Corporate
Highlights Global financial markets are currently dealing with a fresh round of uncertainty related to U.S.-China trade tensions. Yet while equities and government bond yields have fallen in response to the U.S. imposition of tariffs and escalation of the trade war with China, corporate bond markets in the developed economies have been relatively well-behaved (so far). Credit spreads have only widened modestly, which perhaps should not be surprising given central bankers’ increasingly dovish bias combined with early signs of a cyclical global growth rebound (Chart 1). Feature Chart 1Global Corporates: Shifting To A Friendlier Growth Backdrop? With that in mind, this week we are presenting the latest update of our Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 15. The main conclusion from the latest readings on our CHMs is that slower economic growth over the past year has resulted in some erosion of overall global credit quality. The deterioration was most pronounced in the more economically fragile regions that have suffered the deepest pullbacks in growth: Europe and Japan. The CHMs are currently giving an overall “neutral” signal in the U.S., although there are some worrying trends developing within the sub-components like interest coverage and short-term liquidity. Meanwhile, the CHMs in the U.K. and Canada are showing modest cyclical deterioration from very strong levels. Broadly speaking, the CHMs support our main global corporate bond market investment recommendations: a tactical aggregate overweight versus global government bonds, with a regional bias favoring the U.S. over Europe, and a quality bias tilted towards U.S. high-yield (HY) over investment grade (IG). Renewed U.S.-China trade hostilities represent a threat to that pro-cyclical fixed income asset allocation, although we expect more aggressive responses from policymakers on both sides (more fiscal and monetary stimulus in China, a more dovish bias from the Fed) to offset any tariff-induced weakness in growth. U.S. Corporate Health Monitors: Cyclically OK, But Longer-Term Problems Are Brewing Our top-down U.S. CHM is sending a neutral message on credit quality, sitting right on the threshold separating “deteriorating health” from “improving health” (Chart 2). The indicator, however, has been trending in a direction showing improving credit metrics over the past year. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate tax cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. The ratios directly related to corporate profits that go into the top-down CHM – return on capital, profit margins and interest coverage – have all gone up over the past year, generating the bulk of the directional improvement in the top-down CHM. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. In other words, there are no immediate domestic pressures on U.S. corporate finances that should require significantly wider credit spreads to compensate for rising downgrade/default risk. That does not mean that all the news is good, however. The short-term liquidity ratio has fallen sharply and is now at levels last seen in the years leading up to the 2008 Financial Crisis. Similar deteriorations can be seen in the short-term liquidity ratios within the bottom-up versions of our U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4). Coming at a time when interest coverage ratios have been steadily declining for IG, and are already at low levels for HY, declining short-term liquidity would leave U.S. corporates highly vulnerable during the next economic downturn. Chart 2Top-Down U.S. CHM: A Neutral Reading Chart 3Bottom-Up U.S. IG CHM: Modest Deterioration With Worrying Trends We see no reason yet to exit our tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates. For now, however, the message from our bottom-up U.S. CHMs is the same as that from our top-down U.S. CHM, with all hovering near the zero line suggesting no major deterioration in overall credit quality. We see no reason yet to exit our tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates (Chart 5). Our favored indicators continue to point to a rebound in global growth in the latter half of 2019, and the Fed currently has no desire to push the funds rate into restrictive territory, so the risk/reward over the next six months still favors staying overweight U.S. corporates. The medium-term outlook, however, is far more challenging given the growing body of evidence pointing to the advanced age of the U.S. credit cycle, such as falling interest coverage and liquidity. Chart 4Bottom-Up U.S. HY CHM: A Cyclical Improvement, Nothing More Chart 5U.S. Corporates: Stay Tactically Overweight IG & HY One final point – in Appendix 2 starting on page 17, we present bottom-up CHMs for the main industry sector groupings of companies that go into our overall U.S. IG CHM. Most of the sector CHMs are hovering near the zero line, but two industry groupings stand out as having a rising CHM that is now well within “deteriorating health” territory – Consumer Staples and Utilities. Euro Corporate Health Monitors: Worsened By Weaker Growth The message from our bottom-up CHMs for the euro area shows that there was some damage done to credit quality from last year’s growth slump, evidenced by lower profit margins and interest coverage ratios. Although overall credit quality remains fairly neutral (i.e. the CHMs remain near the zero line). For euro area IG, the gap between domestic and foreign issuers in the euro area corporate bond market continues to widen, with the former now slightly in the “deteriorating health” zone (Chart 6). Profit margins have fallen far more sharply for domestic issuers, reflecting the very rapid slowing of euro area growth over the latter half of 2019. Interest coverage for domestic issuers is also lower than for foreign issuers, while short-term liquidity ratios have weakened for both over the past year. For euro area HY, the signal from the bottom-up CHM is more consistently positive between domestic and foreign issuers (Chart 7). Leverage has declined, but profit-based metrics have worsened for both sets of issuers. Interest/debt coverage and liquidity, however, are far worse for domestic issuers. Chart 6Bottom-Up Euro Area IG CHMs: Weaker Growth Hitting Domestic Issuers Chart 7Bottom-Up Euro Area HY CHMs: Healthier Through Lower Leverage Within the euro area, our bottom-up IG CHMs for Core and Periphery countries have worsened over the past year, from healthy levels, and are now hovering just above the zero line (Chart 8). Interest coverage is considerably stronger for Core issuers, although profitability metrics are remarkably similar. Short-term liquidity ratios have also fallen for both regional groups over the past year. The spread tightening already seen in euro area credit is too extreme relative to the still sluggish pace of economic growth in the region. Despite the lack of a major overall negative signal from the euro area CHMs, we are only maintaining a neutral allocation to euro area corporates, even within our current overweight stance on overall global corporates (Chart 9). The spread tightening already seen in euro area credit is too extreme relative to the still sluggish pace of economic growth in the region. This will inhibit the ability for spreads to tighten further in the event of a pickup in growth, while also leaving spreads vulnerable to widening pressures if euro area growth continues to languish. Chart 8Bottom-Up Euro Area Regional IG CHMs: Trending In The Wrong Direction Chart 9Euro Area Corporates: Stay Tactically Neutral IG & HY Chart 10Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe In addition, we are sticking with our preference to favor U.S. corporates – both IG and HY – over euro area equivalents for two important reasons: stronger U.S. growth and better U.S. corporate health. The gap between the combined IG/HY bottom-up CHMs for the U.S. and euro area has been strongly correlated to the difference in credit spreads between euro area and U.S. issuers (Chart 10).1 The latest trends show a narrowing of the gap between the U.S. and euro area CHMs, suggesting relative corporate health favors U.S. names (middle panel). At the same time, the relatively stronger performance of the U.S. economy continues to support U.S. corporate performance versus euro area equivalents (bottom panel). U.K. Corporate Health Monitor: Brexit Uncertainty Is Not Helping Our top-down U.K. CHM remains in the “improving health” zone, although the indicator has been drifting towards “deteriorating health” over the past two years. Almost all of the components of the U.K. CHM have contributed to this worsening trend (Chart 11), with only short-term liquidity remaining in a powerful multi-year uptrend. Most worryingly, the interest and debt coverage ratios remain historically depressed, even as the Bank of England has keep interest rates at extraordinarily low levels for the past several years. The cyclical deterioration in the U.K. CHM components can be traced to the sluggish performance of the U.K. economy and corporate profits. The cyclical deterioration in the U.K. CHM components can be traced to the sluggish performance of the U.K. economy and corporate profits. The persistent uncertainty from Brexit has weighed on business confidence and investment spending by U.K. firms, keeping growth at a below-trend pace. While the immediate deadline of “Brexit Day” came and went back in March, there is still a high degree of uncertainty over the U.K.’s future economic relationship with the European Union. With Prime Minister Theresa May now set to step down, an election will extend the period of politically-driven uncertainty in the U.K. We have maintained a moderate underweight recommendation on U.K. corporates in our model bond portfolio over the past year, despite the lack of an obvious negative signal from our U.K. CHM. Spread widening in 2018 has been followed by spread tightening in 2019 (Chart 12), but the latter has been driven by the global rally in risk assets rather than diminished perceptions of U.K. political risk. Chart 11U.K. Top-Down CHM: Modest Pullback From Healthy Levels Chart 12U.K. Corporates: Stay Modestly Underweight Although there has been some improvement in U.K. economic data of late, leading economic indicators continue to trend lower. In addition, the Bank of England continues to hint that any positive resolution to the Brexit uncertainty could result in a tightening of monetary policy (although that is less of a threat given the synchronized dovish turn by global central bankers over the past few months). Given all the uncertainties, the risk/reward balance continues to favor a modest underweight in U.K. corporates, particularly at current tight spread levels to Gilts. Japan Corporate Health Monitor: A Modest Cyclical Deterioration Our bottom-up Japan CHM has shown a worsening trend over the past year and now sits in the “deteriorating health” zone (Chart 13).2 Interestingly, all of the individual components have contributed to that move in the CHM, and not just the cyclical components (profit margins, return on capital, interest coverage) that reflect the recent slowing of economic growth in Japan. Leverage has increased (albeit from very low levels), while short-term liquidity has also weakened (albeit from very high levels). Strictly looking at the overall level of all the Japan CHM components, the message does not signal a major deterioration in Japanese corporate credit quality. Leverage, defined here as the ratio of total debt to the book value of equity, is still below 100%, well below the 100-140% range seen between 2006 and 2015. The same story applies to the return on capital, which at 5% is still high versus Japan’s history (although very low by global standards). Interest coverage and short-term liquidity both remain high relative to the past decade. The absolute level of Japanese corporate health remains solid, but there has been marginal deterioration from weaker economic growth. On that front, the cyclical momentum in Japan’s economy is not improving. According to the latest Tankan survey, Japanese firms reported that their business outlook was worse than previously expected. Declining confidence has damaged capital spending, as shown by the falling growth of domestic machinery and machine tool orders. Japan’s economy remains highly levered to global growth and export demand and their economy has taken a hit from the slower pace of global trade over the past year. Wage growth has also weakened after finally seeing some positive momentum in 2018, which is weighing on consumer confidence and spending. Japan’s corporate spread has widened slightly (+5bps) since the beginning of this year (Chart 14), in contrast to the spread tightening seen in other major developed economy corporate bond markets (the Bloomberg Barclays Global Corporates index spread has tightened by -33bps year-to-date). This is a sign that the markets have responded to the slowing growth momentum in Japan with a bit of a wider risk premium. Yet despite that widening, Japanese corporates with small positive yields continue to generate positive excess returns versus Japanese Government Bonds (JGBs) with yields held near zero by the Bank of Japan’s Yield Curve Control policy. Thus, we continue to recommend an overweight stance on Japanese corporates vs JGBs as a buy-and-hold carry trade, even with the softening in our Japan CHM. Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Chart 14Japan Corporates: Stay Overweight Vs JGBs For Carry Canada Corporate Health Monitor: Still In Decent Shape Our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health, with both remaining in the “improving health” area over the past few years (Chart 15). The marginal moves have shown some modest deterioration in the cyclically-sensitive components (most notably, return on capital and profit margins for the top-down Canadian CHM). This should not be surprising given how rapidly Canadian economic growth slowed in the final quarter of 2018. There has also been some deterioration in the non-cyclical components. Leverage is high and rising, while the absolute levels of return on capital and debt/interest coverage are historically low. This may be building up risks for the next major Canadian economic downturn, but for now, Canadian companies look in decent shape. With so much of Canada’s economy (and its financial markets) geared to the performance of the energy sector, the recent recovery in global oil prices is a significant boost for the overall Canadian corporate market. Our commodity strategists see additional upside in oil prices over the next six months, which will further underpin the health of Canadian oil companies – and should also help support Canadian corporate bond performance. The Bank of Canada is now taking an extended pause from its rate-hiking cycle, with policy rates well below the central bank’s own estimate of neutral (2.25-3.25%). Accommodative monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates attractive, in an environment of decent growth and firm corporate health. Chart 15Canada CHMs: Still Healthy, Despite Slower Growth Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt We continue recommending an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. Spreads have been in a very stable range since the 2009 recession (Chart 16), ranging between 100-200bps even during periods when our CHMs were indicating worsening corporate health. To break out of that range to the upside, we would need to see a prolonged deterioration of Canadian economic growth or sharp monetary tightening from the Bank of Canada – neither outcome is likely over the next 6-12 months. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.3 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors Footnotes 1 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from U.S. companies that issue in the euro area market that are part of our U.S. CHMs. 2 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 3 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.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
Analysis on the Philippines and Argentina are below. Highlights Analysis on the Philippines starts on page 9 and Argentina on page 12. Relative return on capital for non-financial corporations points to continuous EM equity underperformance versus the U.S. and probably versus other DMs as well. Taking into consideration the poor corporate profitability, EM equity valuations are not attractive in absolute or relative terms. The rationale for continuous U.S. dollar appreciation is a superior return on capital in the U.S. relative to the rest of the world. Short the Korean won and the Philippines peso versus the U.S. dollar. Feature In general, the most important drivers of relative equity performance between emerging and developed markets are corporate profitability and exchange rates. The outlook for corporate earnings and profitability at the current juncture is poor for EM in both absolute terms and versus the U.S. Further, the U.S. dollar is in the process of breaking out. As this breakout transpires, EM equities will continue to underperform their U.S. and probably DM counterparts. The most important drivers of relative equity performance between emerging and developed markets are corporate profitability and exchange rates. Corporate Profitability Chart I-1Relative Corporate Profitability And Share Prices: EM Versus U.S. Chart I-1 shows relative share prices in common currency terms along with the average of relative return on equity (RoE) and return on assets (RoA) for non-financial companies in EM and the U.S. This chart portends that in the medium- and long term, relative RoE and RoA explain relative equity prices in common currency terms reasonably well. Importantly, both RoE and RoA are ratios and are therefore not impacted by exchange rates. Consequently, it is reasonable to use RoE and RoA to gauge both share prices and exchange rates. Critically, relative RoE and RoA are not impacted by currency movements either. Further, we use EBITDA to calculate these profitability ratios for both EM and the U.S. As a result, they are not influenced by last year’s U.S. tax cuts as well as by corporate depreciation and one-off adjustments (Chart I-2). What’s more, we use data for non-financial companies because profitability measures for financial companies, especially banks, are contingent on their recognition of bad loans and provisioning. If banks lend a lot but do not provision, their profitability becomes unjustifiably inflated. Chart I-2Non-Financials Corporate Profitability: EM And U.S. Going forward, the outlook for EM versus DM share price performance largely hinges on currency market dynamics. If the dollar experiences a broad-based upsurge, which appears to be emerging, EM will likely underperform not only the U.S., but DM ex-U.S. as well. The rationale is that currency depreciation will be more positive for equity markets in Europe, Japan, Canada and Australia than for EM bourses. The former group does not have U.S. dollar debt, while currency weakness will boost the profits of their non-financial companies. Meanwhile, many EM companies are sitting on U.S. dollar debt, and as such currency depreciation is toxic for them. Bottom Line: Relative RoE and RoA for non-financials point to continuous EM underperformance versus the U.S. Profitability And Equity Valuations Is it possible that EM corporate profitability is currently improving, and valuations are already discounting a lot of the negatives? Shouldn’t relative corporate profitability be compared with relative equity valuations between EM and the U.S.? For now, there are no signs that EM corporate profitability is improving. On the contrary, our best indicator for EM EPS in dollar terms points to continuous profit contraction until the end of this year (Chart I-3). As EM EPS shrinks, RoE and RoA will also decline. Stabilization and potential improvement in China’s growth could benefit EM corporate revenues and profits toward year-end. However, to date, China’s imports from EM and the rest of the world continue to contract. China’s credit and fiscal spending impulse leads its manufacturing PMI's import sub-component by nine months and predicts a bottoming around August (Chart I-4). Chart I-3EM EPS Is ##br##Contracting Chart I-4Chinese Imports Will Stabilize Around August Notably, the continued deterioration in EM top and bottom lines implies that EM ex-financials’ RoE and RoA will roll over at their 2008 lows -- reached at the nadir of the global recession (Chart I-5). Investors should elect the multiples they want to pay for companies that cannot deliver RoE and RoA above their 2008 lows. Chart I-5EM Corporate Profitability And Multiples Taking into consideration such historically low RoE and RoA, EM equity valuations do not appear cheap. The bottom panel of Chart I-5 illustrates that, stripping out the 10% of sub-sectors with the highest and lowest multiples, EM equity multiples are at their historical mean. As to U.S. corporate profits, the key risks are a strong dollar and a potential profit margin squeeze. Nevertheless, a rising dollar is an even bigger risk to EM equities than it is to U.S. equity prices. U.S. share prices always outperform EM equities in common currency terms when the greenback is appreciating. Bottom Line: After adjusting for corporate profitability, EM equity valuations are not attractive in absolute or relative terms. Return On Capital Drives Exchange Rates The U.S. dollar is attempting to break out, and odds are that it will succeed. This will again challenge EM risk assets, as the latter typically perform poorly when the greenback appreciates. The rationale for continuous U.S. dollar appreciation is the superior return on capital in the U.S. relative to the rest of the world. Currency markets are often driven by relative return on capital.1 Chart I-6 shows the average of U.S. non-financials’ RoE and RoA relative to the same measure for DM ex-U.S. Broadly, the long-term trends in the narrow trade-weighted dollar have tracked the relative corporate profitability ratios between non-financial companies in the U.S. and other DMs. Relative return on capital at the moment suggests an upleg in the greenback. Chart I-6Relative Return On Capital And U.S. Dollar The thesis that exchange rate gyrations are steered by the relative trajectory of return on capital is especially true in EM. As exhibited in Chart I-7, relative RoE and RoA between EM- and U.S.