Asset Allocation
Highlights Recent data suggest central bankers remain behind the curve in boosting inflation expectations. Ergo, expect a dovish bias to persist over the next few months. Our thesis remains that global growth is in a volatile bottoming process. However, market focus could temporarily flip towards short term data weakness, which warrants taking out some insurance. Meanwhile, in an environment where volatility is low and falling, it also pays to have insurance in place. Rising net short positioning in the yen and Swiss franc is making them attractive from a contrarian standpoint. Maintain a limit-buy on CHF/NZD at 1.45. The path of least resistance for the dollar remains down. This is confirmed by incoming data that suggests the euro area economies have bottomed, which should boost the EUR/USD. The rising dollar shortage remains a key risk to our sanguine view. But the forces driving dollar liquidity lower are largely behind us. Feature Investors looking for more clarity on the global growth picture from the April data print have been left in a quandary. In the U.S., the headline first-quarter real GDP growth number of 3.2% was well above consensus but was boosted by volatile components such as inventories and net exports. Real final sales to domestic purchasers, a cleaner print for final demand, came in at 1.5%, the lowest increase since 2015. Assuming trend growth in the U.S. is around 2%, a view shared by the Federal Open Market Committee (FOMC), then the increase in first-quarter final sales was a big miss. Most importantly, the U.S. ISM manufacturing index fell to 52.8 in April, a drop that was broad-based across seven of the 10 components. Chart I-1At The Cusp Of A V-Shaped Recovery? Across the ocean, European growth was a tad stronger. Italy managed to nudge itself out of a technical recession, while Spanish year-on-year growth of 2.4% helped drive euro area GDP growth to the tune of 1.2%. The most volatile components of euro area growth tend to be investment and net exports. Should both pick up on the back of stronger external demand, then GDP could easily gravitate towards 1.5%-2%, pinning it well above potential. The German PMI is currently one of the weakest in the euro zone. But forward-looking indicators suggest we are at the cusp of a V-shaped bottom over the next month or so (Chart I-1). China remains the epicenter of any growth pickup and the headline PMI numbers were soft, with the official NBS manufacturing PMI falling to 50.1 from 50.5, and the private sector Caixin manufacturing PMI falling to 50.2 from 50.8. Still, the numbers remain above the critical 50 threshold level, and well beyond the 45-48 danger zone. Export growth numbers across southeast Asia remain weak, and after a brisk rise since the start of the year, many China plays including commodity prices, the yuan, emerging market stocks, and Asian currencies are all rolling over. The bearish view is that there are diminishing marginal returns to Chinese stimulus, and the authorities need to be more aggressive to turn the domestic economy around. The reality is that policy stimulus works with a lag, and we need about three to six months before we see the effects of the current policy shift. Southeast Asian exports track the Chinese credit impulse with a lag of six months, and there is little reason to believe this time should be different (Chart I-2). Chart I-2Global Trade Should Soon Bottom The broad message is that global growth likely bottomed in the first quarter. However, before evidence of this fully unfolds, markets are likely to be swayed by the ebbs and flows of higher-frequency data, making for a volatile bottoming process. We recommend maintaining a pro-cyclical bias, but taking out some insurance against a potential spike in volatility. The Fed On Hold This week’s FOMC meeting focused on the lack of inflationary pressures in the U.S. but was largely a non-event for financial markets, aside from a spike in volatility. Nonetheless, there were three key takeaways. First, the dip in inflation appears to be “transitory,” driven by lower clothing prices and financial services fees. Second, Chair Powell made it clear that the Fed will only feel the need to ease policy if inflation runs “persistently” below target. Finally, the Fed’s interpretation of its “symmetric” inflation target is slowly shifting. Many FOMC members increasingly believe that the Fed should explicitly pursue an overshoot of its 2% inflation target to make up for past misses. Taken together, we expect the Fed to remain on hold for the time being, but to eventually start raising rates again as inflationary pressures pick up. Chart I-3Inflation Should Be Higher In The U.S. Versus The Euro Area The bigger picture is that in a very globalized world with fully flexible exchange rates, it is becoming more and more difficult for any one central bank to independently achieve its inflation objective. This is because, should inflation be on the rise and moving higher in one country, expectations of higher interest rates should lift its currency, which eventually tempers inflationary pressures, and vice versa. This is obviously a very simplistic view of the world economy, since other factors such as demographics, productivity, labor mobility, openness of the economy, and policy divergences among others, play important roles. However, it is remarkable that almost every developed market central bank has continued to attempt to boost inflation to the 2% level since the Global Financial Crisis, but very few have been able to achieve this independently. In a very globalized world with fully flexible exchange rates, it is becoming more and more difficult for any one central bank to independently achieve its inflation objective. Take the case of Europe versus the U.S., two economies that could not be more different. Euro area imports constitute about 41% of GDP, while the number in the U.S. is only 15%, so tradeable prices matter a lot more for the former. Meanwhile, the demographic profile is worse in Europe, with the old-age dependency ratio at 32% in Europe versus 23% in the U.S. Finally, other measures of supply-side constraints such as labor market slack or capacity utilization suggest the euro area is well behind the U.S. on the path toward a closed output gap (Chart I-3). Despite this, since 2015, headline inflation in both the U.S. and euro area have moved tick-for-tick. Yes, policy divergences between the two countries have been very wide, either via the lens of quantitative easing or simply the differential in policy rates (Chart I-4). But the fact that the magnitude and direction of overall inflation has moved homogenously, begs the question of the ability of either central bank to influence overall prices. One explanation could be that variations in headline CPI are largely driven by volatile items that tend to be exogenous, while variations in core CPI tend to be mostly driven by endogenous factors. This is confirmed by most research that suggest there is a weak link between rising commodity prices and longer-term inflation.1 That said, over the shorter run, commodity price gyrations can dominate and be the main driver of inflation expectations (Chart I-5). Chart I-4U.S. And Euro Area Overall CPI Are Broadly Similar Chart I-5In The Short Term, Commodity Prices Matter For Inflation Expectations The bottom line is that muted inflationary pressures are a global phenomenon, and not centric to the U.S. This means that as a whole, global central banks are set to stay accommodative for the time being, which will be bullish for global growth (Chart I-6). This warrants maintaining a pro-cyclical stance but being extremely selective in what might be a volatile bottoming process. Chart I-6Global Monetary Policy Needs To Ease Further Maintain A Pro-Cyclical Stance With the S&P 500 breaking to all-time highs, crude oil prices up around 40% from their lows, and U.S. 10-year Treasury yields rolling over relative to the rest of the world, this has historically been fertile ground for high-beta currency trades. That said, the lack of more pronounced strength in pro-cyclical currencies like the Australian, New Zealand, and Canadian dollars suggest that caution prevails. Our bias is that currency markets continue to fight a tug-of-war between strong dollar fundamentals and fading tailwinds. Our portfolio consists mostly of trades along the crosses, but we have been cautiously adding to U.S. dollar short positions over the past few weeks: Long AUD/USD: Our limit-buy on the Aussie was triggered at 0.70. Data out of Australia are showing tentative signs of a bottom. Last week’s important jobs report showed that the economy continues to offer more employment than the consensus expects. Meanwhile, the credit growth data out of Australia this week suggests that macro-prudential policies continue to drive a wedge between owner-occupied and investor housing (Chart I-7). House prices in Australia are already deflating to the tune of around 6%. Once the cleansing process is through, we expect house price growth to eventually converge toward levels of credit and/or natural income growth. Moreover, the Australian dollar remains a commodity currency, and will benefit from rising terms-of-trade. Iron ore prices remain firm on the back of supply-related issues. Meanwhile, a rising mix of liquefied natural gas in the export basket will provide tailwinds as China continues to steer its economy away from coal. Finally, Chinese credit growth has been a key determinant of the re-rating of Australian equities. Ergo, a rising Chinese credit impulse will ignite Australian share prices, and by extension the Australian dollar (Chart I-8). Chart I-7Australian Credit Growth Converging To Steady State Chart I-8More Chinese Credit Will Help Australian Equities Long GBP/USD: Our buy-limit order on the British pound was triggered at 1.30 on March 29th. As we argued back then, the pound is sitting exactly where it