buy a 35-dollar stock if it ever got to 18, and quite another to follow through now that it’s gone from 35 to 21 in short order. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The bull market began on March 10, 2009, at 676.53, and ended February 19, 2020, at 3,386.15. Its 400% advance was achieved at an annualized rate of 15.8%. 2 Nominal 4Q19 UK GDP was about 560 billion pounds. 3 Believe it or not, this is kind of a big deal for Berlin. 4 As we were going to press, it looked as if House Democrats and the administration were nearing agreement on a package to protect vulnerable workers and small businesses, while the combined private- and public-sector efforts outlined in the Rose Garden suggested that the US might be capable of stemming the spread of the virus soon. 5 Type [ticker]-F8-PUT into Bloomberg for the full menu of maturities and strike prices for any given stock. The annualized return for writing the put is equal to the option premium divided by the strike price, multiplied by (360/the number of days until expiration). For near-month contracts, if the premium is around 1% of the strike, the annualized return on the notional capital committed is 10%.
Feature “People have been asking me whether this is the time to buy. My answer is more nuanced: it’s probably a time to buy.” Howard Marks, Oaktree Capital, Monthly Memo March 2020 Markets have moved dramatically since we published our Monthly Portfolio Update on March 2. Global stocks have fallen by 27% since then. The 10-year US Treasury yield fell from 1.2% to 0.4% before rebounding to 0.8%. And there have been some strange market moves: the US dollar fell then rebounded, and the classic safe haven, gold, has fallen by 7%. Investors are struggling with how to think about this environment, and how to position. Chart 1Risk Assets Should Bottom When New Ex-China Cases Peak Table 1US Healthcare Is Top Quality Our view has not greatly changed. We still believe that risk assets will bottom around the time when global COVID-19 cases peak. They showed signs of a rebound when cases in China peaked on February 13. And they started their recent crash when ex-China cases began to accelerate dramatically (Chart 1). It is likely – and well anticipated – that there will be a sharp rises in cases in the US (and probably the UK and Canada too) over the coming two or three weeks. It is wrong to think, though, that the US is particularly badly prepared for this. The US has a high standard of healthcare, with many more intensive-care beds per person than other developed countries (Table 1) – though it is worrying that some 20% of the US population is uninsured. We see two possibilities for how the pandemic will pan out in coming weeks: The US is the last big cluster and new cases peak there in early April. This causes a two-quarter recession. But if COVID-19 turns out to be seasonal (it has not spread much in hot countries such as Singapore, or in the southern hemisphere where it is now summer – Chart 2) and by April and May it peters out. US consumers stop going out for a while (the professional hockey, basketball, and soccer seasons have been put on hold) and so demand falls. Typically, stocks fall by 25-30% in a recession of this type (Table 2) – and so this is already close to being discounted. There are no longer-term impacts, and soon the world economy is getting back close to normal. Chart 2Will Hot Weather End The Pandemic? Table 2Peak-To-Trough Falls In Equities In Bear Markets The pandemic continues for months. Governments are able to slow contagion via social distancing in order to spread out the pressure on their health services over a longer period. But ultimately one-half to two-thirds of the world’s population gets the disease and the death rate among those people is 0.7% (the rate in Korea, which extensively tested for the virus and has a good medical system). This means worldwide deaths of about 20 million, disproportionately concentrated among the over-70-year-olds and those with chronic illnesses (Chart 3). The disease could spread to poor countries, such as India and Africa, where healthcare services would not be able to cope. The global economy would slow significantly, causing a severe recession. There would be second-round effects: for example, a blow-up in the US corporate credit markets, where debt is already high as a percentage of GDP (Chart 4), which could cause banks to drastically tighten lending conditions. This could cause problems with foreign-currency EM borrowers. It could trigger another euro zone crisis, as banks in southern Europe prove unable to cope with rising defaults. In this scenario, the peak-to-trough decline in global equities could be 40-50%. Chart 3COVID-19 Mostly Kills Old And Sick People Chart 4US Corporate Debt Is A Vulnerability In our last Monthly, we talked about the usefulness of a Bayesian approach in this sort of uncertain environment. We ascribed a “prior” probability of 10-20% for the latter scenario. The probability has now risen, to perhaps 25%. Chart 5Close To Capitulation But the potential upside from Scenario 1) is considerable. Central banks around the world are throwing everything at the problem. Countries from the UK and Italy, to Japan and Australia have rolled out big fiscal packages this week. The key now is what will the US do. How positively would markets react if the US in coming days scripted a coordinated announcement, with the Fed cutting rates to zero, and the White House and Congress agreeing an $800 billion fiscal package. The Fed is likely to do this – indeed the market is pricing in the Fed Funds Rate at zero by the next FOMC meeting on March 18. The dynamics of fiscal stimulus are more complicated – the Democrats don’t want to give President Trump a boost that will help his election prospects, but they don’t want to be seen to be obstructive in a time of emergency either.1 So what should investors do? We have been tempted in recent days to lower our Overweight recommendation on equities, which has evidently proved wrong, to Neutral. But we fear it is too late to do this, particularly with equities having fallen by 15% over the past two days. There is probably still some downside. We would now look for signs of a bottoming-out, most notably the peak in new COVID-19 cases outside China, but also evidence of capitulation by investors (Chart 5). Moreover, we would pay attention to potential upside surprises (in addition to a Fed/White House/Congress joint package, maybe