-listed non-financial companies foreshadows EM exchange rate movements reasonably well, and points to further EM currency depreciation. Chart I-7Relative Return On Capital And EM Currencies While interest rate differentials also correlate with exchange rates in DM, the former often reflect a relative return-on-capital differential. For example, when an economy performs well amid rising interest rates, it implies that its potential growth and potential return on capital are sufficiently high. Typically, the currency of that country will tend to appreciate. By contrast, when an economy struggles amid rising interest rates, it is a sign that its potential growth and potential return on capital are poor, and that the current level of interest rates is unsustainably high. In this scenario, the exchange rate will most likely depreciate despite rising interest rates. In a nutshell, return on capital is an important driver of exchange rates. Chart I-8Interest Rates Do Not Drive EM Currencies In developing countries, the interest rate differential with the U.S. cannot be used to forecast exchange rates. As can be seen from Chart I-8, high-yielding currencies such as the ZAR and BRL have often been negatively correlated with their respective interest rate spread over U.S. rates. Crucially, in the case of high-yielding EM currencies, exchange rate swings often steer interest rates. When these currencies depreciate, both their interest rates and their spread over U.S. rates rise. In contrast, appreciation of high-yielding EM currencies prompt interest rates in their respective economies to drop, and their spread with U.S. rates to narrow. Bottom Line: U.S. relative return on capital is ascending versus both EM and other DM, heralding further dollar appreciation. Investment Observations And Conclusions The snapshot of the above analysis is that the relative return on capital explains both relative share price performance and exchange rates. Chart I-9 demonstrates that EM relative equity performance tracks the trajectory of EM relative EPS versus the U.S. in both common and local currency terms. Chart I-9EM Versus U.S.: EPS And Stock Prices It is tempting to bet on a mean reversal in EM relative equity performance against the U.S. However, our indicators do not point to such a reversal in EM underperformance for now. In short, we continue to recommend underweighting EM stocks versus DM in general and versus the U.S. in particular. Finally, the U.S. dollar is poised to stage a meaningful rally. Last week, we showed that currency volatility has dropped to historic lows. Typically, this occurs before a major market move (Chart I-10). Our view has been one of dollar appreciation, and recent market actions vindicate this stance. In our Special Report on Korea published on February 28, we flagged a tapering wedge pattern in the KRW/USD exchange rate and recommended going long the KRW on a breakout, or short on a breakdown. The won seems to have broken down, so we now recommend shorting the KRW versus the U.S. dollar (Chart I-11). In the meantime, we are taking profits on our short KRW/long equal-weighted basket of the U.S. dollar and JPY trade. This trade has generated a 3.9% gain since its initiation on February 14, 2018. Chart I-10The Dollar Is On Verge Of Major Move Chart I-11The Korean Won Is Breaking Down To play EM exchange rate depreciation, we continue to recommend shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, IDR, MYR, PHP and KRW. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com The Philippines: Dovish Central Bank Amid Rising Inflation = Currency Plunge Philippine stocks have outperformed the EM benchmark lately and have risen in absolute terms due to the sharp drop in U.S. rates (Chart II-1). Chart II-1Philippine Stocks Relative Performance Yet, investors have been ignoring the buildup in genuine inflationary pressures in the economy. Consequently, the latter will carry negative repercussions for Philippine financial markets. In particular, unit labor costs are on the cusp of rising precariously. For instance, the minimum wage in Metro Manila increased by 5% in 2019 – the highest largest hike in six years. Meanwhile, President Rodrigo Duterte issued an executive order raising salaries for government workers and military personnel. Worryingly, President Duterte is also attempting to pass a bill to abolish contractual labor. The latter is a very favorable form of hiring for employers. President Duterte made the successful passing of this bill a top priority and has been urging Congress to fast-track it. In the meantime, President Dueterte issued an executive order banning companies from hiring certain types of contract-based employment. This policy is already starting to take a toll on companies. For instance, Murata Manufacturing, a Japanese electronics parts maker, saw its labor costs surge by 20% in the Philippines as it was ordered to convert 400 of its contract employees to full-time workers. Higher labor costs will push up inflation and/or squeeze companies’ profit margins. Investors have been ignoring the buildup in genuine inflationary pressures in the economy. In the meantime, the Philippines’ fiscal policy remains extremely stimulative. Government expenditures are currently growing at an 18% rate annually. This is despite the fact that the fiscal deficit is widening sharply (Chart II-2, top panel). Chart II-2The Philippines: A Large Twin Deficit Consequently, higher wages and fiscal spending will keep domestic demand robust, worsening the Philippines’ current account deficit (Chart II-2, bottom panel). The latter is a form of hidden inflation as it gauges the level of excess demand relative to the productive capacity of the economy. Crucially, given president Duterte’s reluctance to cut government spending, it will be up to monetary policy to solely contain inflation. Yet the independence of Philippine’s central bank – Bangko Sentral ng Pilipinas or BSP – is questionable: In March, president Duterete appointed his former budget secretary Benjamin Diokno as the new governor of the central bank. Therefore, the BSP will continue to err on the side of easy monetary policy and will further fall behind the curve. In particular, the BSP might justify staying on hold by the fact that headline and core inflation are now falling. However, that might prove to be a temporary development. Muted headline and core consumer inflation mainly reflect the crash in oil prices late last year. In particular, core inflation dipped because prices of items sensitive to oil prices – such as transportation costs and electricity – fell. The recent spike in oil prices will push inflation higher in the coming months. Crucially, the Philippines inflation problem is genuine in nature because it emanates from higher wages, rising unit labor costs and credit and fiscal stimulus-driven demand excesses. Genuine inflation coupled with a central bank that is behind the curve is a disastrous recipe for the currency. We recommend shorting the peso versus the U.S. dollar. A plunging Philippine peso will cause local bond yields to rise, hurting the stock market. While the central bank could choose to defend the currency by selling foreign exchange reserves, such policy will shrink the banking system liquidity – excess reserves at the BSP – which will result in higher interbank rates. On the whole, the BSP is facing the Impossible Trinity dilemma: given the nation has an open capital account, it cannot control both interest rates and the exchange rate simultaneously. Commercial banks and property stocks – which make up 15% and 29% of the Philippines MSCI market cap – will sell off hard as the currency depreciates and interest rates come under upward pressure. We continue to recommend shorting property stocks. The previous rise in interest rates is already hurting interest-rate sensitive sectors in the Philippines as credit growth is slowing sharply – albeit from a high level (Chart II-3). Commercial banks will in turn face rising NPLs and will be forced to raise provisions markedly. Both NPLs and provisions are currently too low in light of the relentless credit boom of the past several years. Finally, commercial banks have been lowering their provisions to boost their profits (Chart II-4, top panel). This means provisions will have to rise aggressively and bank earnings will contract severely. This will come on top of low net interest income margins (Chart II-4, bottom panel). Chart II-3Philippine Real Estate Stocks Are Ignoring Slowing Credit Growth Chart II-4Weak Profitability Ahead For Commercial Banks Bottom Line: We are initiating a new trade: short the PHP against the U.S. dollar. Equity investors should continue underweighting Philippine stocks relative to the EM benchmark, and within this bourse short property stocks. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Argentina: A Point Of No Return? The Argentine peso remains vulnerable due to deficient external funding and public debt sustainability concerns. A lack of external funding and a depreciating peso are causing rising inflation and interest rates. The latter are spurring a downfall in the economy diminishing incumbent President Mauricio Macri’s re-election chances. Chart III-1A Point Of No Return? Importantly, a depreciating peso, as well as high and rising external and domestic borrowing costs are making public debt unsustainable. All of these dynamics are feeding into plunging investor confidence creating a powerful negative feedback loop. Argentina may have reached a point of no return (Chart III-1). The odds that the authorities can stabilize financial markets are rapidly diminishing. Foreign currency-denominated public debt currently stands at $250 billion, and the country’s foreign debt service obligations for 2019 alone are $40 billion. We estimate the country will require an additional $10 billion of external funding this year (Table III-1). Given worsening investor sentiment, both the public and private sectors will not be able to raise external funding. As icing on the proverbial cake, potential U.S. dollar appreciation and portfolio outflows out of EM will reinforce the turmoil in Argentine markets. Argentina may have reached a point of no return. The odds that the authorities can stabilize financial markets are rapidly diminishing. Hence, without the IMF’s authorization for the central bank to use a large share of its foreign currency reserves to defend the exchange rate, the peso will continue to fall. How much more downside could there be in Argentina’s financial markets and economy? When compared with the major financial crises, bank share prices could drop much more. For example, Argentine banks stocks plunged by 95% in U.S. dollar terms during the nation’s 2001-2002 crisis (Chart III-2, top panel). During the 1997-1998 Asian financial crisis, bank equities in Korea and Thailand on average dropped by 95% in dollar terms (Chart III-2, bottom panel). Chart III-2History Suggests More Downside In Argentine Equities By comparison, since their peak in January 2018, Argentine banks are down 66% in dollar terms. Hence, more downside should not come as a surprise. As to currency depreciation, the peso’s real effective exchange rate has so far depreciated by 36% and remains undervalued by one standard deviation (Chart III-3). This compares with median and mean of 52% devaluations during previous crises in Argentina (Table III-2). Thus, more downside is likely in the currency in both real and nominal terms. The contraction in economic activity in this recession has so far been 6.5% (Table III-2). This is on par with median and mean contractions of 7% during previous crises but economic activity can undershoot this time. Chart III-3The Currency Can Get Cheaper Bottom Line: Investors should continue to avoid Argentine financial markets, as the downside could still be substantial. Do not catch a falling knife. Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com Footnotes 1 We herein use the term return on capital in a broader sense. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Portfolio Strategy Yield curve dynamics, higher oil prices, recovering balance sheets, and compelling valuations and technicals all suggest that energy stocks will burst higher in the coming months. Melting medical cost inflation, BCA’s rising interest rate expectations along with an economy running at full steam, all suggest that managed health care margins and profits will overwhelm in the coming quarters. Recent Changes Upgrade the S&P managed health care index to overweight today. Add the S&P energy index to the high-conviction overweight list today. Table 1 Feature On the eve of earnings season, the SPX ended last week higher as bank profits delivered and allayed fears of recession. All-time absolute highs in the S&P tech sector and in the Philly SOX index suggest that global growth will likely reaccelerate in the back half of the year, vaulting the broad market to new highs. In addition, the suppressed Treasury term premium1 signals that the path of least resistance for equities is higher on a cyclical time horizon (term premium shown inverted, Chart 1). Chart 1All Clear... Nevertheless, some caution is still warranted from a tactical perspective. Since March 4 when we first turned short-term cautious on the broad equity market,2 the SPX has moved roughly 100 points both ways. Internal market moves, financial conditions, fund flows, complacency and the current economic backdrop all signal that stocks are not out of the woods yet. Namely, the S&P high beta versus the S&P low volatility tilt has failed to confirm the slingshot in the SPX (Chart 2). Similar to the small cap underperformance, mega cap tech is trouncing small cap tech stocks (Chart 3). Not only do large cap technology stocks have pristine balance sheets, but they also have earnings. In contrast, from the 89 S&P 600 tech constituents 54 have no forward profits. The weak over strong balance sheet underperformance is emitting the same signal (top panel, Chart 3). Chart 2...But Some... Chart 3...Caution... The bond market is also sending a warning shot. High yield corporate bonds are underperforming long-dated Treasurys (middle panel, Chart 2). And, the junk bond option adjusted spread has not fallen to the 2018 lows, let alone all-time lows (not shown). While a lot has been said on easier financial conditions, they have yet to return to the early-2018 lows. In fact, similar to the non-confirmation of the all-time SPX highs in late-September, the GS financial conditions index (FCI) is tracing a higher low, warning that equities have room to fall (FCI shown inverted, bottom panel, Chart 2). Mutual fund flows on all equity related products are contracting on a net sales basis. Historically, fund flows and equity returns are joined at the hip and the current divergence suggests that equity prices will likely succumb to deficient demand (top panel, Chart 4). Chart 4...Is Warranted On the economic front, last Wednesday we highlighted in an Insight Report, that lumber – a hyper sensitive economic indicator – failed to corroborate the recent equity market euphoria. The weak Citi Economic Surprise Index, also warns that the economic data has yet to turn the corner and should weigh on equities (bottom panel, Chart 4). What ties everything together is SPX profits. The news on this front is mixed, at least for the next little while: EPS will most likely contract in the first half of the year, but equity investors are looking through this earnings recession. Last year’s U.S. dollar appreciation will dent both revenues and EPS, and Q1/2019 is the first quarter where such greenback strength will subtract from corporate P&Ls (Chart 5). Chart 5Dollar Trouble? What worries us most is the sectorial concentration of 2019 profit growth in one sector, financials. Another source of concern is the heavyweight tech sector’s negative profit path for calendar 2019. Such sudden internal profit moves both in magnitude and in a short time frame are far from reassuring, especially given that overall profit estimates are still trimmed. Chart 6A depicts the current sector profit contribution to 2019 growth, and compares it with the January 22nd iteration (Chart 6B). What a difference three months make. In sum, internal equity and bond market dynamics, financial conditions, the economic soft-patch and the looming profit recession all signal that short-term equity market caution is still warranted. This week we upgrade a health care subsector and reiterate our bullish stance on a deep cyclical sector. Catch Up Phase Looms For Energy Stocks Last week we broadened out our research on the yield curve (YC) inversion beyond the S&P 500 to the GICS1 sectors.3 As a reminder, the SPX peaks following the yield curve inversion and on average the S&P energy sector performs the best from the time the YC inverts until the S&P 500 peters out (please refer to Table 3 from the April 8, Special Report). While every cycle is different, if history at least rhymes, deep cyclical energy stocks will likely outperform as the SPX eventually breaks out to fresh all-time highs. Already, year-to-date the S&P energy sector is the third best performing sector, besting the SPX by over 200bps. More gains are in store, especially given the big dichotomy between the oil price recovery and the relative share price ratio (Chart 7). What is perplexing is the ingrained sell-side analyst pessimism (Chart 6A) and lack of belief that oil prices will remain near current levels or even continue their ascent as our sister Commodity & Energy Strategy (CES) service publication predicts. Not only are EPS forecast to contract in every quarter this year, or 10% year-over-year according to IBES, but also revenues are slated to fall in every quarter in 2019. We would lean against this extreme analyst bearishness. While the $3.5/bbl backwardation in WTI oil futures prices one year out, and more than twice that 24-months out, underpins Wall Street’s gloomy energy sector outlook, U.S. oil extraction productivity reinforces sector profits. As U.S. crude oil production hits new all-time highs this is extracted by fewer oil rigs (bottom panel, Chart 7). If BCA’s CES constructive oil price expectation pans out, then energy stocks will easily surpass the profit and revenue bar that analysts have set extremely low for the sector. Delivering on the profit front will likely serve as a catalyst to rerate these deep cyclical stocks higher (Chart 8) and thus a catch up phase looms for energy stocks, at least up to the current level of WTI crude oil prices (top panel, Chart 7). Chart 7Catch Up Chart 8Bombed Out Valuation Granted, the U.S. dollar is a key determinant of oil prices and if BCA’s view proves accurate that global growth will return in the back half of the year (second panel, Chart 9), that is synonymous with a depreciating greenback, which in turn is bullish the broad commodity complex in general and oil prices (and thus energy stocks) in particular (middle panel, Chart 7). As a reminder, oil prices are an excellent global growth barometer, similar to their sibling Dr. Copper. Recovering global growth will boost energy stocks in an additional way: via a favorable supply/demand crude oil balance. Not only is OPEC rebalancing the global oil market through a reduction on the supply front, but a trio of potential supply shocks from Iranian sanctions, Venezuelan infrastructure and Libyan conflict are providing price support. Further, global growth has historically been tightly correlated with rising non-OECD oil demand (Chart 10). Chart 9Global Growth Beneficiary Chart 10Favorable Supply/Demand Dynamics Meanwhile, the broad energy sector is still licking its wounds from the late-2015/early-2016 manufacturing recession and is stabilizing debt and increasing EBITDA (fifth panel, Chart 11), thus the net debt/EBITDA ratio for the index has collapsed from over 11 to around 2, a level similar to the broad market (second panel, Chart 11). Interest coverage (EBIT/interest expense) is also renormalizing higher and is no longer sending a default warning for the energy space as a whole (third panel, Chart 11). The junk energy bond market corroborates/reflects this balance sheet improvement and is no longer flashing red (bottom panel, Chart 9). Finally, bombed out technical conditions are contrarily positive, and such extreme negative readings have marked the start of playable and sizable relative outperformance periods (Chart 12). Chart 11No Red Flags Chart 12Contrary Alert: Depressed Technicals Netting it all out, YC dynamics, higher oil prices on the back of rising global growth and a favorable supply/demand crude oil backdrop, recovering balance sheets, and compelling valuations and technicals suggest that energy stocks will burst higher in the coming months. Bottom Line: We reiterate our above benchmark recommendation in the S&P energy sector and today we are adding it to our high-conviction overweight list. Buy Into Managed Health Care Weakness A little over a year ago we moved to the sidelines in the S&P managed health care index, crystalizing significant relative profits of 28% for our U.S. equity portfolio.4 Now the time has come anew to explore this niche health care index from the long side. While we left some money on the table since our late-May 2018 move, relative share prices have come full circle, valuations have fallen roughly 18% from the late-2018 peak and analysts’ euphoria has been reined in (Chart 13). Chart 13Reset The inter- and intra-industry M&A fever has died down from mid-2018 and the rising momentum of a “Medicare For All” bill has weighed negatively on HMO sentiment. With regard to the latter, our geopolitical strategists believe that passage is possible. If the Democrats can unseat an incumbent president in 2020, they will also likely take the Senate and keep the House. This means they will be in the position to pass a major piece of legislation. While Trump is favored to win, barring a recession, the risk of both a Democratic sweep and a push for “Medicare for All” could be as high as 27%, and this would have a dramatic impact on the health care sector.5 Tack on the near 90bps drop in the 10-year U.S. Treasury yield since the November 2018 peak, and factors have fallen into place for a bearish raid in this pure play health insurance index. Thin managed health care margins and profits move in close lockstep with interest rates as roughly 10% of the industry’s operating income is tied to “investment income”. In other words, as insurers receive the premia they typically invest it in Treasurys and that explains the high EPS and margin sensitivity on interest rate moves (Chart 14). While at first sight, the outlook for profits appears grim, BCA’s bond strategists expect a selloff in the bond market to materialize in the back half of the year simultaneously with a pick-up in global growth which will prove a tonic to both margins and EPS. In addition, leading indicators of heath care insurance profit margins are flashing green. Not only are medical costs melting including drug price inflation (second & bottom panels, Chart 15), but also industry cost structures are kept at bay with wages climbing below a 2%/annum rate growth and trailing overall wage inflation (third panel, Chart 15). Chart 14Overdone Chart 15Melting Cost Inflation On the demand front, as the economy is running at full employment, with unemployment insurance claims probing 60-year lows and with wages representing a headache for small and medium business owners, enrollment should stay healthy (Chart 16). Most importantly, the combination of decreasing medical cost inflation and a healthy overall labor market herald a steep decline in the industry’s medical loss ratio. All of this is unambiguously bullish for margins and profits. Finally, relative valuations and technicals have both corrected from previously stretched levels and offer a compelling entry point for fresh capital (Chart 17). Chart 16Full Employment Is Bullish Chart 17Unloved And Under-Owned Netting it all out, despite the risks that “Medicare For All” pose, melting medical cost inflation, BCA’s rising interest rate expectations along with an economy running at full steam, all suggest that managed health care margins and profits will overwhelm in the coming quarters. Bottom Line: Boost the S&P managed health care index to overweight today. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, ANTH, HUM, CNC, WCG. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 According to the NY Fed: “Treasury yields can be decomposed into two components: expectations of the future path of short-term Treasury yields and the Treasury term premium. The term premium is the compensation that investors require for bearing the risk that short-term Treasury yields do not evolve as they expected.” https://libertystreeteconomics.newyorkfed.org/2014/05/treasury-term-premia-1961-present.html 2 Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly” dated March 4, 2019, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, “10 Most FAQs From The Road” dated April 8, 2019, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, “Seeing The Light” dated May 29, 2018, available at uses.bcaresearch.com. 5 If there is a 60% chance the Democrats nominate a left-wing candidate, and a 45% chance they win the election, then there is a 27% chance that they are in a position to push for “Medicare for All” with fair odds of passage. Everything will depend on the specific outcomes of the Democratic primary, presidential campaign, general election, post-election government policy priorities, and congressional passage. Stay tuned as in the coming months we will be publishing a Special Report on “Medicare For All” and health care sector implications co-authored with our sister Geopolitical Strategy service. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights The first quarter is in the books, … : Risk may have been out in the fourth quarter, but it is squarely back in fashion so far this year, with equities and high yield posting gaudy first-quarter returns. … and events have compelled us to modify our high-conviction Fed call, … : There may yet be another four or more rate hikes, but they’re not going to occur this year. … but we’re still confident in our asset-allocation recommendations, … : The Fed may no longer be a menacing presence, but that doesn’t mean Treasuries and longer-maturity bonds are going to have it easy from here. … which should benefit from a more accommodative monetary policy outlook: Conditions remain favorable for equities and spread product, and unfavorable for Treasuries, even if the underlying drivers have shifted. Feature Table 1Whipsaw Newton’s Third Law holds that for every action there is an equal and opposite reaction. Markets have been busy supporting the theorem, as the fourth quarter’s sharp selloff has been nearly erased by the potent first-quarter rally (Table 1). Risk assets have been on a rollercoaster ride, though our economic outlook has been more or less unchanged. We chalked up the fourth quarter’s selloff to fears that the Fed was threatening the expansion. Conversely, the first quarter’s snapback likely owed quite a bit to the Fed’s pivot. By shifting its emphasis from trying to prevent inflation from getting away on the upside to trying to keep inflation expectations from falling too far, the Fed has gone from removing the punch bowl to promising to keep it full. In financial markets, risk assets should be the biggest relative beneficiaries. The Fed’s turn thwarted our more-hikes-than-expected call, at least in the near term. That surprise has been compounded by the administration’s seeming intent to pack the board of governors with nominees chosen solely on the basis of their uber-dovishness, and has inspired us to reflect on our calls. We like to share our reflections, as well as the internal BCA discussions and the client questions that shed light on our views. This week’s report examines some of the most important issues on our minds, and the minds of our colleagues and clients. Q: What does the Fed do from here? The quarterly summary of economic projections compiles FOMC meeting participants’ expectations for the likely path of key economic indicators (real GDP growth, unemployment and inflation) and monetary policy. The latest release revealed that Fed governors and regional presidents sharply dialed back their rate hike expectations between the December meeting and the March meeting (Chart 1). The median participant lopped 50 basis points (“bps”) off of his/her year-end 2019 and terminal fed funds rate projections, calling for no hikes in 2019 and just one more for the current cycle, in 2020. The rationale is a bit of a mystery, as the median participant’s estimates of GDP and inflation only came down modestly, and his/her unemployment rate estimates only rose modestly. It made sense for the Fed to turn away from the gradual pace of hikes it pursued in 2017 and 2018 in response to the sharp tightening in financial conditions brought on by the fourth-quarter selloff. The ensuing rallies in equities and high-yield bonds have undone much of that tightening, however. From a data perspective, it seems the Fed is mostly holding off to see how the outlook for the rest of the world evolves. The minutes of the March meeting, released last week, suggested that there may be more nuance to the Fed’s embrace of patience than markets initially perceived. The money markets had been calling for a 25-bps cut in the fed funds rate, to 2.25%, by the end of 2020; following the March meeting, they swiftly moved to price in a high likelihood of a second cut, to 2% (Chart 2). That outlook does not exactly accord with the committee’s more measured take: “Several participants observed that the [‘patient’] characterization … would need to be reviewed regularly[.] … A couple of participants noted that the ‘patient’ characterization should not be seen as limiting the Committee’s options[.] … Several participants noted that their views of the appropriate target range for the federal funds rate could shift in either direction[.] … Some participants indicated that if the economy evolved as they currently expected, … they would likely judge it appropriate to raise the target range … modestly later this year[.]” Chart 2... To Keeping It Full We continue to believe that the Phillips Curve is alive and well inside the Fed’s policy framework. The inverse relationship between inflation and unemployment is embedded in its macroeconomic models, and will compel the Fed to tighten policy in response to an unemployment rate that is nosing around 50-year lows (Chart 3). With the committee seemingly willing to let inflation get a bit of a head start before it tightens policy, it may well have to hike faster, and establish a higher terminal rate, than it otherwise would have if it had continued to follow a steady course. We believe the tightening cycle has been postponed rather than truncated, contrary to the money market’s view. Chart 3Sixties Flashback Bottom Line: The Fed is not going to take the fed funds rate to 3.25 - 3.5% by year end, as we expected late last year. We still believe the terminal rate is in that neighborhood, however, and the longer the Fed cools its heels, the greater the potential that it could exceed our estimate. Q: What is the outlook for the rest of the world? The March minutes revealed that conditions in the rest of the world continue to influence the Fed’s policy decisions. The slowdown in China, the uncertain outcomes of ongoing trade talks and Britain’s separation from the EU shadow the outlook in emerging economies and the major non-U.S. developed economies. The outlook for China, other emerging markets, and Europe have been a spirited subject of discussion within BCA. With a majority of the managing editors perceiving the signs of some green shoots, we upgraded Chinese equities to overweight from equal weight, and European and EM equities to equal weight from underweight, at our monthly View Meeting last week. An end to China’s deleveraging campaign may be all the rest of the world needs to show a little more life. Chart 4As China Goes China is a critical influence on our global view. We expect that policymakers have already begun de-emphasizing their deleveraging campaign, as suggested by March’s credit data, released Friday, and will encourage lenders to lend. No one at BCA expects a stimulus campaign on the order of the massive 2008 and 2016 efforts, but the general view is that policymakers can take steps to end the deceleration in China’s growth, since it was rooted in their deleveraging drive. The deceleration weighed on trade and manufacturing activity around the world (Chart 4), and may have been the catalyst for the global mini-slowdown. The rest of the world should benefit from the easing in financial conditions driven by the global equity rally. The decline in bond yields has also helped ease financial conditions, and the nearly unanimous dovishness of major-economy central banks may provide investors and consumers with additional comfort. The key issue for the U.S. economy, and U.S.-oriented investors, is whether or not the other major economies will slow enough to cool off the U.S. at a time when its fiscal impulse is slowing. We have a sense that China and Europe are beginning to turn, and we do not expect spillovers to drag on U.S. growth, but continued rallies in U.S. risk assets probably require some sort of revival beyond its shores. Q: How do corporate profits look? Is the consensus overly optimistic? The corporate profit outlook is getting less ambitious by the day. Over the last three months, consensus expectations for first quarter S&P 500 share-weighted earnings have fallen by 6.5%, as analysts downwardly revised their year-over-year growth projections from +3.5% to -2.2%. Management teams seek to under-promise and over-deliver, and do their best to guide analyst expectations to a level their companies can exceed. Since 1994, according to Thomson Reuters, about two-thirds of companies have reported earnings that beat estimates. On average over that stretch, companies have beaten estimates by a margin of 3.2%. We are therefore inclined to take the projected earnings contraction with a grain of salt. Corporations seem to have lowered the bar to a level they should be able to clear without too much trouble. Chart 5Wages Aren't Yet Pressuring Margins ... We are further inclined to question the projected 2.2% contraction in earnings, given that revenues are projected to grow by 5% in the quarter. The disparity implies margin contraction of close to 7%. Compensation is the largest component of corporate expenses, with the remainder roughly split between interest expense and other input costs. The other meaningful input is the dollar, which should most often exhibit an inverse relationship with margins. Real unit labor costs is the compensation series that most directly impacts profit margins, and it has been contracting on a year-over-year basis, augmenting margins (Chart 5). It will continue to do so as long as nominal wage growth lags inflation and productivity gains. BBB-rated corporate yields were materially higher in the first quarter than they were a year ago, and may have taken a modest bite out of margins, but they’re now back to where they were then and cannot explain the projected 7-ppt margin haircut by themselves (Chart 6). Producer prices grew just 2.2% on a year-over-year basis, slightly ahead of consumer prices (Chart 7), suggesting that margins only slightly narrowed from the disparity between input costs and selling costs. Chart 6... And Interest Rates Aren't Anymore Chart 7Input Costs Are Manageable The broad trade-weighted dollar gained 6% from 1Q18 to 1Q19. Assuming corporations lower prices to defend market share against foreign competitors, profit margins should fall when the dollar rises. Dollar appreciation likely exerted some incremental pressure on margins, but the internal model we’ve previously referenced pegs the EPS impact of a 10% rise in the dollar at 2.5%, far too small for a 6% rise in the dollar to drive a 7-ppt fall in margins. If the revenue estimates are accurate, it seems to us that management must be sandbagging its earnings guidance to some degree. The 10-year Treasury yield will have a harder time falling further now that the Fed is already awfully dovish. Q: Are you having any second thoughts about your duration recommendation? Our below-benchmark duration call was largely founded on our expectation that the Fed was going to surprise complacent markets by hiking more than they expected. It instead surprised dovishly, and the OIS curve responded by pricing in an additional rate cut by the end of next year. The 10-year Treasury yield melted, in accordance with our U.S. Bond Strategy service’s golden rule1 (Chart 8). Chart 8The Golden Rule The surest way to mess up a Fed call is to allow what one thinks the Fed should do to intrude on one’s assessment of what the Fed will do. We did not fall into that trap: our view that the Phillips Curve exerts considerable influence over the Fed and other central banks is founded in the observation that virtually every mainstream macroeconomic model incorporates an inverse relationship between inflation and unemployment. As noted above, we see the Fed’s hiking campaign as extended rather than ended. We believe pausing the hiking campaign will extend the expansion and allow the economy to build up more momentum. More momentum would merit higher real rates, and we also expect it would promote inflation pressures given that the output gap is already closed. We were admittedly on the wrong side as the 10-year Treasury yield fell from 3.25% to 2.4%, but still lower yields would be incompatible with our constructive view of the U.S. economy. With much of the drag on Treasury yields seeming to have come from overseas, it’s also important to note that lower major-economy yields would be incompatible with our house view that the global economy is on the cusp of rebounding (Chart 9). Chart 9Yields Rise When Green Shoots Appear Bottom Line: We missed the slide in the 10-year Treasury yield because we failed to foresee the Fed’s pivot, and because we may have focused too much on U.S., rather than global, conditions. We do not see yields falling much further, however, now that the Fed’s capacity for dovish surprises is spent, and green shoots are starting to appear in China and Europe. Q: How was the Final Four? Fantastic, and we recommend gathering some old college friends and making the trip to cheer on your alma mater should it qualify. Bring your kids if they’re old enough. If your school wins it all, you’ll share lifelong memories of the sort the Virginia alumni who attended the games will cherish. We’ll always have Minneapolis. Go ‘Hoos! Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Treasuries beat cash when the Fed hikes less than the money market expects, and lag cash when it hikes more than expected. Please see the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” published July 24, 2018. Available at usbs.bcaresearch.com.