was after the 2016 referendum results, but the odds of a hard Brexit have significantly fallen since then. On the domestic front, economic surprises in the U.K. relative to both the U.S. and euro area continue to soar. The reality is that the pound and U.K. gilt yields should be much higher – solely on the basis of hard incoming data. Employment growth has been holding up very well, wages are inflecting higher, and the average U.K. consumer appears in decent shape. Full-time employees continue to creep higher as a percentage of overall employment (Chart I-9). This view was echoed in yesterday’s Bank Of England (BoE) policy meeting, where the central bank raised its growth forecast while striking a more hawkish tone. Chart I-9U.K.: What Brexit? Chart I-10Sweden: Volatile Bottom Long SEK/USD: The Swedish krona should be one of the first currencies to benefit from any bottoming in European growth (Chart I-10). The Swedish economy appears to have bottomed relative to that of the U.S., making the USD/SEK an attractive way to play USD downside. From a technical perspective, the cross is trading at its lowest level since the global financial crisis (Chart I-11). Economic surprises in the U.K. relative to both the U.S. and euro area continue to soar. The main appeal of the Swedish krona is that it is extremely cheap. Meanwhile, despite negative interest rates, Swedish household loan growth has been slowing as consumers are increasingly financing purchases through rising wages. This will alleviate the need for the Riksbank to maintain ultra-accommodative policy, despite its recent dovish shift. Buy Some Insurance Given current low levels of volatility and elevated equity market valuations, the dollar would have been a great insurance policy for any stock market correction. But with U.S. interest rates having risen significantly versus almost all G10 countries in recent years, the dollar has itself become the object of carry trades. This has also come with a good number of unhedged trades, as the rising exchange rate has lifted hedging costs. Chart I-11How Much Lower Could The Swedish Krona Go? Chart I-12Buy Some##br## Insurance It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. As markets become volatile and some carry trades are unwound, unhedged trades will become victim to short-covering flows. Currencies such as the Japanese yen and the Swiss franc that could have been used to fund carry trades are ripe for reversals. This suggests at a minimum building some portfolio hedges. One such hedge is going long the CHF/NZD. This trade has a high negative carry, so we do not intend to hold it for longer than three months. But it should pay off handsomely on any rise in volatility (Chart I-12). Maintain a limit-buy at 1.45. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Stephen G Cecchetti and Richhild Moessner, “Commodity Prices And Inflation Dynamics,” Bank Of International Settlements, Quarterly Review, (December 2008). Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. continue to moderate: Annualized Q1 GDP came in at 3.2% quarter-on-quarter, well above estimates. Personal income increased by 0.1% month-on-month in March, below the estimated 0.4%. On the other hand, personal spending increased by 0.9% month-on-month in March. PCE deflator and core PCE deflator fell to 1.5% and 1.6% year-on-year, respectively in March. Michigan consumer sentiment index slightly increased to 97.2 in April. Markit manufacturing PMI increased from 52.4 to 52.6 in April, while ISM manufacturing PMI fell to 52.8. Q1 nonfarm productivity increased by 3.6%, surprising to the upside. DXY index fell by 0.3% this week. On Wednesday, the Fed announced their decision to keep interest rates on hold at current levels, further suggesting that there is no strong case to move rates in either direction based on recent economic developments. Moreover, Fed chair Powell reiterated their strong commitment to the 2% inflation target. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area are improving: Money supply (M3) in the euro area increased by 4.5% year-on-year in March. The sentiment in the euro area remains soft in April: economic sentiment indicator fell to 104; business climate fell to 0.42; industrial confidence fell to -4.1; consumer confidence was unchanged at -7.9. Q1 GDP came in at 1.2% year-on-year, surprising to the upside. Unemployment rate fell to 7.7% in March. Markit PMI increased to 47.9 in April. EUR/USD appreciated by 0.3% this week. European data keep grinding higher. Italian GDP moved back into positive territory in Q1. Spanish GDP also rebounded in Q1. Positive Chinese credit data suggests the euro will soon benefit from rising Chinese imports. Report Links: Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: The unemployment rate in March increased slightly to 2.5%; job-to-applicant ratio was unchanged at 1.63. Tokyo consumer price inflation increased to 1.4% year-on-year in March, the highest level since October 2018. Industrial production fell by 4.6% year-on-year in March. However, projections for April suggest a 2.7% month-on-month jump. Retail sales grew by 1% year-on-year in March, higher than expected. Housing starts grew by 10% year-on-year in March. This is the highest growth level since February 2017. USD/JPY fell by 0.2% this week. The Japanese government’s intention to raise sales tax this October could be a highly deflationary outcome. However, there is still an outside chance that the tax hike will be postponed. We continue to recommend yen as a safety hedge. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been positive: U.K. mortgage loans in March increased to 40K. Nationwide housing prices increased by 0.9% on a year-on-year basis in April. Markit manufacturing PMI came in above expectations at 53.1 in April, even though it fell; Markit construction PMI however increased to 50.5. Money supply (M4) increased by 2.2% year-on-year in March. GBP/USD increased by 1% this week. The Bank of England kept rates on hold at 0.75% this week. In the May inflation report, the BoE mentioned that U.K.’s economic outlook will depend significantly on the nature and timing of EU withdrawal, and the new trading agreement with EU in particular. But governor Carney struck a slightly hawkish tone, revising up GDP estimates and guiding the next policy move as a rate hike. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have shown tentative signs of recovery: Private sector credit growth fell to 3.9% year-on-year in March. However, this is heavily biased downwards by lending to home investors that has slowed to a crawl. The Australian Industry Group (AiG) manufacturing index increased to 54.8 in April. RBA commodity index increased by 14.4% year-on-year in April. AUD/USD fell by 0.4% this week. The data are starting to look brighter in Q2, suggesting that the economy might have bottomed in Q1. The Australian dollar is likely to grind higher, especially driven by rising terms of trade. Report Links: Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand are mixed: ANZ activity outlook increased by 7.1% in April. ANZ business confidence in April improved to -37.5. On the labor market front in Q1, the employment change fell to 1.5% year-on-year; unemployment rate was unchanged at 4.2%, but participation rate fell to 70.4%; labor cost index fell to 2% year-on-year. Building permits contracted by 6.9% month-on-month in March. NZD/USD depreciated by 0.4% this week. The data from New Zealand continue to underperform its antipodean neighbor. We anticipate this trend will persist. Stay long AUD/NZD, currently 0.5% in the money. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada continue to underperform: GDP in February contracted by 0.1% on a month-on-month basis. Markit manufacturing PMI fell below 50 to 49.7 in April. USD/CAD fell by 0.1% this week. During Tuesday’s speech, Governor Poloz acknowledged recent negative developments in the Canadian economy, and blamed it on the U.S.-led trade war, as well as the sharp decline in oil prices late last year. While a bottoming in the global growth could be a tailwind for the Canadian economy near-term, a Ricardian equivalence framework will suggest fiscal austerity over the next few years, will be a headwind for long-term CAD investors. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell to 96.2 in April. Real retail sales contracted by 0.7% year-on-year in March. SVME PMI fell below 50 to 48.5 in April. USD/CHF fell by 0.1% this week. The reduced volatility worldwide could make the Swiss franc less attractive. Moreover, the relative outperformance of the euro area is a headwind for the franc. Our long EUR/CHF position is now 1% in the money. We intend to trade the franc purely as an insurance policy near-term. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales increased by 0.6% in March, in line with expectations. This was a marked improvement from the 1.2% drop in February. The unemployment rate held low at 3.8% USD/NOK increased by 1% this week. We expect the Norwegian krone to pick up based on the strong fundamentals and positive oil price outlook. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mostly positive: Retail sales increased on a month-on-month basis by 0.5% in March, but fell to 1.9% on a yearly basis. Producer price index was unchanged at 6.3% year-on-year in March. Trade balance came in at a large surplus of 7 billion SEK in March. Manufacturing PMI fell to 50.9 in April, but notably, import orders and backlog orders rose. USD/SEK increased by 0.4% this week. Despite the RiksBank’s dovish shift last week, we continue to favor our long SEK position. Our conviction is rooted in the fact that the Swedish krona is undervalued, and relative PMI trends favor Sweden vis-à-vis the U.S. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Open an equity market relative overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, the majority of this year’s absolute gains have already been made. Core euro area bond yields will edge modestly higher… …and EUR/USD will appreciate, as the backward-looking data on which the ECB depends catches up with the more perky real-time economic data. Feature Vertical charts scare us, as we contemplate falling over the edge. But they also excite us, as we contemplate a lucrative investment opportunity. Right now, the vertical chart that is causing us palpitations is technology versus healthcare (Chart of the Week). Chart of the WeekTechnology Versus Healthcare Has Gone Vertical! The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Meaning that the technology versus healthcare relative performance has unavoidable consequences for regional and country stock market allocation (Chart I-2 and Chart I-3). The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Chart I-2When Technology Underperforms Healthcare, Netherlands Underperforms Switzerland Chart I-3When Technology Underperforms Healthcare, China Underperforms Switzerland Specifically, from a European stock market perspective, the Netherlands is overweight technology while Switzerland and Denmark are both overweight healthcare. Further afield, the U.S. is overweight technology while China is both overweight technology and underweight healthcare. Explaining Verticality And The Subsequent Fall What creates vertical charts? To answer the question, let’s turn it on its head: what prevents vertical charts? The answer is: the presence of value investors. In a healthy market, a cohort of value investors will sit on the side lines and only transact with the marginal seller when the price falls to a semblance of value. In other words, the value sensitive investors help to set the price, preventing verticality. But if the value sensitive cohort switches out of character to join a strong uptrend, the cohort will suddenly become value insensitive. In this case, the marginal seller will set the price higher and the formerly uninterested value sensitive buyer will now buy at the higher price. The market has morphed into a trend-following market. As more of the value cohort switch sides, the process adds rocket fuel to the rally. Driven by the ‘fear of missing out’ the marginal buyer will buy at larger and larger price increments, and the chart becomes vertical. What triggers the subsequent fall? When all of the value cohort have joined the uptrend, the fuel has run out: the marginal seller will no longer find a willing marginal buyer at the elevated price. At this critical point, one of two things will happen. Either: a completely new cohort of even deeper value investors will switch out of character and provide new fuel to the trend, allowing it to continue. Or: the deep value investors will stay true to character and will only deal with the marginal seller when the price falls, perhaps sharply, to a semblance of deep value. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased. Both the theoretical and empirical evidence suggests that at this critical point, the probability of trend-continuation decreases to about a third and the probability of a trend-reversal increases to about two-thirds. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased (Chart I-4). Chart I-4Technology Versus Healthcare: The Probability Of A Trend-Reversal Is High Therefore, on a tactical horizon, it is now appropriate to underweight technology versus healthcare – which, to reiterate, carries unavoidable consequences for country and regional stock market allocation: Open an overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. Distinguishing Between Valuation And Growth Is Extremely Difficult There is another problem for value investors. Over short periods – meaning less than a year – it is very difficult, if not impossible, to decompose a price return into its two components: the component coming from the change in valuation and the component coming from the change in earnings growth expectations. A stock market’s actual earnings are highly sensitive to small changes in economic growth. This is universally the case but is especially true in Europe, because the European stock market’s skew towards growth-sensitive cyclicals gives it a very high operational leverage to GDP growth: a seemingly minor 0.5 percent change in economic growth translates into a major 25 percent change in stock market earnings growth (Chart I-5). The slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Chart I-5A Minor Upgrade To Economic Growth = A Major Upgrade To Profits Growth Given this very high operational leverage, the slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Which of course lifts the market’s price, P, very sharply. In contrast, equity analysts’ forecasts for earnings, which drive the market’s ‘official’ forward earnings, E, adjust much more slowly. As my colleague, Chris Bowes explains: “analysts get married to a view and usually require overwhelming evidence to materially change it.” The upshot is that the P rises very sharply but the official forward E does not, meaning that the official forward P/E also rises very sharply. This gives the impression that the move is mostly valuation driven, but the truth is that the move is mostly earnings growth driven. In a similar vein, when central banks guide interest rates lower, how much of the equity market’s move is due to a higher valuation, and how much is due to improved prospects for economic growth resulting from the central bank policy change? Over relatively short periods of time, it is extremely difficult to tell. All of which provides an important lesson: over short periods, do not focus on separately forecasting the valuation change and earnings growth change of a stock market. Much better to forecast the stock market price directly, by focussing on the two main things which will drive it: changes to central bank policy, and changes to short-term real-time economic growth. Focus On Central Banks And Short-Term Economic Growth Central bank policy now ‘depends’ on relatively longer-term changes (say, year-on-year) in backward-looking data, most notably the consumer price index. Whereas the stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators (Chart I-6). Chart I-6Quarter-On-Quarter Growth Is Rebounding Hence, the ‘sweet spot’ for equity markets is when, in simple terms, year-on-year CPI inflation is decelerating, implying central banks will become more dovish, while quarter-on-quarter economic growth is accelerating, implying the market will upgrade earnings growth (Chart I-7). The stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators. The ‘weak spot’ for equity markets is the exact opposite, when year-on-year CPI inflation is accelerating, implying central banks will become less dovish, while quarter-on-quarter economic growth is decelerating, implying the market will downgrade earnings growth. As 2019 progresses, our high-conviction prediction is that equity markets will move from a sweet spot to a weak spot. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, it implies that the majority of 2019’s gains have already been made in the first four months of the year – and the market is unlikely to be significantly higher at the end of the year. Compared to the equity market, the bond, interest rate, and currency markets are – almost by definition – much more dependent on central banks’ lagging reaction functions than on real-time growth. Which solves the mystery as to why bond yields are close to new lows while equity markets are close to new highs. It also solves the mystery as to why EUR/USD has lagged the very clear recovery in euro area real-time growth and in euro area stock markets (Chart I-8). Central banks are following lagging indicators. Chart I-7Stock Markets Take Their Cue from Real-Time Indicators Chart I-8Central Banks Are Following Lagging Indicators, Stock Markets Are Following Real-Time Indicators But as the backward-looking data, on which the ECB depends, catches up with the more perky real-time data, core euro area bond yields will edge modestly higher, and EUR/USD will gently appreciate. Next week, in lieu of the usual weekly report, I will be giving this quarter’s webcast titled ‘From Sweet Spot to Weak Spot?’ live on Wednesday May 8 at 10.00 AM EDT (3.00 PM BST, 4.00 PM CEST, 10.00 PM HKT). Through a series of key charts, the webcast will reveal the prospects and opportunities for all asset-classes through the remainder of 2019. At the end of the webcast, I will also unveil a brand new investment recommendation. So don’t miss it! Fractal Trading System* Supporting the arguments in the main body of this report, fractal analysis suggests that the recent rally in China’s stock market is at a technical point that has reliably signaled previous major reversals. Accordingly, this week’s recommended trade is a stock market pair trade, short China versus Japan. Set the profit target at 2.5 percent with a symmetrical stop-loss. We now have six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9Short China Vs. Japan The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of April 30, 2019. The quant model has not made significant changes in the major country allocations, but has upgraded Australia to slight overweight from underweight and downgraded Sweden to slight underweight from overweight, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark by 43 bps in April, with 113 bps of outperformance from the Level 2 model, offset by 11 bps of underperformance from Level 1. Directionally, 8 out of the 12 choices generated positive alpha. The largest contributions to the outperformance in April came from the overweight in Germany and Netherlands, as well as the underweight in Japan and the U.K. Since going live, the overall model has outperformed by 152 bps, with 365 bps of outperformance by the Level 2 model, offset by a slight underperformance from Level 1. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. Chart 3GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of April 30, 2019. Chart 4Overall Model Performance Table 3Model’s Performance (March 1, 2019 - Current)Table 4Current Model Allocations The model’s relative tilts within cyclicals and defensives have changed compared to last month. The model has turned more cautious on Materials and cut it from overweight to underweight due to a weakness in its momentum component. This in turn increases the overweight allocations to Industrials and Utilities, the model’s two overweights, and decreases the underweight allocation to the nine remaining sectors. While global growth is set to bottom, the hard data has not fully materialized yet, therefore preventing the model from being outright bullish on cyclicals. The valuation component remains muted across all sectors. The model is still overweight Utilities due to positive inputs from its growth and liquidity components. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model,” dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com