a making-up between Russia and Saudi Arabia on oil production cuts). In the meantime, when markets move as violently as they have, often the baby gets thrown out with the bathwater. There are many individual securities, in both debt and equity markets, that look very attractively valued now. For example, we see a lot of attraction in high-dividend-yield stocks, which might appeal to investors who no longer see the point of investing in government bonds, where the upside – even in a severe recession – is likely to be very limited. Table 3 shows a screening of large-cap stocks in developed markets with a dividend yield of more than 10%, taken from BCA Research’s ETS quants screening service. While many of these are in the Energy sector (where the price/book ratio is now below the lows of 2008 and 2015 – Chart 6), quality names among European Financials and Asia Industrials are also prominent. Table 3Stocks With Dividend Yield Above 10% Chart 6Energy Sector Valuation At Record Low For investors who want to remain risk-off, we would not recommend government bonds as a hedge. It is notable that the Swiss 10-year government bond yield has not fallen in the recent melt-down. They are simply at their theoretical lower bound. German Bunds must be close. The Fed has been clear that it will not cut policy rates below zero, which means that the lower limit for US Treasurys is probably around 0% too. Even in the severest recession, therefore, the upside for Treasurys is limited to 9% (Table 4). This means returns are likely to be very asymmetrical since, in a rebound in risk appetite, yields could rise sharply. Table 4Little Upside From Government Bonds We prefer cash as a hedge. This gives investors dry powder for use when they do want to reenter risk assets. We have been recommending gold, and it will probably continue to serve as a safe haven in the event of our most pessimistic scenario happening. But it looks very overbought in the short term (Chart 7) – as demonstrated by the way that it has recently been correcting even on days when equities fall. TIPS offer a better hedge than nominal bonds, given how low inflation expectations have fallen – the 5-year/5-year forwards now point to CPI inflation in 2025-2030 averaging 1.5% (Chart 8). This implies – highly unrealistically – that the Fed will miss its 2% PCE inflation target by 1 percentage point a year over that period. Chart 7Gold Is Overbought Chart 8Inflation Expectations Unrealistically Low Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy, Weekly Report, "GeoRisk Update: Leap Year, Or Steep Year?" available at gps.bcaresearch.com.
Dear Client, In addition to this week’s report, BCA Research will hold webcasts over the coming days to discuss the economic and financial outlook amid the myriad of uncertainties gripping global markets. I will take part in a roundtable discussion alongside my fellow BCA Strategists Arthur Budaghyan, Mathieu Savary, and Caroline Miller for a live webcast on Friday, March 13 at 8:00 AM EDT (12:00 PM GMT, 1:00 PM CET, 8:00 PM HKT). In addition, I will hold a webcast on Monday, March 16 at 12:00 PM EDT (4:00 PM GMT). Best regards, Peter Berezin, Chief Global Strategist Highlights A global recession is now a fait accompli. The only question is whether there will be a technical recession lasting a couple of quarters, or a more prolonged downturn that produces a sizeable increase in unemployment rates. We lean towards the former outcome. Unlike during most recessions, the decrease in labor demand will be mitigated by a decline in labor supply, as potentially millions of workers are confined to their homes. This will limit the rise in unemployment, at least initially. The pandemic is likely to prompt firms to increase inventory levels for fear of further disruptions to their supply chains. This should provide a short-term boost to output. While it is possible that spending will remain broadly depressed even after the panic subsides, this seems unlikely. Private-sector finances were reasonably strong going into the crisis, while ultra-low government bond yields will incentivize increased fiscal outlays. Spending on leisure travel and public entertainment will remain subdued well into 2021, but much of this demand will be redirected to other categories of discretionary consumer purchases, particularly in the online realm. Health care expenditures will also increase. The collapse in oil prices following the breakdown of OPEC 2.0 represents a positive supply shock for the global economy, albeit one that will have negative consequences for oil-extraction sectors. We tactically upgraded stocks on the morning of Friday, February 28. That was obviously a major mistake: While global equities did rally 7% higher after our upgrade, they have since given up all their gains (and then some). For now, we are maintaining a modest overweight recommendation to equities. However, this is a low-conviction view, and we would not dissuade more conservative investors from reducing risk exposure. We would only consider upgrading stocks to a high-conviction overweight if the S&P 500 dropped to 2250, or the number of new infections outside of China peaked. In the meantime, we are downgrading high-yield credit tactically, as the odds of earnings weakness prompting a near-term rise in default expectations warrant caution. What A Way To Start The Decade So far, the 2020s may not be roaring, but they are certainly not boring. At the outset of the crisis, there were three scenarios for the COVID-19 outbreak: 1) A regional epidemic largely confined to China; 2) a series of global outbreaks, successfully short-circuited by a combination of government intervention and voluntary “personal distancing” measures; 3) A full-blown pandemic that exposes a significant proportion of the planet to the virus. Unfortunately, the first scenario has been ruled out. Policymakers are now trying to achieve the second scenario. Successful containment would “flatten the curve” of new infections, while allowing the sick to receive better treatment than they would otherwise. It would also buy precious time to develop a vaccine and increase the output of face masks, hand sanitizers, and other products that could slow the spread of the disease. Health Versus Growth Ironically, while the second scenario is clearly preferable to a full-blown pandemic from a health perspective, it may be more damaging from the very narrow, technical perspective of GDP accounting. It all