Highlights We remain constructive on the U.S. economy, …: It was another uneven week, but conditions remain broadly favorable for the U.S., and the expansion is intact. … and things seem to be perking up in the rest of the world, in line with BCA’s house view, …: China’s PMI data gave global markets a boost and European PMIs hinted at the potential for green shoots on the continent. … but money managers get paid to worry for their clients, and we get paid to worry for the managers, …: We would be remiss if we didn’t explore alternative scenarios, especially around an unobservable variable like the equilibrium fed funds rate. … so we’re always looking for the ways that we could be getting it wrong: This week’s report explores how the landscape would look from the perspective of consumption, investment, and government spending if a recession were at hand. Feature Chart 1Selloff, What Selloff? Last week’s data were mixed, but there is no doubt, as we’ve acknowledged throughout 2019, that the U.S. economy is decelerating. The deceleration has fanned recession fears, and the yield curve’s fleeting inversion two weeks ago added fuel to the fire.1 The sell-off in financial markets in the fourth quarter seemed largely to have been animated by concerns that the Fed was pushing the fed funds rate into restrictive territory. The sharp decline in equities, and the sharp rise in corporate bond yields, amounted to a material tightening in financial conditions that threatened to become a self-fulfilling prophecy. What a difference a quarter makes. The potent first-quarter rally has reversed much of the fourth quarter’s tightening of financial conditions (Chart 1), while the FOMC’s March meeting indicated that the Fed has pivoted from defending against inflation overshoots to trying to correct its extended post-crisis undershoot. The threat that the Fed would follow the typical path of tightening into a recession has now receded, at least for the rest of 2019. As long as inflation doesn’t suddenly flare up, the expansion should remain intact, provided that the Fed hasn’t already lifted short rates into restrictive territory. We have contended that it hasn’t, as the fed funds rate is comfortably below our current estimate of the equilibrium rate, and is even further below our year-end equilibrium projection. We are well aware that the equilibrium rate cannot be directly observed, and that our estimate may be off the mark. We therefore devote this week’s report to considering what the building blocks of GDP might look like if a recession were about to begin. We particularly focus on consumption, which accounts for the lion’s share of U.S. activity, and indirectly affects both investment and government spending.2 Is Consumption On A Recession Path? Retail sales contracted month-over-month in February, though upward revisions to the January data made the release something of a wash. Year to date, though, retail sales growth has not been strong enough to erase the disappointment from December’s lousy print. From a longer-term perspective, real retail sales don’t suggest anything definitive about the business cycle: although they’re in a mini downtrend, previous pre-recession slides have been steeper and/or longer (Chart 2, top panel). Growth in real personal consumption expenditures (PCE), the consumption input to GDP, has been trendless for the last three years, but is not in the extended slide that preceded other recessions, nor has it yet become stretched in this cycle (Chart 2, bottom panel). Chart 2Neither Here Nor There Chart 3Steady As She Goes We find that consumption fundamentals are sending a clearer message than the retail sales or PCE series themselves. We segment the fundamentals into three components: ongoing demand for workers, the prospects for wage increases, and households’ capacity to borrow to support spending. The labor market is currently quite strong and net payroll growth has been remarkably steady for the last four years (Chart 3). Our payrolls model, which incorporates initial unemployment claims, temporary workers and NFIB small business hiring plans, projects no more than modest slowing (Chart 4). Chart 4No More Than Mild Deceleration Ahead Prices rise when demand outpaces supply, and the excess of job openings over unemployed workers (Chart 5) bodes well for wage growth. The elevated rate of employees quitting their jobs is also a positive sign (Chart 6). A worker doesn’t quit one job unless s/he has a higher-paying one lined up. We therefore read the elevated quits rate as an indication that the competition to attract employees is fierce, and that workers have regained some measure of bargaining power. Chart 5More Jobs Than Candidates ... Chart 6... Makes For A Johnny Paycheck Labor Market ... The combination of rising household income and a light debt-servicing burden augurs well for consumption. A negative unemployment gap (an unemployment rate below the estimated natural rate of unemployment) also tends to be good for compensation growth. Over the last 30 years, annualized average hourly earnings (AHE) have grown one-and-a-half times faster when the unemployment gap is negative than when it is positive, and the earnings growth rates have been remarkably consistent (Chart 7). Household income will have a solid tailwind behind it if AHE gains can catch up to the nearly 4% level consistent with negative gaps in the late ‘80s, late ‘90s and mid-aughts. Chart 7... Where Employers Have To Keep Employees Happy Employment and wage gains suggest that rising household incomes will support spending, but the support would be undermined if households chose to use the income gains to pay down debt. Households have been shoring up their balance sheets ever since the crisis, more than tripling the savings rate from its summer 2005 low (Chart 8, top panel), and have now unwound nearly all of the debt (as a share of GDP) they took on in the ’01-’07 expansion (Chart 8, second panel). They may not yet be done, but the pace at which they’ve been deleveraging has slowed considerably over the last few years. With today’s still-low interest rates, servicing households’ debt burden is easier than it has been at any time in the last 40 years (Chart 8, bottom panel). Households are positioned to take on more debt if they so choose. Chart 8Low Rates Make For A Light Burden Bottom Line: Prospects for continued payroll expansion and wage gains are good, and households have the capacity to borrow to augment spending. We therefore expect that consumption is not on a recessionary path. The fundamentals underlying the U.S. economy’s largest pillar are solid. Could Investment Tip The Economy Into A Recession? Consumption is clearly the 800-pound gorilla of the U.S. economy. It accounted for close to 70% of GDP in the fourth quarter, and when it sneezes, the overall economy catches a cold. It has been a relatively stable series over time, however, and its infrequent contractions tend to be pretty modest. The story is quite different for private domestic investment, which routinely makes wild swings, and tends to seize up during recessions (Chart 9). Even though investment and government spending each account for just a quarter of consumption’s weight, it’s statistically easiest for investment to negate 2% growth in the rest of the economy (Table 1). Chart 9Consumption May Be Larger, But Investment Punches Harder Table 1The Road To Recession We have previously demonstrated that consumption leads capex. It turns out that fixed investment is the opposite of the if-you-build-it-they-will-come “Field of Dreams” mantra; corporations will only build if the customers have already come (Chart 10). Consumption is gently slowing right now, which suggests that corporate investment is not about to boom. To induce a recession, though, fixed private investment would have to crater, and nothing in consumption’s current trend, the employment outlook, the compensation outlook, or households’ borrowing capacity suggests that consumption is at risk of plunging. Chart 10Consumption Drives Capex Surveys asking corporations about their investment plans have been decent coincident indicators of corporate fixed investment. The dip in capital spending plans from the NFIB survey suggests that demand for non-defense capital goods is headed lower (Chart 11, top panel), as does the decline in capex plans in the regional Fed surveys (Chart 11, bottom panel). Neither implies the sharp decline that would be required to offset trend growth in the rest of the economy, however. The corporate tax cut does not appear to have inflated 2018 capex, so 2019 investment should not be at risk of suddenly unwinding. Chart 11Capex May Soften, But It's Not About To Melt Residential investment accounts for around a fifth of private domestic investment. We have written about housing at length over the last several months and will not rehash the discussion here, other than to note that permits and starts remain in a broad uptrend (Chart 12, top panel), as do new and existing home sales (Chart 12, middle panel). Affordability has revived with the decline in mortgage rates, and is once again above its pre-crisis peaks. The inventory of homes for sale is also at multi-year lows (Chart 12, bottom panel). With the Fed sidelined for an extended period, housing demand appears as if it will hold up, and there’s nothing to worry about from a supply perspective. Chart 12The Housing Market Is Fine Bottom Line: The investment component of GDP does not appear as if it is about to contract in a significant way. It is unlikely to be the source of a cyclical inflection. Government Spending By virtue of its modest size and muted volatility relative to consumption and investment, government spending is the least likely component of GDP to extinguish the expansion. The prospects for a negative-two-standard-deviation event that could trigger a recession look especially slim. With employment and household incomes rising, and home values still appreciating, state and local tax receipts should be well supported. Pro-cyclical federal fiscal policy is an anomaly (Chart 13), but we see no signs that the current administration will reverse course with a presidential election on the horizon. Although defense has accounted for a shrinking share of federal spending ever