Feature What Could Sour The Sweet Spot? This continues to look like a very benevolent environment for risk assets. Growth in the U.S. remains decent, with Q1 GDP growth beating expectations at 3.2% QoQ annualized (albeit somewhat distorted by rising inventories). Leading indicators point to U.S. GDP growth of around 2.5% for 2019. The rest of the world is showing the first “green shoots” of economic recovery. China continues to expand credit, and the effects of this are starting to stabilize growth in Europe, Japan, and the Emerging Markets (Chart 1). Recommended Allocation Chart 1China Reflation Helping Growth To Bottom At the same time, central banks everywhere have turned accommodative. Following the Fed’s dovish shift late last year, the market has priced in rate cuts by end-2019. The ECB is about to relaunch its TLTRO funding program, and is expected to keep rates in negative territory for at least another year (Chart 2) – though there are worries whether Mario Draghi’s successor as ECB president might be more hawkish. The Bank of Canada and Bank of Japan, among others, have recently reemphasized monetary caution. Chart 2No Rate Hikes Anywhere Chart 3Term Premium Keeping Down Yields This goes some way to explain the biggest puzzle in markets currently: why, despite global equities being less than 1% below a record high, long-term interest rates remain so low, with the 10-year U.S. Treasury yield at 2.5%, and yields in Germany and Japan hovering around zero. There are other explanations too. A decomposition of the U.S. 10-year yield shows that most of the downward pressure has come from a sharp drop in the term premium (Chart 3). This is partly because lousy growth in other developed economies, such as Germany and Japan, has pushed down yields in these countries and, given that spreads to the U.S. were at record highs, depressed U.S. rates too. It also reflects a lingering pessimism among investors who bought Treasuries at the end of last year to hedge against recession and who remain concerned about the economy. This is evidenced by continuing strong flows into bond funds in 2019 (Chart 4). A decomposition of the U.S. 10-year yield shows that most of the downward pressure has come from a sharp drop in the term premium. Chart 4Investors Buying Bonds, Not Equities Chart 5Why Has Inflation Fallen? A further explanation is the recent softness in inflation, with the Fed’s focus measure, core PCE inflation, slowing to an annual rate of only 0.7% over the past three months (Chart 5). This is probably mostly due to the economic slowdown late last year. But it may also have structural causes: the recent improvement in labor productivity can perhaps allow wages to rise without feeding through into consumer price inflation (Chart 6). Chart 6Maybe Because Of Better Productivity Chart 7Indicators Suggest Inflation Will Still Trend Up How is this all likely to pan out? We think it improbable that inflation will stay low for long if growth is as robust as we expect. Leading indicators of inflation continue to suggest prices will trend higher (Chart 7). The Fed may not rush to raise rates (not least since, with the lower inflation recently, the Fed Funds Rate in real terms is now at neutral according to the Laubach-Williams model, Chart 8). But we also find it inconceivable that the Fed will cut rates, if growth remains strong, stocks continue to rise, and global risks recede. By the end of this year, it should be able to make a renewed case for a further hike. But even if it doesn’t do that – and permits either inflation to overheat for a while, or asset bubbles to form – these scenarios should be more conducive to equity outperformance, than bond outperformance. Global equities have already risen by 22% since last December’s low and may struggle to make rapid progress over the next few months. The key to further upside for stocks will be earnings: since analysts have cut EPS forecasts for S&P 500 companies for this year to only 4%, those expectations should not be hard to beat. In the Q1 earnings season, for instance, 79% of companies have so far come in ahead of the consensus EPS forecast. For global asset allocators, the key decision is always at the asset-class level. Will equities outperform bonds over the coming 12 months? Equities should have further upside if our macro scenario proves correct. On the other hand, we find it hard to imagine that global bond yields will not rise moderately if global growth recovers, the Fed refrains from cutting rates, inflation rises somewhat, and investors turn less wary of equities. We continue, therefore, to expect the stock-to-bond ratio (Chart 9) to rise further over the next 12 months. We think it improbable that inflation will stay low for long if growth is as robust as we expect. Chart 8Is Fed Now At Neutral? Chart 9Stock-To-Bond Ratio Can Rise Further Chart 10Europe And EM Outperform Only Briefly Equities: We remain overweight global equities, but are reluctant to take higher beta country exposure until there is greater clarity on the bottoming out of ex-U.S. growth. Moreover, the structural headwinds that have prevented anything more than short-term outperformance for eurozone stocks (banking sector weakness) and Emerging Markets (excess debt and poor productivity) since 2010 remain powerful negative factors (Chart 10). Our moderately pro-cyclical sector recommendations (overweight energy and industrials) should hedge us against upside risk emanating from a strong rebound in Chinese imports. Fixed Income: Over the past few years, periods where equities have decoupled from bond yields have been resolved with bond yields playing catch-up (Chart 11). We expect the same to happen over the next few months, with global government bond yields rising moderately. The risk-on environment continues to be positive for credit. We prefer credit to government bonds within fixed income, but are only neutral within our overall recommended portfolio. U.S. high-yield bonds in particular look attractively valued, as long as growth continues and default rates don’t start to rise too much (Chart 12). Chart 11When Bonds And Equities Diverge… Chart 12Junk Bonds Attractively Valued Currencies: A pick-up in global growth would be negative for the U.S. dollar, typically a counter-cyclical currency (Chart 13). BCA’s currency strategists have slowly been moving towards a more positive stance on some currencies versus the dollar, particularly the euro and Australian dollar. We would expect to see the trade-weighted dollar start to depreciate in H2 once global growth accelerates, fueled by the very skewed long-dollar positioning currently. However, this may be only a six- to 12-month move, since growth and interest-rate differentials suggest that the structural dollar bull market that began in 2012 has not yet fully run its course. Commodities: Oil remains dominated by supply-side dynamics. How much the ending of waivers on Iranian oil sanctions, plus troubles in Venezuela and Libya, push up oil prices will depend on whether President Trump can persuade Saudi Arabia and UAE to increase production. BCA’s energy team expects he will be only partially successful in doing so, and see Brent reaching $80 a barrel and WTI $77 (from $72 and $64 currently) during 2019. Industrial commodities prices will depend on the strength and nature of China’s reflation: our commodities strategists see copper, the most sensitive metal to Chinese demand, as the best way to play this.1 Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Chart 13Stronger Growth Would Be Dollar Negative Footnotes 1 Please see Commodity & Energy Strategy Weekly Report, “Copper Will Benefit Most From Chinese Stimulus,” dated April 25, 2019, available at ces.bcaresearch.com GAA Asset Allocation