depends on how severe the measures to quash each outbreak need to be. If simple hygiene measures and social distancing turn out to be enough, the economic fallout will be minimal. If ongoing mass quarantines and business closures are necessary, the damage will be severe. History suggests that containment efforts can work. During the Spanish flu, US cities such as St. Louis, which took early action to slow the spread of the disease, ended up with far fewer deaths than cities such as Philadelphia which did not (Chart 1). Western Samoa did not impose any travel restrictions and lost a quarter of its population. American Samoa closed its border and suffered no deaths. Chart 1Containment Efforts Can Be Effective: The Case Of The Spanish Flu Recent experience suggests that COVID-19 can be stopped, even after community contagion has set in. The number of new Chinese cases has fallen from 3,892 on February 5 to 31 on March 11. South Korea seems to be getting the virus under control. The number of new cases there has declined from 813 on February 29 to 242 (Chart 2). Japan and Singapore also appear to be succeeding in preventing the virus from spreading rapidly. Chart 2Coronavirus: The Authorities In East Asia Seem To Be In Control Of The Situation What remains unclear is whether other countries can replicate East Asia’s experience. A recent Chinese study estimated that R-naught – the average number of people someone with the virus ends up infecting – fell from 3.86 at the outset of the outbreak to 0.32 following interventions (Chart 3).1 In other words, China was able to lower R-naught to one-third of what was necessary to stabilize the number of new infections. If one wanted to be optimistic, one could argue that other countries could get away with less heavy-handed measures, even if it is at the expense of a somewhat slower decline in the infection rate. Chart 3Severe Containment Measures Have Changed The Course Of The Wuhan Outbreak Unfortunately, given how contagious the virus appears to be, it is unlikely that simple measures such as regularly washing one’s hands, avoiding large gatherings, and wearing a face mask in public when sick will suffice. Trade-offs will have to be made between growth and health. Moreover, if the virus becomes endemic in a few countries that do not have the institutional capacity to contain it, this could create a viral reservoir that produces repeated outbreaks in the wider world. The result could feel like a ghastly game of whack-a-mole. The Fatality Rate The degree to which countries pursue costly containment measures depends on how deadly the virus turns out to be. On the one hand, there is some evidence that the fatality rate from COVID-19 is lower than the 2%-to-3% that has been widely reported once mild or asymptomatic cases, which often go undetected, are taken into account. This may explain why South Korea, which has arguably done a better job of testing suspected patients than any other country, has reported a fatality rate of only 0.7%. Like the seasonal flu, the death rate from COVID-19 appears to be heavily tilted towards the elderly. In Italy, 89% of COVID-19 deaths have occurred among those who are 70 and older. On the ill-fated Diamond Princess cruise liner, not a single person under the age of 70 has died. The fatality rate for passengers on the ship older than 70 is 2.4%. The seasonal flu kills about 1% of those it infects over the age of 70. Based on this simple calculation, COVID-19 is more lethal, but not light-years more lethal, than the typical flu (and possibly less lethal than the flu is for young children). Unfortunately, these optimistic estimates assume that patients with COVID-19 can continue to receive appropriate care. As we saw in Wuhan, where the official death rate stands at 4.5% compared to 0.9% in the rest of China, and as we are now seeing in Italy, once the health care system becomes overwhelmed, death rates can rise sharply. Bottom Line: Containing the virus will be economically costly, but given the potentially large death toll from a full-blown pandemic, most countries will be willing to pay the price. A Global Recession Even before the virus became endemic outside China, we estimated that global growth would fall to zero on a quarter-over-quarter basis in Q1. As we cautioned back then, the risk to our forecast was tilted to the downside, and that has proven to be the case. We now expect the global economy to shrink not just in the first quarter but in the second quarter as well, as country after country experiences a surge in new infections. Two consecutive quarters of negative growth constitute a technical recession. Despite the drop in new cases in China over the past two weeks, most high-frequency measures of economic activity such as property sales, railway-loaded coal volumes, and traffic congestion have yet to return anywhere close to normal levels (Chart 4). In the US, hotel occupancy rates, movie ticket sales, and attendance at sporting events were all close to normal levels as of last week. However, that is changing quickly. Already, automobile traffic in Seattle, one of the cities most hard-hit by the virus, has fallen sharply (Chart 5). Chart 4China: It Will Take Time For Life To Return To Normal Chart 5US: Staying Home More In Seattle Due To The Virus? Qualitatively Different While a recession in the first half of 2020 is now unavoidable, the nature of this recession is likely to be quite different than in the past. To understand why, it is useful to review what causes most recessions. A typical recession involves a prolonged loss of aggregate demand. Such a loss of demand can result from either financial market overheating or economic overheating. Financial market overheating can occur if a credit-fueled asset bubble bursts, leaving people with less wealth struggling to pay off debt. For example, US residential investment fell from 6.6% of GDP in 2005 to 2.5% of 2010. Thus, even after the credit markets thawed, there was still a large hole in aggregate demand that needed to be filled. A similar, though less severe, loss of demand occurred when the bursting of the dotcom bubble led to severe cutbacks in IT spending. Economic overheating occurs when a lack of spare capacity puts upward pressure on inflation. Wary of accelerating prices, central banks slam on the brakes, raising interest rates into restrictive territory. This often results in a recession. In both types of recessions, there are usually second-round effects