since the end of the Cold War, it still accounts for 60% of federal spending (Chart 14, bottom panel), and a quarter of aggregate government spending. Consistent with CBO projections, we expect defense spending will continue to expand through 2020, as it remains a Republican priority. Federal entitlements were a sacred cow in the 2016 Trump campaign and will remain so in the 2020 campaign, given their importance to the administration’s aging rural base. Chart 13Fiscal Policy Has Turned Pro-Cyclical State and local spending account for the majority of aggregate government spending (Chart 14, top panel). Healthcare and education are the biggest line items in state budgets, and healthcare reforms have the potential to alter budget composition, but aggregate spending moves in lockstep with aggregate revenues, as many states are constitutionally mandated to maintain balanced budgets. The main sources of state revenues are income taxes and sales taxes. Municipalities rely heavily on property taxes. Chart 14State Spending Matters ... State income tax receipts are clearly a function of employment, though the link has come and gone this cycle as the expansion has matured (Chart 15, top panel). Sales tax receipts move with employment as well, because consumption is tied to income (Chart 15, second panel). Property taxes are a function of appraised property values, for which home prices are a solid proxy (Chart 15, third panel). If demand for labor remains robust, wages face upward pressure, and home prices don’t contract, state and local government spending is unlikely to dry up anytime soon. Chart 15... And It's Tied To Income, Consumption, And Property Prices As long as the expansion remains intact (and valuations don’t get silly), risk-friendly positioning remains appropriate. Bottom Line: Nothing points to a sudden decline in government expenditures on the order of the negative-two-standard-deviation move which would be required to induce a recession. Weakness in employment and wage growth would hurt state tax revenues, reinforcing a slowdown in consumption, but that is not our base-case scenario for 2019. Investment Implications Investors should stay the course and remain overweight equities, given that a recession is not imminent. Although we think the Fed’s largesse will ultimately be reversed in potentially heavy-handed fashion, its implicit pledge to remain on the sidelines into the second half of this year extends the runway for risk asset outperformance. We are not in love with the S&P 500 at current levels, and will be surprised if it continues to appreciate at its current pace, but the policy climate – monetary and fiscal – is conducive to outperforming cash and high-quality fixed income. We would hold some capital in reserve to deploy in the event of a pullback, but continue to advocate a risk-friendly portfolio tilt. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Senior Analyst, Global ETF Strategy jenniferl@bcaresearch.com Footnotes 1 With the yield curve clawing its way back to positive territory by March 29’s close, it actually has yet to invert on a monthly basis. We have heard its downbeat growth message loud and clear, however, and are on alert for further potential weakness. 2 We leave net exports out of our analysis, as they’re not consequential to the comparatively closed U.S. economy.
Highlights Odds are that the recent improvement in Chinese manufacturing PMIs could be due to inventory re-stocking rather than a decisive turnaround in final demand. “Hard” data have not shown meaningful improvements in China’s final demand. Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index breaks above 1125, which is 4% above its current level. Keep Malaysia on an upgrade watch list. Downgrade Brazil to underweight. Feature The strong Chinese PMI prints released this week have challenged our negative view on EM assets and China plays. This week we take a deeper look at the underlying reasons behind the recent improvement in China’s PMI data. In addition, we elaborate on what it would take for us to alter our current strategy on EM risk assets. A Manufacturing Upturn The upturn in China’s manufacturing PMIs in March has been validated by improvement in Taiwanese PMI’s export orders (Chart I-1, top panel). The latter’s amelioration has been broad-based across all sectors: electronics and optical, electrical machinery and equipment, basic materials, and chemical/biological/medical (Chart I-1, bottom panel). China accounts for 30% of Taiwanese exports, making Taiwan’s manufacturing sector heavily exposed to China’s business cycle. Does this improvement in manufacturing PMIs reflect a final demand revival in China? Looking For Final Demand Revival China’s domestic and overseas orders remain weak, as exhibited in Chart I-2. These indicators give us the primary trajectory of the Chinese business cycle, while the PMI indexes exhibit considerable short-term volatility. Chart I-1One-Month Surge In China's And Taiwan's PMIs Chart I-2Noise And Business Cycle Trajectory The domestic demand and overseas orders reflect quarterly data from 5,000 enterprises. The latest datapoints are from Q1 2019 and were released on March 22. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. Consumer spending: There has been no improvement in households’ propensity to spend. Our proxy for households’ marginal propensity to spend has not turned up (Chart I-3). Consistently, China’s smartphone sales and passenger car sales are contracting at double-digit rates, while the growth rate in online sales of services has not improved (Chart I-4, top three panels). Chart I-3Chinese Consumers' Propensity To Spend Chart I-4China: No Improvement In "Hard" Data The bottom panel of Chart I-4 demonstrates the retail sales of consumer goods during the Chinese New Year compared with the previous year’s spring festival. It is evident that as of mid-February, when this year’s spring festival took place, there was no improvement in Chinese consumer demand. Business spending / investment: Our proxy for enterprises’ propensity to spend continues to decline (Chart I-5). Companies’ propensity to spend has historically led the cyclical trajectory in industrial metals prices. Crucially, this has not corroborated the rebound in base metals prices over the past three months. Besides, China’s imports of capital goods, its total imports from Korea and its machinery and machine tool imports from Japan are all still contracting at a double-digit rate (Chart I-6). Chart I-5China: Enterprises' Propensity To Spend And Metals Chart I-6Contracting At A Double Digit Rate China’s fixed asset investment in infrastructure has picked up of late and will continue to improve. However, this may not be sufficient to revive the mainland’s economy. China’s growth decelerated in 2014-2015 and industrial commodities prices dwindled, despite robust growth in infrastructure investment at the time (Chart I-7). The culprit was the decline in property construction in 2014-2015. As to the property market, the People’s Bank of China’s (PBoC) Pledged Supplementary Lending (PSL) financing points to further weakness in property demand in the coming months (Chart I-8). Chart I-7China's Infrastructure Investment And Base Metals Prices Chart I-8China: The Outlook For Residential Property Demand Moreover, property starts have been surging, yet their completions have been tumbling. This suggests a ballooning amount of work-in-progress on real estate developers’ balance sheets. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. It may well be that property developers do not have financing to complete work or that they are reluctant to bring new units to the market amid tame demand. Whatever the case, the mediocre pace of construction activity is negative for suppliers to the construction industry. Government spending: Aggregate government spending in China – including central and local government as well as government-managed funds (GMF) – has been very robust in the past year (Chart I-9). Hence, government spending has not been the reason behind the economic slowdown. Chart I-9China's Aggregate Fiscal Spending For 2019, overall government spending is projected to expand by 11% in nominal terms from a year ago, down from 17% in 2018. The key fiscal risk is shrinking land sales, which account for 86% of GMF revenues. The latter have substantially increased in size and now makeup 27% of aggregate fiscal spending. Local and central government expenditures account for 62% and 11% of aggregate fiscal spending, respectively. If land revenues undershoot, GMF and local governments will not be able to meet their expenditure targets without Beijing altering the former’s borrowing quotas. In brief, fiscal policy may be involuntarily tightened due to a shortfall in land sales revenues before the central government permits local governments to borrow more. Exports: Chinese shipments to the U.S. will recover as China and the U.S. finalize their trade deal. The media is extremely focused on the trade negotiations, and markets have been trading off the headlines. Nevertheless, it is essential to realize that China’s exports to the U.S. make up only 3.6% of the country’s total GDP (Chart I-10). This contrasts with capital spending that accounts for 42% of the mainland’s GDP. Consequently, we believe the credit cycle that drives construction and capital spending is more important to China’s growth than its shipments to the U.S. Global ex-China Demand: The areas of global final demand that weighed on global growth last year remain depressed. Global semiconductors and auto sales have been shrinking at a rapid pace and have so far not experienced a reversal (Chart I-11). Chart I-10China Is Not Reliant On Exports To The U.S. Chart I-11Global "Hard" Data Are Still Bad Bottom Line: There is a lack of pertinent “hard” business cycle data in China that have improved. What Does It All Mean Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. Unfortunately, in China, there is limited reliable data that quantifies inventory levels well in various industries. Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. The consensus view in the investment community is that China’s credit stimulus has boosted the economy since the beginning of this year. Business conditions have certainly improved. The rally in Chinese stocks has in turn mirrored this improvement. Yet it is not clear that this revival in the business cycle is due to the credit stimulus. Chart I-12 plots the credit impulse, including local government general and special bonds issuance, with the three typical business cycle variables: manufacturing PMI and nominal manufacturing production growth. Chart I-12China: Credit Impulse Leads "Hard" Data As can be seen from the chart, the manufacturing PMI is very volatile. In the short term, there is little correlation between it and the credit impulse (Chart I-12, top panel). Meanwhile, the credit impulse leads nominal manufacturing output growth by nine months (Chart I-12, bottom panel). Based on the past time lag relationships, the mainland’s business cycle should not have bottomed until the third quarter of this year. Hence, the bottom in the manufacturing PMIs in January does not fit the historical pattern of the relationship between the credit impulse and the mainland’s business cycle. Bottom Line: Presently, it is hard to make a definite conclusion on the reasons behind the pick-up in Chinese manufacturing. That said, business cycles do not always evolve in a common-sense manner that can be both rationalized and forecast by indicators. Therefore, it is essential for investors, to have confirmation signals from financial markets on the direction of the business cycle. Financial Markets As A Litmus Test We continuously monitor numerous financial markets that are sensitive to both the global and Chinese business cycles. These financial market-based indicators are often coincident with EM asset prices. Hence, they can be used to confirm or refute EM market direction. Our Risk-On-to-Safe-Haven (ROSH) currency ratio has recently softened, flashing a warning signal for EM share prices (Chart I-13). Chart I-13Currency Markets Are Flashing Amber For EM Stocks The ROSH ratio is the relative total return (including carry) of six commodities currencies (AUD, NZD, CAD, CLP, BRL and ZAR) versus two safe-haven currencies: the yen and Swiss franc. Hence, this currency ratio is agnostic to U.S. dollar trends, making its signals especially valuable. Our Reflation Confirming Indicator has retreated, also signaling a pullback in the EM equity index (Chart I-14). This indicator is composed of an equal-weighted average of industrial metals prices (a play on Chinese growth), platinum prices (a play on global reflation) and U.S. lumber prices (a proxy play on U.S. growth). Chart I-14Commodities Markets Are Flashing Amber For EM Stocks Within EM credit markets, corporate investment-grade spreads have begun narrowing versus high-yield spreads (Chart I-15). This typically coincides with lower EM share prices. Finally, EM share prices have been underperforming DM since late December. Relative performance of EM ex-China stocks against the global equity index has been even more underwhelming. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Bottom Line: These financial market signals are not consistent with a durable China-led recovery in the global business cycle. Investment Strategy A number of financial markets are currently at a critical juncture. These markets will either break out or break down, with subsequently significant moves. The broad U.S. trade-weighted dollar has been flattish in the past nine months despite falling interest rate expectations in the U.S. and the risk-on market environment. We read this as a sign of underlying strength. The trade-weighted dollar is presently sitting on its 200-day moving average (Chart I-16). Consistent with a flattish trend in the greenback, the U.S. dollar volatility has dropped to very low levels. Exchange rates usually do not trade sideways much longer than that. Hence, the dollar is about to break out or break down and any move will be lasting and large. Chart I-15A Message From EM Corporate Credit Market Chart I-16The U.S. Dollar Is About To Make A Big Move The Korean won has been forming a tapering wedge pattern from both short-term and long-term perspectives (Chart I-17, top and middle panels). Its volatility has also plunged to a record low (Chart I-17, bottom panel). Chart I-17The Korean Won Is At Crossroads Chart I-18A Stop-Buy On EM Stocks Finally, emerging Asian equities’ relative performance to global stocks is facing an important technical resistance as are copper and oil prices. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Consistently, China’s “soft” data that has improved markedly yet there is no “hard” data confirmation. Moreover, there is some evidence to suggest that the pickup in the soft data may simply reflect inventory building. Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index in U.S. dollar terms breaks above 1125, which is 4% above its current level (Chart I-18). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Malaysia: Keep On Upgrade Watch List Malaysian equities have been underperforming their EM counterparts since 2013 and are now resting around their 2017 lows (Chart II-1). The odds are high that this market’s underperformance is late. Chart II-1Malaysian Stocks Relative to EM Investors should keep Malaysian equities on an upgrade watch list. We upgraded the Malaysian bourse from underweight to neutral in December 2018. In a Special Report published at that time, we argued that the structural outlook for Malaysia had improved, yet the cyclical downturn would persist. The latter did not warrant moving the bourse to overweight. This view is still at play. Economic Slowdown Is Advanced The Malaysian economy has been digesting credit and property market excesses. Property sector: Property sales have declined by 37% since 2010, and prices for some property segments are beginning to deflate (Chart II-2). Similarly, housing construction approvals have slumped severely since 2012. Consumers: Passenger vehicle sales have been falling since 2012 along with households' declining marginal propensity to consume, and retail trade has been very weak (Chart II-3). Chart II-2Property Sector Is Depressed Chart II-3Consumer Sector Is Weak An ongoing purge of excesses by companies entails lower wage growth and weaker employment, resulting in subdued household income growth. The latter could extend the consumer slump. Business sector: Capital spending growth in real terms has decelerated and may contract. Both profit margins and return-on-equity (ROE) for non-financial publicly listed companies have slumped and are currently resting below their 2008 levels (Chart II-4). This warrants cost-cutting and reduced corporate spending/capital expenditures for now. Chart II-4Corporate Restructuring On The Way? Reduced employment and weak wage growth are negative dynamics for households but positive for companies’ profit margins. Commercial Banks: Malaysian banks remain unhealthy. At 1.5%, their NPLs remain low relative to the credit boom that occurred over the past decade. Moreover, Malaysian banks have been lowering their provisions levels to boost profits. This is an unsustainable strategy. Provided economic growth will remain weak, both NPLs and provisions will rise, hurting banks’ profits and share prices. Banks hold a very large market-cap weighting in this bourse, and the negative outlook for banks’ profits deters us from upgrading this equity market. Purging Excesses: Implications For The Exchange Rate Purging of economic excesses is painful in the short- and medium-term, as it instills deflation. A currency often depreciates during this phase to mitigate the deflationary forces in the economy. However, purging excesses, deleveraging and corporate restructuring are ultimately structurally bullish for a currency. First, corporate restructuring and improved capital allocation lift productivity growth in the long run. The Malaysian economy has been digesting credit and property market excesses. Second, low inflation or outright deflation allow the currency to depreciate in real terms. The Malaysian ringgit is already cheap based on the real effective exchange rate (Chart II-5). Finally, amid deflation and in the absence of widespread bailout of debtors funded by bank loans or excessive government borrowing, cash becomes “king”. Hence, deleveraging is ultimately currency positive. In contrast, pervasive bailouts funded by money creation – i.e., mushrooming money growth – usually undermine residents’ and foreigners’ willingness to hold the currency. A capital flight ensues and the currency plunges. Malaysia in 2015 was the latter case, with the ringgit plummeting as residents converted their ringgits to U.S. dollars (Chart II-6, top panel). Chart II-5The Ringgit Is Cheap Chart II-6Malaysia: 2015 Vs. Now Presently, the opposite dynamics are at play. The central bank is reducing commercial banks’ excess reserves, domestic private credit growth is weak and residents are not fleeing the ringgit (Chart II-6). In addition, the structural reorientation of the economy from commodities to semiconductors/technology is beginning to bear fruit. As a result, overall trade balance has significantly improved, despite weak commodities prices. This is also positive for the currency. Finally, a more stable (i.e., modestly weaker) exchange rate amid both a global and domestic downturn will allow Malaysia’s central bank to reduce interest rates and smooth the growth slump. This is in contrast to 2015 when capital outflows and the plunging currency did not allow the central bank to reduce borrowing costs. Investment Conclusions We recommend keeping Malaysian stocks on an upgrade watch list for now. We recommend upgrading Malaysian sovereign credit and local currency government bonds from underweight to neutral relative to their respective EM benchmarks A relatively stable ringgit will benefit Malaysia’s local and U.S. dollar bonds. Furthermore, foreign ownership of local bonds has fallen meaningfully, diminishing the risk of future outflows. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Downgrading Brazil: The Honeymoon Is Over In our October 9 report, we upgraded Brazil following the outcome of the first round of presidential elections. We, like the market, gave a benefit of the doubt to the new president. However, the honeymoon is over for President Bolsonaro. The markets are becoming increasingly pessimistic because of the lack of progress on the social security reforms front. It is no secret that Brazil needs bold pension reform to make its public debt sustainable. As things stand now, the public debt dynamic in Brazil is precarious. Two prerequisites for public debt sustainability are (1) for interest rates to be below nominal GDP growth or (2) continuous robust primary fiscal surpluses. Hence, a government can stabilize its debt-to-GDP ratio by either having nominal GDP above its borrowing costs, or by running persistent and sizable primary fiscal surpluses. Neither of these two stipulations are presently satisfied in Brazil. The gap between government local currency bond yields and nominal GDP growth is still very wide (Chart III-1). Meanwhile, the primary fiscal deficit is 1.5% of GDP (Chart III-2). Chart III-1Brazil: An Unsustainable Gap Chart III-2Brazil: Public Debt Dynamics Are Precarious In the early 2000s, the government stabilized its public debt dynamics by running persistent primary surpluses of about 4% of GDP (Chart III-2, top panel). Will Brazil achieve primary fiscal surpluses in the coming years assuming some form of the pension reform is adopted? It is doubtful. According to the government’s own forecasts, the submitted draft of social security reforms, including the one for the army, will save only BRL190 billion in next four years or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP (Chart III-2). Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated or the primary surplus will be very small. Overall, it seems unlikely that the government’s proposed pension reforms will be sufficient to turn around Brazil’s public debt dynamics in the next several years - barring very strong economic growth that will fill in government coffers. Bottom Line: We are downgrading Brazil from overweight to underweight within EM equity, local currency bonds and sovereign credit benchmarks. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Two weeks ago, we highlighted that S&P 500 profit margins have likely peaked for the cycle and that our margin proxy, weighed down by mounting concerns over wage growth and nil pricing power, was pointing to a further decline (top panel). We are updating this today to show BCA’s Monetary Indicator (MI) and its confirming negative signal for SPX margins (MI shown inverted, second panel) These profit headwinds have been likely reflected in sell-side estimates that have forward EPS growth rates trailing forward revenue growth rates according to IBES data, implying contracting margins through the first nine months of the year. Including the slight year over year margin contraction in Q4/18, this means a full calendar year of falling margins. Grinding lower margins are a cause for short-term concern. Nevertheless, from a cyclical perspective we reiterate two important points: first, unit labor costs – the best measure of wage growth – remain muted as productivity growth has ramped up recently. Second, using empirical evidence dating back to the 1960s, the ultimate SPX profit margin mean reversion occurs during recessions, when EPS suffer a major setback; as a reminder, BCA’s review remains that the U.S. will avoid recession in the next 12 months. Thus, despite a near-term margin soft patch, we expect a mid-year margin inflection point courtesy of EPS growth green-shoots (please refer to Chart 3 from the March 18th Weekly Report).