Highlights Oil & Bond Yields: Global growth indicators are starting to rebound, risk assets have returned to previous cyclical highs, and oil prices remain buoyant. This is a combination that will eventually result in rising global bond yields, but more through higher inflation expectations that will bear-steepen yield curves. Stay below-benchmark on overall portfolio duration, but enter new reflationary trades in core Europe (long inflation breakevens) and Australia (yield curve steepeners). EM vs DM Credit: Signs of a pickup in Chinese growth will be more supportive for growth in EM economies. Hedging against an extended downturn in China is no longer needed. Upgrade EM U.S. dollar denominated sovereign and corporate debt to neutral (3 of 5), at the expense of a smaller overweight position in U.S. investment grade corporates. Feature Chart of the WeekA Consistent Message On Rebounding Growth Evidence is starting to point to a bottoming in global economic momentum. Credit growth has notably picked up in China, global leading economic indicators are stabilizing and sentiment measures like our Duration Indicator have started to climb (Chart of the Week). While it is still early in this reflation process, the leading data is now moving in a direction that bodes well for continued gains in global equities and growth-sensitive spread product. The sharp rallies across risk assets seen so far this year have merely retraced the stinging losses incurred in the final months of 2018. Those moves were fueled by a combination of slowing global growth and overly hawkish central bankers. Now that policymakers have “course corrected” towards dovishness, led by the Fed’s 180-degree turn on the outlook for rate hikes in 2019 that drove U.S. Treasury yields lower, the next leg of the risk rally can begin, led by improving global growth. At some point, looser financial conditions – higher equity prices, tighter credit spreads and lower market volatility – will require global central bankers to retreat from dovish forward guidance (Chart 2). Policymakers who have been focused on sluggish global growth, “persistent uncertainty” (as ECB President Mario Draghi has described it), and falling inflation expectations will eventually have to adjust their policy bias once those factors reverse. On that front, the combination of improving global growth, rising oil prices and an increasingly likely U.S.-China trade deal will help boost global bond yields through rising inflation expectations first and higher interest rate expectations later (Chart 3). Chart 2A Full Unwind Of Late-2018 Moves...Except For Inflation Chart 3Get Ready For A Bond-Bearish Turn In Growth We continue to recommend a high-level fixed income portfolio construction that will benefit from these trends: below-benchmark on overall duration exposure with overweights on global corporate debt versus government bonds. We also see a case to selectively position for steeper yield curves and higher inflation expectations in countries more sensitive to higher oil prices and where central banks will be less hawkish/more dovish. Most importantly, we no longer see a need to maintain a defensive underweight in emerging market (EM) hard currency spread product, as we discuss later in this report. Yes, Oil Prices Still Matter For Bond Yields Global oil prices hit a new 2019 high last week on news that the Trump administration was letting waivers expire on U.S. sanctions of Iranian oil exports. Coming on top of the lost output from Venezuela, increased tensions in Libya and persistent production discipline from the major oil players (OPEC, the so-called “OPEC 2.0” of Russia and Saudi Arabia, and even U.S. shale producers), a boost to global oil demand from faster global growth is likely to result in even higher oil prices in the next 6-9 months. The combination of improving global growth, rising oil prices and an increasingly likely U.S.-China trade deal will help boost global bond yields. Our colleagues at BCA Commodity & Energy Strategy remain steadfast bulls on oil prices, with a year-end price target of $80/bbl on the Brent crude benchmark. They view the supply constraints as large and persistent enough to cause oil prices to continue rising alongside firmer global demand. Our most optimistic forward-looking growth indicator, the diffusion index of global leading economic indicators, is now calling for a sharp rebound in cyclical data like the global manufacturing PMI in the latter half of 2019. A move back to the 55-60 range for the global PMI, which the diffusion indicator is pointing towards (Chart 4, bottom panel), would be consistent with the +50% year-over-year growth rates in oil prices implied by BCA’s bullish oil forecasts (middle panel). Chart 4The 2019 Oil Rally Is Not Over Yet Over the past several years, there has been a strong correlation between oil prices and government bond yields in most developed economies (Chart 5). Since the most recent bottom in global yields back on March 27, that behavior has persisted. Longer-term bond yields have risen more than shorter-dated yields, alongside higher inflation expectations further out the yield curve (Table 1). Chart 5Inflation Expectations Still Driving Bond Yields Such “bear-steepenings” do not usually last for long periods of time. Inflation targeting central banks typically look at the reflationary implications of higher oil prices – faster economic growth with more future inflation as energy costs seep into core inflation measures – as a sign to maintain a more hawkish bias for monetary policy. That is not the case today, though, as data dependent central bankers have been more focused on past soft readings on both growth and inflation momentum. This should support a growth-driven rise in global oil prices in the coming months, as policymakers will be reluctant to alter the current dovish guidance without signs of both faster growth and higher realized inflation. Within the major developed markets, the recent correlations between oil prices (in local currency terms) and inflation expectations have been weakest in regions where central banks are most likely to keep policy interest rates stable. In the euro area, Japan and Australia – where core inflation rates are well below central bank targets and money markets are discounting flat-to-lower interest rate expectations over the next 1-2 years – market-based measures of inflation expectations like CPI swap rates have diverged from the rising path of local-currency denominated oil prices (Chart 6). In the U.S. and Canada, which have only recently paused their rate hike cycles, the correlation between oil prices and inflation expectations has been a bit more in line with the experience of the past several years. The same goes for the U.K., although inflation expectations there seem more driven by currency weakness stemming from the Brexit uncertainty rather than a central bank that is perceived to be too hawkish (even though the Bank of England only recently shifted away from its past language signaling a desire to start normalizing very low interest rates). Table 1A Reflationary Bear-Steepening Of Yield Curves Since Yields Troughed In March Correlations between longer-term inflation expectations and the slopes of government bond yield curves have also become less consistent across countries (Chart 7). In particular, 2-year/10-year yield curves been more positively correlated to inflation expectations in the euro zone, Australia and even Japan (where the BoJ is actively targeting the yield curve) than in the U.S., U.K. and Canada. Chart 6Higher Oil, Higher Inflation Expectations Chart 7Position For Reflationary Yield Curve Steepening Given BCA’s bullish oil forecast, we recommend positioning for higher inflation expectations and steeper yield curves in selected countries based on the above correlations. We are already doing this in the U.S., where we are running a long position in U.S. 10-year TIPS breakevens. This week, we are entering the following new positions in our Tactical Trade portfolio (see page 15): Long 10-year CPI swaps (or inflation-linked bonds versus nominal debt) in Germany A 2-year/10-year government bond curve steepener in Australia We are not confident enough about the growth outlook in Canada and Japan, and the political outlook in the U.K., to recommend inflation-focused trades in those markets at the present time. We recommend positioning for higher inflation expectations and steeper yield curves in selected countries. Bottom Line: Global growth indicators are starting to rebound, risk assets have returned to previous cyclical highs, and oil prices remain buoyant. This is a combination that will eventually result in rising developed market global bond yields, but more through higher inflation expectations that will bear-steepen yield curves. Stay below-benchmark on overall portfolio duration, but enter new reflationary trades in core Europe (long inflation breakevens) and Australia (yield curve steepeners). Upgrade EM U.S. Dollar Denominated Debt To Neutral Chart 8A Cyclical Rebound In China Is Underway Back in January, we upgraded our recommended allocation for global corporate debt to overweight, while downgrading developed market government bonds to underweight.1 That decision was in response to the Fed’s dovish turn, which lowered the risk of a monetary policy-induced U.S. recession that spooked investors in late 2018. Yet while a more accommodative Fed meant an extension of the U.S. business cycle expansion, it did not solve the problems of slowing growth elsewhere in the world – most notably in China and Europe. For that reason, we have maintained a preference for U.S. investment grade and high-yield corporate debt relative to European and EM spread product, even within an overall overweight recommended allocation to global corporates. In particular, we maintained an outright underweight stance on EM U.S. dollar denominated sovereigns and corporates within our model bond portfolio. That tilt served as a hedge to the risk of persistent softening growth in China – the nation to which EM economies remain most highly levered. It is the pickup in the China credit impulse that is most relevant for EM growth and asset markets. Now, amid signs that Chinese policy stimulus is starting to show up in faster credit growth – a reliable precursor to greater Chinese domestic demand (Chart 8) – that EM hedge to our overweight stance on global corporates is no longer needed. Thus, this week, we are upgrading our recommended exposure on EM USD-denominated sovereign and corporate debt to neutral, while reducing the size of our recommended overweight in U.S. investment grade corporates in our model bond portfolio (see the changes on page 14). The broadening rebound in Chinese economic data makes us more confident that growth there has turned the corner (Chart 9): Aggregate government spending is up 15.5% on a year-over-year basis. Infrastructure spending is now starting to grow again after the sharp slowdown seen in 2018. The China manufacturing PMI rose sharply in March, with the surge in the import sub-component of the overall PMI suggesting that