that can swamp the initial shock to aggregate demand. As spending falls, firms start to lay off workers. The resulting loss in household income leads to less spending. Even those who retain their jobs are apt to feel less confident, leading to an increase in precautionary savings. For their part, businesses tend to cut production as inventory levels swell. Things only return to normal once enough pent-up demand has accumulated and/or policy has become sufficiently stimulative to revive spending. Framed in this way, one can see that the current downturn differs from past downturns in at least three important respects. First, unlike during most recessions, the decrease in labor demand this time around will be partly mitigated by a decline in labor supply, as potentially millions of workers are confined to their homes. While this will not prevent many workers from temporarily losing income, it will limit the increase in unemployment, at least initially. We have already seen this in China, where GDP growth collapsed but companies are complaining about a shortage of migrant labor. Second, rather than falling, inventory levels may actually rise. Since companies will have to deal with pervasive supply shocks of unknown frequency, duration, and magnitude, their natural inclination will be to increase inventory levels for fear that they will not be able to access their supply chains when they need them. If recent reports of hoarding of toilet paper and bottled water are any guide, the same sort of behavior will show up among consumers. Again, in the short term, this additional demand will help to keep unemployment from rising as much as it would otherwise. Third, and perhaps most importantly, the ongoing crisis is the result of an exogenous shock rather than an endogenous slowdown. In fact, a variety of economic indicators such as US payrolls, the Chinese PMI, and German factory orders were all pointing to an acceleration in global growth before the crisis began. This suggests that growth could recover quickly once the panic subsides. While it is impossible to say with any degree of certainty how long it will take for the panic to end, it may not last as long as many fear. Investors should particularly pay attention to the situation in Italy. If the number of new cases peaks there, it could create a sense that other western countries will be able to get the virus under control. Second-Round Effects? Although it is possible that economies will remain depressed even after the panic subsides, this seems unlikely. Private-sector finances were reasonably strong going into the crisis. The private-sector financial balance – the difference between what companies and households earn and spend – is in surplus in most countries, including China (Chart 6). Chart 6The Private Sector Spends Less Than It Earns In Most Economies Chart 7Lower Oil Prices Eventually Lead To Higher Growth Granted, not all sectors are likely to prove equally resilient. Spending on leisure travel and public entertainment will remain subdued well into 2021. The collapse in oil prices following the breakdown of OPEC 2.0 will also wreak havoc on oil producers. In both cases, however, there will be offsetting benefits. Much of the demand for travel and entertainment will be redirected to other categories of discretionary consumer purchases, particularly in the online realm. And while lower oil prices will hurt producers, they represent a boon for consumers and companies that use petroleum as an input. In general, as Chart 7 illustrates, global growth usually accelerates following declines in oil prices. Fiscal Policy Will Turn More Stimulative Even before the crisis began, we argued that most governments should permanently increase fiscal deficits in order to raise the neutral rate of interest. At the current juncture, with a recession upon us and government bond yields at ultra-low levels, the failure to enact meaningful fiscal stimulus would be economic malpractice of the highest order. In addition to easing measures being rolled out by central bankers, our sense is that we will get a lot of fiscal stimulus, sooner rather than later. During most recessions, there is always a chorus of voices from people whose own jobs are secure about how a downturn is necessary to cleanse the system. This time around, it is obvious that the victims are not to blame. Politicians will not endear themselves to voters by denying the need for fiscal support to households struggling with medical bills and lost time from work and businesses facing bankruptcy. President Trump’s pledge this week to cut payroll taxes and increase transfers to those affected by the virus is just a taste of what’s to come. Investment Conclusions Chart 8Stock-To-Bond Ratio: A Lot Of The Bad News Has Already Been Priced In We tactically upgraded stocks on the morning of Friday, February 28. That was obviously a major mistake: While global equities did rally 7% higher after our upgrade, they have since given up all their gains (and then some). In retrospect, we should have paid more attention to our own analysis in our report “Markets Too Complacent About The Coronavirus.” For now, we are maintaining a modest overweight recommendation to equities. The total return ratio between stocks and bonds has fallen by a similar magnitude as in the run-up to prior recessions, suggesting that much of the bad news has already been priced in (Chart 8). Nevertheless, significant downside risks remain, which is why we would characterize our equity overweight as a fairly low-conviction view. We would not dissuade more conservative investors from reducing risk exposure. As discussed above, containing the virus could lead to significant economic disruptions. We would only consider upgrading stocks to a high-conviction overweight if the S&P 500 dropped to 2250, or the number of new infections outside of China peaked. In the meantime, we are downgrading high-yield credit tactically, as the odds of earnings weakness prompting a near-term rise in default expectations warrant caution. Safe-haven government bond yields will probably not rise much from current levels, at least in the near term. The Fed cut rates by 50 basis points last week and will cut rates by another 50 basis points next week. Looking further out, however, bonds are massively overvalued and will suffer mightily as life returns to normal. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1Chaolong Wang, Li Liu, Xingjie Hao, Huan Guo, Qi Wang, Jiao Huang, Na He, Hongjie Yu, Xihong Lin, Sheng Wei, and Tangchun Wu, “Evolving Epidemiology and Impact of Non-pharmaceutical Interventions on the Outbreak of Coronavirus Disease 2019 in Wuhan, China,”medrxiv.org, March 6, 2020. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