domestic demand may be improving. In addition, with all signals pointing to a U.S./China trade deal being signed by the end of May, a major source of uncertainty weighing on the Chinese (and global) economy will soon be lifted. It is the pickup in the China credit impulse that is most relevant for EM growth and asset markets. Over the past decade, the credit impulse has led both the EM (ex-China) manufacturing PMI and annual growth in overall EM corporate earnings by around 9-12 months (Chart 10). The credit impulse bottomed back in October 2018, which means EM growth should begin to improve in the third quarter of 2019. Financial markets will discount that improvement in advance, however, which is why it makes sense to increase EM credit allocations today. Chart 9The Arrows Are Pointing 'Up' For Chinese Growth Chart 10EM Growth Is Highly Dependent On China As can be seen in the bottom panels of Chart 11 and Chart 12, there is a strong correlation between Chinese credit (as a % of GDP) and the relative performance of EM U.S. dollar denominated spread product versus U.S. investment grade corporates. Our colleagues at BCA China Investment Strategy recently noted that if the pace of China’s credit expansion seen in Q1 were to be maintained over the rest of 2019, this would imply a credit overshoot beyond the stated medium-term goal of Chinese policymakers to avoid significant further increases in leverage.2 Such additional stimulus would very beneficial for EM growth (via strong Chinese import demand), supporting continued EM credit market outperformance. Chart 11Upgrade EM USD Sovereigns Vs U.S. IG Corporates Chart 12Upgrade EM USD Corporates Vs U.S. IG Corporates By moving our EM credit allocation only to neutral, we are merely responding to the pickup in Chinese credit growth seen over the past several months. The increasingly positive cyclical story is not yet bullish enough to justify a full-blown overweight stance on EM credit, however, for several reasons: Past periods of EM credit market outperformance have typically occurred during periods of U.S. dollar weakness. Chart 13A Weaker USD Is Good For EM Markets The amount of policy stimulus likely to be delivered in China in 2019 will be more limited than in past cycles, given policymakers’ concerns over high Chinese debt levels and excess industrial capacity. A U.S.-China trade deal may not involve the swift reduction in U.S. tariffs on Chinese imports, if the White House chooses to use tariffs as the mechanism to ensure Chinese compliance with the terms of an agreement. “Hard data” in China that measures private sector spending (retail sales, autos sales, etc.) has yet to bottom, which may indicate that the improvement seen in the credit aggregates and survey data like the manufacturing PMI is overstating the growth rebound. The U.S. dollar remains firm, and past periods of EM credit market outperformance have typically occurred during periods of dollar weakness (Chart 13). We do anticipate moving to an overweight position sometime in the next several weeks, after getting more Chinese economic data to confirm the improvement seen in March. This also lines up with the timetable for a potential trade deal, the details of which will be critical for boosting investor sentiment towards assets sensitive to Chinese demand, like EM credit. We will also look for signs of the U.S. dollar breaking to the downside to confirm any decision to upgrade EM credit. One final point – we are only reducing our recommended overweight on U.S. investment grade credit in our model bond portfolio as part of this EM upgrade. We are leaving our U.S. high-yield credit overweights untouched, as U.S. investment grade is much closer to the spread targets laid out by our colleagues at BCA U.S. Bond Strategy than U.S. high-yield. Bottom Line: Signs of a pickup in Chinese growth will be more supportive for growth in EM economies. Hedging against an extended downturn in China is no longer needed. Upgrade EM U.S. dollar denominated sovereign and corporate debt to neutral (3 of 5), at the expense of a smaller overweight position in U.S. investment grade corporates. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th, 2019, available at gfis.bcaresearch.com. 2 Please see BCA China Investment Strategy Weekly Report, “In The Wake Of An Upgrade: An Investment Strategy Post-Mortem”, dated April 17th, 2019, available at cis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Portfolio Strategy China’s ongoing reflation trifecta, rising commodity prices, a back-half of the year global growth recovery, favorable balance sheet metrics and neutral valuations and technicals all signal that the cyclical vs. defensive outperformance phase has more running room. New home-related data releases have been a mixed bag lately and there are high odds that homebuilders have discounted all the good housing market news. Be prepared to book profits. Recent Changes There are no changes in our portfolio this week. Table 1 Feature The SPX hit fresh all-time closing highs last week, as declining profits were not as bad as previously feared. While economic and profit fundamentals remain soft at best, fear of missing out (FOMO) on the rally and proliferating talk of a melt up in stocks have provided the needed spark to fuel the recent equity breakout (Chart 1). Historically, both of these sentiment/anecdotal-type time series have led or coincided with temporary broad equity market peaks and we continue to believe that some short-term caution is still warranted. In other words, we would not chase this multiple expansion-driven market advance and specifically refrain from putting fresh capital to work (please refer to Charts 1 & 2 from last Monday’s Weekly Report)1. Moreover, the easy money on the “reflation trade” has already been made and now the risk/reward tradeoff is to the downside. Our Reflation Gauge (RG), comprising oil prices, the trade-weighted U.S. dollar and interest rates, is quickly losing steam and warns against extrapolating equity market euphoria far into the future (Chart 2). Chart 1Beware Melt Up And FOMO Narrative Chart 2Reflation Stalling As a reminder, crude oil prices are up over 50% from the nadir, the 10-year Treasury yield is up 25bps from the recent lows, and the greenback is on the cusp of a breakout in level terms. The implication from our decelerating RG is also consistent with a cautious equity market stance from a tactical perspective. But, on a cyclical 9-12 month time horizon we continue to have a sanguine equity market view as the U.S. will avoid recession and the Fed will likely stay on the sidelines. We recently updated the S&P 500 dividend payout for calendar 2018 and this week we are introducing our 3,150 SPX target for end-year 2020 derived via three methodologies: SPX dividend discount model (DDM), forward multiple/EPS sensitivity and forward equity risk premium (ERP) analysis. Table 2 summarizes our results. On a side note our end-year 2019 target remains unchanged since our mid-January update at 3,000.2 Table 2SPX Target Using Three Different Methods In all three ways we get a value of roughly 3,150 on the SPX, which serves as our end-year 2020 SPX target. In our DDM, we moved the recession to 2021 from 2020 previously, added a year to our 5-year rolling estimates and continue to conservatively assume no buybacks. With regard to the sensitivity analysis, our 2021 EPS estimate is $191, a discount to the $205 currently penciled in by the sell-side, and our base case calls for a 16.5x forward multiple. Finally, the bottom part of Table 2 shows our forward ERP assumptions. We lifted the equilibrium ERP from 200bps to 250bps given the recent setback it suffered and our 10-year Treasury yield also moved down 50bps to 3.5%. Consistent with our sensitivity analysis base case, the starting point is $191 2021 EPS. In all three ways we get a value of roughly 3,150 on the SPX, which serves as our end-year 2020 SPX target. (If you would like to receive our excel spreadsheet in order to adjust our assumptions please email our client requests department here). This week we update our cyclicals/defensives portfolio bent view and a set a stop sell order to an overweight early-cyclical niche subsector. Stick With Cyclicals Over Defensives, For Now Chart 3China… We were early and right in January when we posited that China’s slowdown was yesteryear’s story and more than discounted in the collapse of the U.S. cyclicals vs. defensives ratio (please refer to Chart 5 from the January 28 Weekly Report). Similarly, in early February when everyone was laser focused on the Fed’s January meeting, our report titled “Don’t Fight The PBoC” highlighted that the Chinese were serious about reflating their economy. The PBoC’s quasi-QE not only recapitalized the banks, but it also injected enormous liquidity into their financial system. The upshot was that U.S. cyclicals would reclaim the upper hand vs. defensives. Now as the story count for “China Slowdown” is coming down fast (story count shown inverted, bottom panel, Chart 3) the question is how much of the looming Chinese recovery is currently priced in the V-shaped cyclical/defensives rebound? Our sense is that while most of the good news is largely reflected in the slingshot recovery in the relative share price ratio, there is some room left for additional gains. Financial variables are upbeat and signal that more gains are in store for the cyclicals/defensives ratio. China’s A-shares year-to-date have trounced the S&P already by a factor greater than 2:1 (in local currency terms, not shown). The MSCI China index is also outperforming the MSCI All-Country World Index (top panel, Chart 4). Sell-side analysts are in synchrony with the markets and they have been upgrading EPS estimates for the MSCI China index (top panel, Chart 5). Chart 4…Signals… Beyond the stock market, the FX market along with commodities are also underpinning relative share prices. The ADXY index (bottom panel, Chart 4) and the CRB metals index (bottom panel, Chart 5) are both moving in lockstep and suggest that commodity related profits will boost cyclicals at the expense of defensives. Chart 5…More Gains… Similarly, the broad trade-weighted U.S. dollar is no longer appreciating at the late-2018 breakneck pace and, at the margin, suggests that cyclicals profits will get an added boost from positive FX translation gains as they garner a larger slice of their revenue from international markets compared with mostly domestically-exposed defensives (U.S. dollar shown inverted, bottom panel, Chart 6). Soft economic data have taken their cue from higher frequency financial market data and have also turned. China’s CAIXIN manufacturing PMI is above the 50 boom/bust line. The implication is that U.S. cyclicals’ profits will outshine U.S. defensives’ EPS (middle panel, Chart 6). Finally, monetary easing is ongoing on the Chinese front. The banks’ reserve-requirement-ratio is falling and so is the interbank lending rate as per SHIBOR (both shown inverted & advanced, top & middle panel, Chart 7). Given the trifecta of Chinese easing on the monetary, fiscal and credit front, it is inevitable that hard data will also soon turn. Chart 6…Are In Store For Cyclicals… Chart 7…At The Expense Of Defensives Chart 8Global LEI Diffusion Concurs Nevertheless, it is not only China that is emitting an unambiguously positive signal for the U.S. cyclicals/defensive ratio. BCA’s global leading economic indicator diffusion index is pushing 65%, underscoring that the majority of the countries we track showcase an improving economic outlook. As a reminder, BCA’s view remains that in the back half of the year global growth will pick up steam. Thus, under such a backdrop, cyclicals will continue to outperform defensives (Chart 8). Stick with a cyclical over defensive portfolio bent, but stay tuned. On the relative operating front, cyclicals are also flexing their muscles and crushing defensives. Since 1980 (the beginning of our dataset), the cyclical/defensive portfolio bent has followed relative return-on-assets (ROA). While over the decades there have been some divergences, this correlation has become extremely tight since early-2000. Currently, following the late-2015/early 2016 manufacturing recession, the relative ROA has jumped 400bps and is signaling that relative share prices are on a solid footing (Chart 9). Chart 9Relative ROA And… With regard to relative debt dynamics, cyclicals also have the upper hand. Net debt/EBITDA and EBIT/interest expense both show that the relative indebtedness favors cyclicals over defensives. While defensives are degrading their balance sheet, cyclicals are still repairing theirs in the aftermath of the recent manufacturing recession (Chart 10). Despite the year-to-date spike in relative share prices, relative valuations and technicals remain tame. Both our relative Valuation and Technical Indicators are timid, and remain below the respective historical averages (Chart 11). Chart 10…Indebtedness Suggests That Cyclicals Have the Upper Hand In sum, China’s ongoing reflation, rising commodity prices, a back-half of the year global growth recovery, favorable balance sheet metrics and neutral valuations and technicals all signal that the cyclical vs. defensive outperformance phase has more running room. Chart 11No Red Flags Bottom Line: Stick with a cyclical over defensive portfolio bent, but stay tuned. Is The Homebuilding Rally Sustainable? While we were slightly early in our upgrade of homebuilding stocks to overweight in late-September, this recommendation has generated alpha close to 10% for our portfolio. Nevertheless, some soft housing related data compel us to put this index on downgrade alert and, from a risk management perspective in order to protect gains, set a stop sell order near the 10% relative return mark. Just to be clear, this is not a negative call on residential real estate. Quite the opposite, housing market long-term drivers remain upbeat in the U.S. Chart 12 shows that household formation is still running higher than housing starts and building permits. This is a bullish industry supply/demand backdrop. Housing affordability, while not as sky-high as when house prices troughed in 2011/2012, remains above the historical mean and above previous peaks (second panel, Chart 12). Tack on still generationally low interest rates and there good odds that first-time home buyers will return to the residential real estate market. Finally, the labor market is as good as it gets with the unemployment rate plumbing multi-decade lows (unemployment rate shown inverted, bottom panel, Chart 12). Job certainty and rising salaries are a healthy combination for housing market prospects. Beyond the positive structural housing market forces, some recent homebuilder specific data have also been positive. New home sales have surged and are now in expansionary territory (top panel, Chart 13). Similarly, the latest inventory data on new homes showed that newly built house inventories are whittled down, with the months’ supply metric falling by over one month (new house supply shown inverted, second panel, Chart 13). Chart 12Bullish Structural Housing Fundamentals Chart 13Select Positive… The 70bps drop in the 30-year fixed mortgage rate since November has shown up in rising mortgage purchase applications that have vaulted to multi-year highs (middle panel, Chart 13). Lumber, a key input cost for new home construction has melted of late and this building material cost relief is a boon for homebuilding margins. True, new home prices are deflating and are an offset, but from an all-time high level and at a slower pace than lumber prices (fourth & bottom panels, Chart 13). One reason median new single family home prices are falling is that homebuilders are competing aggressively for market share with the existing stock of homes available for sale. Price concessions are paying dividends as relative volumes have spiked i.e. homebuilders are successfully grabbing market share (second & third panels, Chart 14). In absolute terms, S&P homebuilding sales are expanding at a healthy pace and the NAHB’s survey of future sales expectations point to a firming new home demand outlook (bottom panel, Chart 14). However, there are some macro headwinds that homebuilders will have to contend with in the back half of the year. While interest rates have fallen during the past six months, our fixed income strategists expect a selloff in the bond market, which, at the margin, will weigh on housing affordability (mortgage rate shown inverted, top panel,Chart 15). Chart 14…Homebuilding Data… Chart 15…But Two Key Risks Remain Netting it all out, housing related data have been a mixed bag of late and homebuilders have likely discounted most of the good housing market news. Thus, in order to protect profits we are setting a stop sell order near the 10% relative return mark. Already, bankers are making it slightly, but steadily, more difficult to get a mortgage loan (third panel, Chart 15). But, what worries us most is that according to the Fed Senior Loan Officer survey, demand for residential real estate loans has collapsed to a level last hit at the depths of the Great Recession. Historically, this bombed out demand indicator has been a precursor of a fall in relative share prices (second panel, Chart 15). Finally, actual mortgage loan origination is quickly decelerating (bottom panel, Chart 15) and short-term momentum is already contracting. Netting it all out, housing related data have been a mixed bag of late and homebuilders have likely discounted most of the good housing market news. Thus, in order to protect profits we are setting a stop sell order near the 10% relative return mark. Bottom Line: Stay overweight the S&P homebuilding index, but we are putting it on our downgrade watch list. Be prepared to monetize gains on a pullback in relative share prices near the 10% return mark since inception. The ticker symbols for the stocks in this index are: BLBG: S5HOME – PHM, DHI, LEN. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Mixed Signals” dated April 22, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Portfolio Strategy Disney’s recent streaming pricing disclosure and a favorable macro backdrop for recreation PCE argue that more gains are in store for the S&P movies & entertainment index. The price of credit, credit quality and credit growth along with equity buybacks all suggest that bank profits will continue to overwhelm. Recent Changes Upgrade the S&P movies & entertainment index to overweight today. Table 1 Feature Equities continued to defy gravity last week as the earnings season warmed up and did not reveal any “skeletons in the closet”. Lower interest rates single-handedly explain the recent stock market exuberance (Treasury yield shown inverted, Chart 1). In more detail, the Fed’s complete pivot has suppressed the 10-year Treasury yield and last year’s forward multiple drubbing – to the tune of a 30% drawdown – has reversed. Chart 1Lower Yield = Higher Multiple Chart 2 shows that, year-to-date, the forward multiple has done all the heavy lifting in the SPX and then some, as EPS have actually subtracted from the broad market’s return. In theory, a lower discount rate should boost the multiple and vice versa. Nevertheless, there are good odds that the 10-year Treasury yield has troughed, and BCA’s fixed income strategists continue to expect a selloff in the bond market for the rest of the year. The implication is that equities are becoming fully priced and if profits fail to pick up the baton from the multiple expansion phase, the risk/reward tradeoff is to the downside on a tactical horizon. Meanwhile, there are a number of indicators we track that are still firing warning shots for the overall equity market. Margin debt has stalled and remains 13% below the all-time peak hit last year. Historically, this has been a coincident equity