On a happy personal note, I will be away on paternity leave for a short time, reacquainting myself with nappies. As such, there will be no Weekly Reports for the next two weeks, but you will receive two excellent Special Reports penned by my colleagues. Given the ongoing turbulence in the financial markets I will also send out short Alerts as and when necessary. Highlights After the worst three-day rout for stocks versus bonds in living memory, six-month investors have fully capitulated, and the markets are now priced for a technical recession. If the recession can be limited to two quarters, stocks are more likely to outperform long-dated bonds by 12 percent than to underperform by a further 12 percent. Tactical trade: overweight S&P500 versus German 30-year bund, currency hedged, setting a 12 percent profit target with symmetrical stop-loss. The closer that a bond yield gets to the -1 percent lower bound, the more limited becomes the possibility for a further yield decline. Overweight positive yielding bonds versus negative yielding bonds, currency hedged. The most attractive structural pair is overweight the US 30-year T-bond versus the German 30-year bund. Feature Chart of the WeekWidow Makers: Shorting Bonds In Japan, Switzerland... And Now The US A Recession Is Now Fully Priced Financial markets have fully priced a downturn when the time horizon of investors that have fully capitulated = the length of the downturn. A week can be a long time in the financial markets. Seven days ago, the markets were not priced for a global recession. Then came the worst three-day rout for stocks versus bonds in living memory, in which stocks underperformed long-dated bonds by 25 percent (Chart I-2).1 Chart I-2The Worst 3-Day Rout: Stocks Underperformed Bonds By 25 Percent The upshot is that investors with six-month horizons have now fully capitulated, meaning the markets are now fully priced for a technical recession (Chart I-3) – defined as a downturn lasting two straight quarters. But the markets are not priced for a more prolonged downturn lasting longer than two quarters. Raising the question: can the downturn be limited to the first half of the year? Chart I-3Six-Month Investors Have Capitulated, Meaning A Recession Is Fully Priced The pessimistic case is that the coronavirus can neither be contained nor normalised by the summer. Or that even if its direct impact ebbs, there might be second-round effects. A major credit default from, say, a distressed airline or other travel-dependent company could trigger aftershocks in the financial system. Moreover, the recent collapse in the oil price injects new uncertainty into the energy patch as well as into geopolitics. The optimistic case is that large segments of the economy are set to receive a 2009 type triple-boost: from a sharp deceleration in bond yields; from a sharp deceleration in the oil price; and from government spending and/or tax cuts – creating a potent cocktail of stimulants for the second half of this year. Investors with six-month horizons have now fully capitulated. Balancing the pessimistic and optimistic cases, we assess that the downturn can be limited to two quarters – albeit this cannot be our highest conviction view, as we are not experts in epidemiology or immunology. Nevertheless, if this assumption holds, there is now a higher probability that stocks outperform long-dated bonds by 12 percent than that they underperform by a further 12 percent. This three-month tactical trade has a slight twist. It is best expressed as: overweight US stocks versus European bonds (currency hedged). This is because core European bond yields are close to their lower limit, meaning that core European bond prices are close to their mathematical upper limit. All of which brings us to a much higher conviction recommendation. The ‘Widow Maker’ Is Back First the widow maker came to Japan, next to Switzerland, then to the rest of Northern Europe. Now the widow maker has come to America. In the financial lexicon, ‘widow maker’ refers to the fatal strategy of shorting high-quality government bonds in an era when yields have been grinding inexorably lower. Any investment manager who has dared to bet that government bond yields would rise, whether starting from 3 percent, 2 percent, or even 1 percent, and whether in Japan, Switzerland, or even the US – has ended up being carried out of their job in a box, feet first (Chart of the Week). Except that in Switzerland over the past year, the widow maker trade has not been as fatal as it used to be. While the 5-year yield in the US has collapsed by 200 bps, in Switzerland it has edged down by just 20 bps (Chart I-4). Put another way, shorting the US 5-year T-bond has cost 11 percent, but shorting the Swiss 5-year bond has been relatively painless (Chart I-5). Chart I-4Swiss Bond Yields Cannot Fall Much... Chart I-5...Meaning Swiss Bond Prices Cannot Rise The simple reason is that Swiss government bond yields are now very close to their lower bound. The Lower Bound To Bond Yields Is Around -1 Percent The practical lower bound to the policy interest rate is -1 percent, because -1 percent counterbalances the storage cost of holding physical cash and/or other stores of value.2 Imagine the policy rate fell to well below -1 percent. If banks passed this deeply negative rate to their depositors, it would be logical for the bank depositors to flee wholesale into cheaper-to-hold physical cash. This deposit flight would kill the banking system. But if the banks didn’t pass the deeply negative policy rate to their depositors, it would wipe out the banks’ net interest margin – the gap between rates on loans and deposits. This inability to make profits would also kill the banking system. At deeply negative interest rates, bank deposits would flee. Could policymakers just abolish physical cash, forcing us all into ‘digital cash’ with unlimited negative interest rates? No, because that would just push us into other stores of value: for example, gold, or ‘decentralised’ cryptocurrencies. The common objections to cryptocurrencies are that their susceptibility to volatility and fraud makes them a poor store of value. But both objections are also true for gold. Yet who has ever argued that gold cannot be a store of value just because it is volatile and can be stolen (Chart I-6)! Chart I-6Gold Is A Store Of Value Despite Its Volatility The lower bound to the policy rate at around -1 percent also sets the lower bound of the bond yield, because a bond yield is just the expected average policy rate over the bond’s lifetime. For completeness, we should mention one technical exception. If bond investors price in the possibility of being repaid in a different and more valuable currency, the bond yield will carry a further redenomination discount as an offset for the potential currency gain. This is relevant to euro area bonds because there remains the remote possibility of euro disintegration. Therefore, bonds which carry the small possibility of a currency redenomination gain – notably, German bunds – possess a small additional discount on their yields. But in jurisdictions where no currency redenomination is possible, such as Switzerland or Sweden, the practical lower bound to bond yields is around -1 percent. Overweight Positive Yielding Bonds Versus Negative Yielding Bonds Switzerland teaches us that the closer that a bond yield gets to the -1 percent lower bound, the more limited becomes the possibility for a further yield decline (price gain), whereas the possibility for a yield increase (price loss) stays unlimited. Making such bonds a ‘lose-lose’ proposition. The convergence in bond yields has much further to go. Therefore, our high conviction recommendation is to short negative yielding bonds in relative terms. In other words, overweight positive yielding bonds versus negative yielding bonds. And currency hedge the position – as, right now, the cost of currency hedging is low. The recommendation is applicable for both tactical (3-month) and structural (2-year plus) investment horizons, and it is applicable for all bond maturities: 5-year, 10-year, and 30-year. Given where yields now stand, the most attractive structural pair is overweight the US 30-year T-bond versus the German 30-year bund (Chart I-7 and Chart I-8). Chart I-7Expect Yields To Converge At 10-Year Maturities... Chart I-8...And At Ultra-Long ##br##Maturities Our structural overweight to a 50:50 combination of U.S. T-bonds and Italian BTPs versus a 50:50 combination of German Bunds and Spanish Bonos at 30-year bond maturities is up by 7 percent in just nine months. But the convergence in yields has much further to go (Chart I-9). Chart I-9Overweight Positive Yielding Bonds Versus Negative Yielding Bonds Fractal Trading System* As discussed, this week’s recommended trade is to overweight stocks versus long-dated bonds expressed as overweight S&P500 versus German 30-year bund. The profit target is 12 percent with a symmetrical stop-loss. In a turbulent week for financial markets, overweight Poland versus Portugal achieved its profit target, short US utilities versus oil and gas and short EUR/CHF hit their stop-losses, and short palladium versus nickel moved comfortably into profit. The rolling 1-year win ratio now stands at 62 percent. Chart I-10Poland Vs. Portugal 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 MSCI All-Country World Index (in dollars) versus US 30-year T-bond. 2 The cost of holding physical cash or gold is the cost of its safe storage. Fractal Trading Model Cyclical Recommendations Structural Recommendations 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
Dear Clients, This week we are issuing two Special Alerts on the Russo-Saudi market share war, one of which you have already received. Our weekly publication will proceed as usual on Friday, March 13. In this Special Alert, we update our view of the US election and address the urgent question of US fiscal stimulus. Upcoming reports will address the question of stimulus outside the United States. All very best, Matt Gertken Vice President Geopolitical Strategy Feature Turmoil has engulfed financial markets as a Russo-Saudi market share war erupts at the same time as panic over the coronavirus spreads from China to Europe and the United States. The US and global stock markets are nearing bear market territory while the 10-year Treasury and global bond yields plumb new lows and deeper negatives (Chart 1). Our key risk-off indicators have all broken down (Chart 2). Chart 1The Bear Awakens Chart 2Global Risk-Off While the daily new cases of the virus are far from peaking in the US, the Democratic Party nomination process has eliminated the downside risk of a left-wing populist presidency. Political risk in the US will shift to Congress, fiscal stimulus, the general election, and the “lame duck” risk now threatening President Trump. Trump Not Yet Doomed, But No Longer Favored The US election is now “too close to call,” with the risks tilted toward a Trump loss. Bear markets tend to coincide with recessions (Chart 3). Woe betide a president seeking reelection amid a recession. Chart 3Bear Markets Tend To Coincide With Recessions We need to look to a previous era to identify precedents for Trump’s survival. William McKinley hung onto the office in 1900, Teddy Roosevelt in 1904, and Calvin Coolidge in 1924, all despite recessions.1 Rising unemployment will undo Trump’s re-election bid. In today’s terms, it is still possible that the virus panic will subside over the summer while a wave of global monetary and fiscal stimulus will kick in around September, creating a rebound that sends voters to the polls in an optimistic mood. But it is increasingly unlikely. Unemployment will rise as consumer confidence collapses in the face of the virus outbreak (Chart 4). This is deadly to a president with such narrow margins of victory in the key swing states. Chart 4Confidence Will Suffer, Layoffs To Ensue Chart 5Trump’s Approval Heading South Chart 6Republican Revival To Fall Back The coronavirus scare is already derailing President Trump’s approval rating. It had only tentatively recovered from a very low level throughout his first term and is highly unlikely ever to breach 50% (Chart 5). The surge in voters identifying as Republicans – which had recently, remarkably, surpassed Democrats – will reverse (Chart 6). Our quant election model is “too close to call” but will soon signal Trump loss. Our quant model was already flashing that the election is “too close to call,” due to the negative impact of Trump’s trade war on key swing states like Michigan and Pennsylvania. The weight of a feather can shift Wisconsin into the Democratic camp and turn the election against Trump (Chart 7). The model will inevitably show Trump losing the election once state-level data starts to reflect the virus shock. Chart 7Our Quant Election Model Says “Too Close To Call” … But Virus Panic Will Cause Wisconsin To Switch Bottom Line: The US election is too close to call at this point. With eight months to go, many things could still change, but a spike in unemployment will ruin Trump’s reelection bid. Biden, Not Sanders, Waiting In The Wings Chart 8Biden Has All But Clinched The Democratic Nomination The bad news for Trump – but the good news for markets – is that former Vice President Joe Biden has solidified his status as presumptive nominee for the Democratic Party presidential candidate. Biden romped to victory in Michigan and Missouri on March 10 – and is virtually tied with Vermont Senator Bernie Sanders in Washington, a liberal state that should favor the self-professed democratic socialist Sanders. Biden now clearly leads the count of pledged delegates to the Democratic National Convention on July 13 – and voting patterns in the remaining primary elections would have to reverse entirely in order to give Sanders a 1,991-vote majority of delegates in the first round of voting in July (Chart 8). It is unlikely that Sanders can deprive Biden of a majority of delegates even though he will trounce Biden in the final debate on March 15. The important state elections on March 17 are all favorable to Biden: Arizona, Florida, Illinois, and Ohio. Our delegate projections show Biden winning an outright majority by May 12 (Chart 9). Chart 9Biden Set To Win Majority Of Democratic Delegates By Spring Over the past year many clients have argued to us that neither Biden nor Sanders is electable. We have rejected this view on the basis that the economic cycle would most likely determine the election, since Trump had the misfortune of being a late-cycle president. The financial markets have dodged a bullet with Biden’s nomination since Sanders was capable of winning the nomination and now, with an impending recession, would be even odds (or favored) to take the White House. Chart 10Head-To-Head Polls Show Trump Vulnerability Average head-to-head polls show both Biden and Sanders beating Trump in the battleground states. This always suggested that Trump was highly vulnerable. But on the margin Biden is more electable than Sanders: he polls better against Trump than any Democrat, while Trump polls worse against him than any Democrat. Biden has an Electoral College pathway to victory via Florida and Arizona, as well as via the Midwestern states where Sanders is also competitive (Chart 10). Democrats ultimately chose Biden because he seemed the most likely to beat Trump. He also has the best position on the issue most important after the economy, which is health care (Chart 11). This reputation comes from his association with both President Barack Obama and the Affordable Care Act (Obamacare). A contested convention, in which the Democratic Party splits and progressive voters sit out the election, was always unlikely and is now virtually foreclosed. As he clinches the nomination Biden will seek to win over the support of progressives by choosing a progressive running mate and adopting more left-leaning policies on issues like inequality and the environment. Chart 11Democrats Chose Biden To Win And Restore Obamacare Chart 12Democratic Primary Turnout Strong In Vital Midwest Voter turnout in the primary elections suggests that voters are fired up in the Midwest (Michigan, Minnesota) but more complacent in the South (Texas, North Carolina) (Chart 12). Primary elections are different from general elections, but a worsening economy will provoke higher turnout. At minimum these data reinforce the point above that Trump is highly vulnerable in the Midwestern “Blue Wall” that narrowly brought him to power. Bottom Line: Biden is not only electable but at this stage equally likely as Trump to sit in the Oval Office in 2021. This is a market-positive policy outcome compared with the alternative – a Sanders presidency – which was almost equally probable in the event of a recession. Financial markets will see Biden as less negative than Sanders on regulation and taxes, and less negative than Trump on trade and foreign policy. Fiscal Stimulus A major source of uncertainty surrounding the election is fiscal policy, as a Democratic victory implies an increase in taxes on households and businesses. Not only is there a spike in tax provisions set to expire (top panel, Chart 13), but President Trump’s signature Tax Cut and Jobs Act could be repealed if he loses or made permanent if he wins. Chart 13Fiscal Uncertainty Looms Over US The short-term outlook is also in flux because the Trump administration is frantically trying to piece together an economic stimulus package to respond to the coronavirus shock. Democrats control the House of Representatives and have an incentive to delay and water down Trump’s stimulus proposals. However, they cannot be seen as playing politics with the nation’s health and livelihood and will ultimately agree to fiscal stimulus. This contradiction implies that financial markets will experience ongoing volatility as talks take place. Ultimately, Trump and the Democrats will cooperate, particularly as the financial constraint intensifies through market selling. Trump’s bid will be to stimulate the overall economy while House Speaker Nancy Pelosi and Senate Minority Leader Chuck Schumer will target the virus so as to keep the nation’s attention on health care without granting Trump a re-election fiscal bonus. The most significant short-term stimulus on offer would be a cut to payroll taxes. Trump’s preference may be to eliminate the entire 6% tax levied on worker income permanently, but he is more likely to get something on the magnitude of the 2011-12 temporary payroll tax cut (second panel, Chart 13). This was a two percentage point reduction in the tax (to 4%) for one year that ended up being extended for a second year. The size of the impact is roughly $75 billion for each percentage point for each year ($300 billion for two percentage points over two years). The risk is that the House Democrats may require modifications to Trump’s Tax Cut and Jobs Act that cause an impasse and financial markets to sell off before an agreement is reached.2 The Democrats, for their part, have a wish list of spending programs that they will insist on in exchange for a payroll tax cut. In particular they will seek to expand unemployment insurance for workers who lose their jobs in the impending slowdown, food stamps for unemployed and for children at home amid school closures, and mandatory paid leave (for parents with kids at home as well as sick people). The bill for such items can easily add up to $50-$100 billion in new spending. In addition, Congress and the White House have already approved an $8 billion virus mitigation package and additional packages of this size can happen quickly as the crisis requires. Trump is interested in another round of farm aid, given that China will fall short of its commodity purchases under the “phase one” trade deal, which could amount to $12-$15 billion. And Trump could always unilaterally rollback some of his tariffs on China or other trade partners. The combination of new spending and payroll tax cuts could bring the package to the $300-$400 billion range that Trump’s top economic adviser, Larry Kudlow, disapprovingly said was out of the question. It could easily amount to half of that. If the market continues to tank and the outlook for the US economy grows blacker, it will convince the Democrats that Trump is ruined unless they hurt their own image by appearing blatantly obstructionist amid a crisis. Bear in mind that the market wants a substantial stimulus not only because of the desire for a clear rebound in activity once the virus panic subsides, but also because the increasing odds of a Democratic victory in November mean that US tax rates will go up and corporate earnings will be revised downward. The country now faces a 50% chance of a 1%-2% fiscal tightening for each year in 2021-25 (Chart 14). Chart 14Biden Tax Hike Will Hit Corporate Earnings Chart 15US Fiscal Thrust To Surprise To Upside Thus a 1% of GDP fiscal stimulus for 2020 is the minimum necessary to improve sentiment. The US fiscal thrust – the change in the cyclically adjusted budget deficit – has already turned slightly positive this year, from what was expected to be a slight negative, due to a fiscally profligate budget deal between Trump and the Democrats last year (Chart 15). The one thing these blood enemies have in common is the need for more spending. Infrastructure spending is popular and has room to rise. Eventually the US will get stimulus, and it will surprise to the upside, even if the Democrats drag their feet to ensure that maximum political damage is inflicted on Trump this year. Not only is the fiscal setting inherently more dovish than it was in 2008, but Congress is bailing out plague-stricken households, not just Wall Street, this time around. The real game changer would be an infrastructure package. Americans spend about $140 billion or 0.7% of GDP each year on transport infrastructure, but popular opinion in both major political parties supports increases (Chart 16). The proposed sums are very large – Trump is proposing $1 trillion over a decade while Biden is proposing $1.3 trillion. The House Democrats have a bill worth $760 billion in new spending over five years ready to be passed. Also Trump is willing to capitulate on the Democrats’ preferred type of spending (direct deficit spending) due to his election constraint. These plans are all projecting considerable infrastructure spending on top of the Congressional Budget Office’s base line projection (Chart 17). Chart 16US Spends 0.7% Of GDP On Infra Each Year Chart 17Median Voter Wants More Infra Spending The fiscal multiplier of government spending is generally higher than tax cuts. Furthermore, the coronavirus hurts the economy by frightening households into their homes, which means that even the Democrats’ proposed cash transfers for low-income earners (those with a high marginal propensity to consume) may be impeded. Government-mandated infrastructure spending, by contrast, ensures that economic activity will pick up once the measures take effect (that is, with a 6-12 month lag … something the Democrats will become increasingly willing to agree to this spring given the election calendar). The impending US fiscal stimulus provides justification for going long infrastructure, construction, engineering, materials, mining, and environmental services sub-sectors included in the BCA Infrastructure Equity Basket (Chart 18). China’s large-scale stimulus measures reinforce this recommendation, since these firms are levered to China/EM growth. On a tactical basis, this trade is akin to catching a falling knife. Given our expectation that the world still faces challenges in overcoming the current turmoil, and the Democrats will hem and haw so as not to grant Trump his re-election wish list immediately, we await an opportune time to initiate this trade. A final reason to remain defensive on risk assets: the “lame duck” risk. If and when Trump’s re-election appears out of reach, he has an incentive to turn the tables. This could involve a radical or disruptive move in foreign or trade policy (e.g. on Iran, North Korea, Venezuela, China, or even Russia). At that point Trump could attempt to cement his legacy of cold war with China, or he could even lash out against Russian President Vladimir Putin, who has ostensibly stabbed him in the back by initiating a market share war with Saudi Arabia that may not be pieced back together in time to prevent job losses in shale oil swing states (Chart 19). Chart 18Look For Chance To Go Long Infrastructure Stocks Chart 19A Russo-Saudi Oil Market War Hurts Trump In Shale Swing States Presidential powers are least constrained in the international sphere. At the moment Trump is trying to save the economy and his presidency. But if it becomes a foregone conclusion that they cannot be saved, then he becomes a pure liability for risk assets. Housekeeping We are throwing in the towel on our US tech sector shorts for a loss of 36% and 11%, respectively, and also closing our long Thailand relative trade for a loss of 17%. We are also closing our tactical long Italian government bonds relative to Spanish for a loss of 2%. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Coincidentally all were Republicans, like Trump – not that it matters. 2 The Democrats may seek to have Trump increase the tax rate on the highest income earners to the pre-TCJA level, or they may seek to increase the cap on the state and local tax deduction, which allows households (mostly high-income earners) in high-tax states to reduce their federal tax bill.