market indicator and a lack of confirmation is troublesome for the overall equity market (bottom panel, Chart 3). Chart 2SPX Return Explained Chart 3M&A Lull... M&A activity has taken a step back, with the total number of deals down 25% from the 2018 zenith (top panel, Chart 3). Similar to margin debt uptake, this is a coincident indicator and the latest weak reading is cause for concern, as it signals that animal spirits are low. With regard to frail sentiment, CEO confidence has taken a beating of late on all fronts. The most recent Business Roundtable and Conference Board CEO surveys reveal that chief executives are a worried bunch. Their views on the overall economic outlook, all industries (including services manufacturing, durable and non-durable), capital outlays, employment, and revenues all remain downbeat, and likely explain the recent M&A lull (Chart 4). On the profit front, last year’s once in a lifetime equity retirement will not repeat this year, warning that artificial EPS growth will weigh on overall profit growth in 2019. Beyond this grim reading on “soft data”, select financial market leading indicators are also not corroborating the euphoric equity market. J.P. Morgan’s EM FX index has petered out recently and both EM and Chinese investable stocks (in U.S. dollar terms) remain well below their early-2018 peaks. Similarly, China-levered U.S. semi equipment stocks are a far cry from their cyclical highs set last year and suggest that some caution is still warranted in the broad equity market (Chart 5). Chart 4...Drop In CEO Confidence... Chart 5...And Financial Indicators Still Flashing Red Finally, on the profit front, last year’s once in a lifetime equity retirement will not repeat this year, warning that artificial EPS growth will weigh on overall profit growth in 2019. In addition, Charts 6A & 6B show that buybacks are already concentrated in a few sectors. Our sense is that this concentration theme will continue this year and likely center around financials as banks will flex their equity retirement muscle. This week we delve deeper into banks and upgrade a communication services subsector. “A Kind Of Magic” Factors have fallen into place to boost the recently rejigged S&P movies & entertainment index to an above benchmark allocation today. DIS and NFLX dominate this index now comprising roughly 97% of the market cap weight and VIAb is merely the third wheel. The dust has settled from the global media industry M&A frenzy of the past two years, but the push to the cloud via online streaming services suggests that it is only a temporary break. We would not rule out another round of inter- and intra-industry M&A, as content is king once again (Chart 7). Chart 7Rejigged Recent pricing news of Disney’s streaming service, expected later this year, sent reverberations across the media space as Disney priced it at such a low point in order to grab market share and likely pave the way for future price hikes. While streaming services have been mushrooming, there is space for a number of competitors, signaling that Netflix’s global streaming domination will not come crumbling down all of a sudden. While the index’s 12-month forward EPS took a hit with the NFLX addition in October, 2018 and the forward P/E jumped to the historical mean, this niche communication services subgroup is now clearly a growth index and will continue to command a premium valuation to the broad market (bottom panel, Chart 8). From a macro perspective there are also compelling reasons to warm up to the S&P movies & entertainment index. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative share prices will narrow via a rise in the latter (top panel, Chart 8). Moreover, a vibrant labor market with payrolls expanding at a healthy clip (top panel, Chart 9), the unemployment rate and unemployment insurance claims at generational lows, all signal that consumers will keep their purse strings loose, especially given rising wages (third panel, Chart 9). Chart 8Positive Macro... Chart 9...Drivers... Tack on the confidence consumers have in residential real estate with house prices expanding both on a year-over-year and on a shorter-term basis (second panel, Chart 9), and the ingredients are in place for an increase in consumer recreation outlays. Disney’s streaming pricing disclosure, a favorable macro backdrop on recreation PCE and sell-side analyst extreme profit pessimism argue that more gains are in store for the S&P movies & entertainment index. Lift to overweight today. One final macro variable that is also on the side of the S&P movies & entertainment index is the ISM non-manufacturing index. Historically, real outlays on recreation activities has moved in lockstep with the ISM services survey and the current message is positive for PCE on recreation (bottom panel, Chart 9). More dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (third panel, Chart 8). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects (middle panel, Chart 10). Chart 10...But Analysts Are Not Buying It Not only are industry EPS slated to trail the SPX by 300bps in the coming year, but also analysts have been vigorously downgrading their EPS estimates weighing on the sector’s net earnings revisions ratio (bottom panel, Chart 10). This is contrarily positive and we would lean against such analyst pessimism. Netting it all out, Disney’s streaming pricing disclosure, a favorable macro backdrop for recreation PCE and sell-side analyst extreme profit pessimism argue that more gains are in store for the S&P movies & entertainment index. Bottom Line: Lift the S&P movies & entertainment index to overweight today. The ticker symbols for the stocks in this index are: BLBG: S5MOVI – DIS, NFLX, VIAb. Bank Update: Primed For A Re-rating By the end of last week most banks reported profits that exceeded expectations and investors breathed a sigh of relief, despite the early-December yield curve inversion and the more recent broadening of the inversion from the 5/3 all the way out to the 10/fed funds rate slope. What partially explains the sector’s EPS resilience is net interest margins (NIMs) that just entered their fifth straight year of widening. While this may seem counterintuitive given the inverted/flattening yield curve, banks are repressing depositors by not passing on higher interest rates on deposits, thus guaranteeing extremely cheap funding. The bottom panel of Chart 11 shows that the 2-year Treasury yield/1-year CD rate slope is steep and it has historically moved in lockstep with bank NIMs. As a reminder, BCA’s bond strategists expect a selloff in the bond market and remain short duration, signaling that bank NIMs will not suffer a setback for the remainder of the year. Beyond the prospects for a further increase in the price of credit, another key source of bank EPS support is equity retirement. Citi explicitly mentioned it this earnings season, and the S&P financials sector buybacks, largely driven by banks, corroborate this anecdote (Chart 12). Chart 11Deciphering Bank Profit Resilience Chart 12New Buyback Kings In fact, there is a wide gap between this artificial EPS lift and relative share prices that will likely narrow in the coming months via a catch up phase in the latter, particularly if banks pass the Fed’s stringent stress test anew as we expect later this summer. On the credit quality front, bank NPLs remain anchored near cycle lows and tight labor markets suggest that a flare up in delinquencies is a low probability event in the coming year, especially given BCA’s view of no recession (bottom panel, Chart 13). Chargeoffs and souring loans are almost non-existent in all the categories that the Federal Reserve tracks, with the slight exception of credit card loans that are ticking higher, but from an extremely low base (we provide more details below in the risk section, second & third panels, Chart 13). Finally, loan growth has held up very well despite the stock market collapse in Q4/2018 and the massive tightening in financial conditions. While our overall loans & leases and C&I loan models are decelerating, they remain squarely in expansion mode and should continue to underpin bank profitability (second and bottom panel, Chart 14). Chart 13Pristine Credit Quality Chart 14Credit Growth Rests On A Solid Foundation Consumer confidence remains sky-high and house prices are also rising at a healthy pace, signaling that mortgage (top panel, Chart 11) and consumer loan origination will remain upbeat (third panel, Chart 14). The price of credit, credit quality, credit growth along with buybacks all suggest that bank profits will continue to overwhelm. Stay overweight the S&P banks index. All of this positive news is already reflected in banks’ return on equity that vaulted higher recently signaling that a re-rating in still-extremely depressed valuations is looming in the coming quarters (Chart 15). Nevertheless, there are two risks to our sanguine S&P banks view that we are closely monitoring. First, our Economic Impulse Indicator remains near the zero line and, coupled with the still downbeat Citi Economic Surprise Index, warn that demand for loans may start softening at the margin (top panel, Chart 16). Chart 15Follow The ROE Chart 16Two Risks To Monitor Second, while the top 100 largest commercial banks are not showing a deterioration on the credit card delinquency front, the rest of the banks are waving a red flag as delinquencies are already at recessionary levels. This explains why the overall credit card delinquency rate is ticking higher (bottom panel, Chart 16). Netting it all out, the price of credit, credit quality, credit growth along with buybacks all suggest that bank profits will continue to overwhelm. Bottom Line: Stay overweight the S&P banks index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, WFC, C, USB, PNC, BBT, STI, MTB, FITB, FRC, KEY, CFG, RF, HBAN, SIVB, CMA, ZION, PBCT. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps