Financials
Recommendation Allocation Highlights Growth was picking up before the election of President Trump. His election merely accelerates the rotation from monetary to fiscal policy. This is likely to cause yields to rise, the Fed to tighten and the dollar to strengthen further. That will be negative for bonds, commodities and emerging market assets, and equivocal for equities. Short term, markets have overshot and a correction is likely. But the 12-month picture (higher growth and inflation) suggests risk assets such as equities will outperform. Our recommendations mostly have cyclical tilts. We are overweight credit versus government bonds, underweight duration and, in equity sectors, overweight energy, industrials and IT (and healthcare for structural reasons). Among alts, we prefer real estate and private equity over hedge funds and structured products. We limit beta through overweights (in common currency terms) on U.S. equities versus Europe and emerging markets. We also have a (currency-hedged) overweight on Japanese stocks. Feature Overview A Shift To Reflation The next 12 months are likely to see stronger economic growth, particularly in the U.S., and higher inflation. That will probably lead to higher long-term interest rates, the Fed hiking two or three times in 2017, and further dollar strength. The consequences should be bad for bonds, but mixed for equities - which would benefit from a better earnings outlook, but might see multiples fall because of a higher discount rate. The election of Donald Trump merely accelerates the rotation from monetary policy to fiscal policy that had been emerging globally since the summer. Trump's fiscal plans are still somewhat vague,1 but the OECD estimates they will add 0.4 percentage points to U.S. GDP growth in 2017 and 0.8 points in 2018, and 0.1 and 0.3 points to global growth. Growth was already accelerating before the U.S. presidential election. Global leading indicators have picked up noticeably (Chart 1), and the Q3 U.S. earnings season surprised significantly on the upside, with EPS growth of 3% (versus a pre-results expectation of -2%) - the first YoY growth in 18 months (Chart 2). Chart 1Global Growth Picking Up Chart 2U.S. Earnings Growing Again The problem with the shift to fiscal, then, is that it comes at a time when slack in U.S. economy has already largely disappeared. The Congressional Budget Office estimates the output gap is now only -1.5%, which means it is likely to turn positive in 2017 (Chart 3). Unemployment, at 4.6%, is below NAIRU2 (Chart 4). Historically, the output gap turning positive has sown the seeds of the next recession a couple of years later, as the Fed tightens policy to choke off inflation. Chart 3Output Gap Will Close In 2017 Chart 4Will This Trigger Inflation Pressures? As the Fed signaled at its meeting on December 14, it is likely to raise rates two or three times more in 2017. But we don't see it getting any more hawkish than that. Janet Yellen has made it clear that she will not preempt Trump's fiscal stimulus but rather wait to see it passed by Congress. The market is probably about right in pricing in an 80% probability of two rate hikes in 2017, and a 50% probability of three. With the Atlanta Fed Wage Growth Tracker rising 3.9% YoY and commodity prices (especially energy) starting to add to headline inflation, the Fed clearly wants to head off inflation before it sets in. We do not agree with the argument that the Fed will deliberately allow a "high-pressure economy." The result is likely to be higher long-term rates. The 10-year U.S. yield has already moved a long way (up 100 BP since July), and our model suggests fair value currently is around 2.3% (Chart 5). Short term, then, a correction is quite possible (and would be accompanied by moves in other assets that have overshot since November 9). But stronger global growth and an appreciating dollar over the next 12 months could easily push fair value up to 3% or beyond. The relationship between nominal GDP growth (which is likely to be 4.5-5% in 2017, compared to 2.7% in 1H 2016) and long-term rates implies a rise to a similar level (Chart 6). Accordingly, we recommend investors to be underweight duration and prefer TIPs over nominal bonds. Chart 5U.S. 10-Year At Fair Value Chart 6Rise In Nominal GDP Could Push It Up To 3% Global equities, on a risk-adjusted basis, performed roughly in line with sovereign bonds in 2016 - producing a total return of 9.2%, compared to 3.3% for bonds (though global high yield did even better, up 15.1%). If our analysis above is correct, the return on global sovereign bonds over the next 12 months is likely to be close to zero. Chart 7Will Investors Reverse The Move##br## from Equities To Bonds? The outlook for equities is not unclouded. Higher rates could dampen growth (note, for example, that 30-year fixed-rate mortgages in the U.S. have risen over the past two months from 3.4% to 4.2%, close to the 10-year average of 4.6%). The U.S. earnings recovery will be capped by the stronger dollar.3 And a series of Fed hikes may lower the PE multiple, already quite elevated by historical standards. Erratic behavior by President Trump and the more market-unfriendly of his policies could raise the risk premium. But we think it likely that equities will produce a decent positive return in this environment. Portfolio rebalancing should help. Since the Global Financial Crisis investors have steadily shifted allocations from equities into bonds (Chart 7). They are likely to reverse that over the coming quarters if bond yields continue to trend up. Accordingly, we moved overweight equities versus bonds in our last Monthly Portfolio Update.4 Our recommended portfolio has mostly pro-cyclical tilts: we are overweight credit versus government bonds, overweight most cyclical equity sectors, and have a preference for risk alternative assets such as real estate and private equity. But our portfolio approach is to pick the best spots for taking risk in order to make a required return. We, therefore, balance this pro-cyclicality by some lower beta stances: we prefer investment grade debt over high yield, and U.S. and Japanese equities over Europe and emerging markets. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking What Will Trump Do? Trump made several speeches in September with details of his tax plan. He promised to (1) simplify personal income tax, cutting seven brackets to three, with 12%, 25% and 33% tax rates; (2) cut the headline corporate tax rate to 15% (from 35%); and (3) levy a 10% tax on the $3 trillion of corporate retained earnings held offshore. He was less specific on infrastructure spending, but Wilbur Ross, the incoming Commerce Secretary, mentioned $550 billion, principally financed through public-private partnerships. The Tax Policy Center estimates the total cost of the tax plan at $6 trillion (with three-quarters from the business tax cut). But it is not clear how much will be offset by reduced deductions. Incoming Treasury Secretary Steven Mnuchin, for example, said that upper class taxpayers will get no absolute tax cut. TPC estimates the tax plan alone will increase federal debt to GDP by 25 percentage points over the next 10 years (Chart 8). The OECD, assuming stimulus of 0.75% of GDP in 2017 and 1.75% in 2018, estimates that this will raise U.S. GDP growth by 0.4 percentage points next year and by 0.8 points in 2018, with positive knock-on effects on the rest of the world (Chart 9). While there are questions on the timing (and how far Trump will go with trade and immigration measures), BCA's geopolitical strategists sees few constraints on getting these plans passed.5 Republications in Congress like tax cuts (and will compromise on the public spending element) and it is wrong to assume that Republican administrations reduce the fiscal deficit - historically the opposite is true (Chart 10). Chart 8Massive Increase In Debt Chart 9GDP Impact Of U.S. Fiscal Stimulus Chart 10A Lot of Stimulus, And Extra Debt Implications for markets? Short term positive for growth and inflation; longer-term a worry because of crowding out from the increased government debt. How Will The Strong USD Impact Global Earnings? We have a strong U.S. dollar view and also favor U.S. equities over the euro area and emerging markets. Some clients question our logic because conceptually a strong USD should benefit earnings growth in the non-U.S. markets, and therefore non-U.S. equities should outperform. Chart 11USD Impact On Global Earnings Currency is just one of the factors that we consider when we make country allocation decisions, and our weights are expressed in USD terms unhedged. We will hedge a currency only when we have very high conviction, such as our current Japan overweight with a yen hedge, which is based on our belief that the BOJ will pursue more unconventional policies to stimulate the economy. This is undoubtedly yen bearish but positive for Japanese stocks. As shown in Chart 11, a stronger USD has tended to weaken U.S. earnings growth (panel 1). However, what matters to country allocation is relative earnings growth. Panels 3 and 5 show that in local currency terms, earnings growth in emerging markets and the euro area did not always outpace that in the U.S. when their currencies depreciated against the USD. In fact, when their currencies appreciated, earnings growth in USD terms tended to outpace that in the U.S. (panels 2 and 4), suggesting that the translation impact plays a very important role. This is consistent with what we have found for relative equity market returns (see Global Equity section on page 13). Currency affects revenues and costs in different proportions. If both revenues and costs are in same currency, then only net profit is affected by the currency. But, since many companies manage their forex exposure, at the aggregate level the currency impact will always be "weaker than it should be". What Is The Outlook For Brexit And The Pound? The U.K. shocked the world on 24 June 2016 with its vote to leave the European Union. However, the process and terms of exit are yet to be finalized pending the Supreme Court's decision on the role of parliament in invoking Article 50 of the Lisbon Treaty. Depending on this decision, there is a spectrum of possible outcomes for the U.K./EU relationship. At the two ends of the spectrum are: 1) a hard Brexit - complete separation from the EU, in which case the pound will plunge further; 2) a soft Brexit - with a few features of the current relationship retained, in which case the pound will rally. Chart 12What's Up Brexit? The fall in the nominal effective exchange rate to a 200-year low (Chart 12) is a clear indication of the potential serious long-term damage. With the nation's dependence on foreign direct investment (FDI) to finance its large current account deficit (close to 6% of GDP), more populist policies and increased regulation will hurt corporate profitability, making local assets less profitable to foreigners. The pound is currently caught up in a vicious circle of more depreciation, leading to higher inflation expectations and depressed real rates, which adds further selling pressure. This is the likely path of the pound in the case of a hard Brexit. For U.K. equities, under a hard Brexit that adds downward pressure to the pound, investors should favor firms with global revenues (FTSE 100) and underweight firms exposed more to domestic business and a potential recession (FTSE 250). The opposite holds true in the case of a soft Brexit. Investors should also underweight U.K. REITs because of cyclical and structural factors that will affect commercial real estate. In the case of a hard Brexit, structural long-term impacts to the British economy include: 1) a decline in the financial sector - the EU will introduce regulations that will force euro-denominated transactions out of London; 2) a slowdown in FDI - the U.K. will cease to be a platform for global companies to access the EU, triggering a long-term decline in foreign inflows; 3) weaker growth - with EU immigration into the U.K. expected to fall by 90,000 to 150,000 per year, estimates.6 point to a 3.4% to 5.4% drop in per capita GDP by the year 2030. What Industry Group Tilts Do You Recommend? In October 2015, we advocated that, because long-term returns for major asset classes would fall short of ingrained expectations, investors should increase alpha by diving down into the Industry Group level.7 How have these trades fared, and which would we still recommend? Long Household And Personal Products / Short Energy. We closed the trade for a profit of 12.2% in Q12016. This has proven to be quite timely as oil prices, and Energy stocks along with it, have rallied substantially since. Long Insurance / Short Banks. The early gains from this trade reversed in Q2 as long yields have risen rapidly, leading to yield curve steepening. However, our cyclical view is still intact. Relative performance is still holding its relationship with the yield curve (Chart 13). Historically, Fed tightening has almost always led to bear flattening. We expect the same in this cycle, which should lead to Insurance outperformance. Long Health Care Equipment / Short Materials. This trade generated early returns but has since underperformed as Materials bounced back sharply. Nevertheless, we remain bearish on commodities and EM-related plays, viewing this rise in Materials stocks as more of a technical bounce from oversold valuations (Chart 14). Commodities remain in a secular bear market. On health care, we maintain our structural bullish outlook given aging demographics, increased spending on health care and attractive valuations. Short Retail / Global Broad. We initiated trade in January after the Fed initiated liftoff. Consumer Discretionary stocks collapsed after, and this trade has provided a gain of 2.01%. We maintain this view as the recent hike and 2017 hikes will continue to dampen Retail performance (Chart 15). Additionally, Retail has only declined slightly while other Consumer Discretionary stocks have falling drastically, suggesting downside potential from convergence. Chart 13Flatter Yield Curve Is Bullish Chart 14An Oversold Bounce Chart 15Policy Tightening = Underperformance Global Economy Overview: The macro picture looks fairly healthy, with growth picking up in developed economies and China, though not in most emerging markets. The weak patch from late 2015 through the first half of 2016, with global industrial and profits recessions, appears to be over. The biggest threat to growth now is excessive dollar strength, which would slow U.S. exports and harm emerging markets. U.S.: U.S. growth was surprising on the upside (Chart 16) even before the election. Q2 real GDP growth came in at 3.2% and the Fed's Nowcasting models indicate 2.6-2.7% in Q4. After rogue weak ISMs in August, the manufacturing indicator has recovered to 53.2 and the non-manufacturing ISM to 57.2. However, growth continues to be driven mainly by consumption, with capex as yet showing few signs of recovery. A key question is whether a Trump stimulus will be enough to reignite "animal spirits" and push corporates to invest more. Euro Area: Eurozone growth has also been surprisingly robust. PMIs for manufacturing and services in November came in at 53.7 and 53.8 respectively; the manufacturing PMI has been accelerating all year. This is consistent with the ECB's forecasts for GDP growth of 1.7% for both this year and next. However, risk in the banking system could derail this growth. Credit growth, highly correlated with economic activity, has picked up to 1.8% YOY but could slow if banks turn cautious. Japan: Production data has reacted somewhat to Chinese stimulus, with IP growth positive (Chart 17) for the past three months and the Leading Economic Index inching higher since April. But the strength of the yen until recently and disappointing inflation performance (core CPI -0.4% YOY) have depressed exports and consumer sentiment. The effectiveness of the BoJ's 0% yield cap on 10-year government bonds, which has weakened the yen by 14% in two months, should trigger a mild acceleration of growth in coming quarters. Chart 16U.S. Economy Surprising ##br##On The Upside Chart 17Growth Picks Up In##br## Most DMs And China Emerging Markets: China has continued to see positive effects from its reflation of early 2016, with the manufacturing PMI close to a two-year high. The effects of the stimulus will last a few more months, but the authorities have reined back now and the currency is appreciating against its trade basket. The picture is less bright in other emerging markets, as central banks struggle with weak growth and depreciating currencies. Credit growth is slowing almost everywhere (most notably Turkey and Brazil) which threatens a further slowdown in growth in 2017. Interest rates: Inflation expectations have risen sharply in the U.S. following the election, but less so in the eurozone and Japan. They may rise further - pushing U.S. bond yields close to 3% - if the Trump administration implements a fiscal stimulus anywhere close to that hinted at. This could, in turn, push the Fed to raise rates at least twice more in 2017. The ECB has announced a reduction in its asset purchases starting in April 2017, too, but the Bank of Japan will allow inflation to overshoot before tightening. Chart 18Earnings Bottoming But##br## Valuation Stretched Global Equities Cautiously Optimistic: Global markets have embraced the "hoped for" pro-growth and inflationary policies from the new U.S. administration since Trump's win on November 8. In the latest GAA Monthly Update published on November 30,8 we raised our recommendation for global equities relative to bonds to overweight from neutral on a 6-12 month investment horizon. However, the call was driven more by underweighting bonds than by overweighting equities, given the elevated equity valuations and declining profit margins.(Chart 18) The hoped-for U.S. pro-growth policies would, if well implemented, be positive for earnings growth, but the "perceived" earnings boost has not yet shown up in analysts' earnings revisions (panel 3). In fact, only three sectors (Financials, Technology and Energy) currently have positive earnings revisions, because analysts had already been raising forward earnings estimates since early 2016. According to I/B/E/S data as of November 2016, about 80% of sectors are forecast to have positive 12-month forward earnings growth, while only about 20% have positive 12-month trailing earnings growth (panel 3). Within global equities, we continue to favor developed markets over emerging market on the grounds that most EMs are at an early stage of a multi-year deleveraging.9 We also favor the U.S. over the euro area (see more details on the next page). The Japan overweight (currency hedged) is an overwrite of our quant model: we believe that the BoJ will pursue increasingly unconventional monetary policy measures over the coming 12 months. The quant model (in USD and unhedged) has suggested a large underweight in Japan but has gradually reduced the underweight over the past two months. Our global sector positioning is more pro-cyclical than our more defensively-oriented country allocations. In line with our asset class call, we upgrade Financials to neutral and downgrade Utilities to underweight, and continue to overweight Energy, Technology, Industrials, and Healthcare while underweighting Telecom, Consumer Discretionary and Consumer Staples. Country Allocation: Still Favor U.S. Over Euro Area GAA's portfolio approach is to take risk where it is likely to be best rewarded. Having taken risk at the asset class level (overweight equities vs. bonds), at the global equity sector level with a pro-cyclical tilt, and at the bond class level with credit and inflation tilts, we believe it's appropriate to maintain our more defensive equity tilt at the country level by being market weight in euro area equities on an unhedged USD basis while maintaining a large overweight in the U.S. Chart 19Uninspiring profit Outlook It's true that the euro area PMI has been improving. Relative to the U.S., however, the euro area's cyclical improvement, driven by policy support, has lost momentum. It's hard to envision what would reverse this declining growth momentum, suggesting European earnings growth will remain at a disadvantage to the U.S. (Chart 19, panel 1) It's also true that the underperformance of eurozone equities versus the U.S. has reached an historical extreme in both local and common currency terms, and that euro equities are trading at significant discount to the U.S. But Europe has always traded at a discount, and the current discount is only slightly lower than its historical average. Our work has shown that valuation works well only when it is at extremes, which is not the case currently. Conceptually, a weak euro should boost euro area equity performance at least in local currency terms, yet empirical evidence does not strongly support such a claim: the severe underperformance since 2007 has been accompanied by a 43% drop in the euro versus the USD (Chart 19 panel 2). In fact, in USD terms, the euro area tended to outperform the U.S. when the euro was strong (panel 3), suggesting that currency translation plays a more dominant role in relative performance. Our currency house view is that the euro will depreciate further against the USD, given divergences in monetary and fiscal policy between the two regions. As such, we recommend clients to continue to favor U.S. equities versus the euro area, but not be underweight Europe given that it is technically extremely oversold. Sector Allocation: Upgrade Financials To Neutral Our sector quant model shifted global Financials to overweight in December from underweight, largely driven by the momentum factor. We agree with the direction of the quant model as the interest rate environment has changed (Chart 20, panel 1) and valuation remains very attractive (panels 2), but we are willing to upgrade the sector only to market weight due to our concern on banks in the euro area and emerging markets. Within the neutral stance in the sector, we still prefer U.S. and Japanese Financials to eurozone and emerging market ones. Despite the poor performance of the Financials sector relative to the global benchmark, U.S. and Japanese financials have consistently outperformed eurozone financials, driven by better relative earnings without any valuation expansion (panel 3). U.S. banks have largely repaired their balance sheets since the Great Recession, and the "promised" deregulation by the new U.S. administration will probably help U.S. banks. In the euro area, however, banks, especially in Italy, are still plagued with bad loans (panel 4). We will watch banking stress in the region very closely for signs of contagion (panel 5) The upgrade of financials is mainly financed by downgrading the bond proxy Utilities to underweight from neutral, in line with our asset class view underweighting fixed income. Chart 20Global Financials: Regional Divergence Chart 21Global Equities: No Style Bet Smart Beta Update: No Style Bet In a Special Report on Smart Beta published on July 8 2016,10 we showed that it is very hard to time style shifts and that an equal-weighted composite of the five most enduring factors (size, value, quality, minimum volatility and momentum) outperforms the broad market consistently on a risk-adjusted basis. Year-to-date, the composite has performed in line with the broad market, but over the past three months there have been sharp reversals in the performance of the different factors, with Min Vol, Quality and Momentum sharply underperforming Value and Size (Chart 21 panel 1). We showed that historically the Value/Growth tilt has been coincident with the Cyclical/Defensive sector tilt (panel 3). Panel 2 also demonstrates that the Min Vol strategy's relative performance can also be well explained by the Defensives/Cyclicals sector tilt. Sector composition matters. Compared to Growth, Value is now overweight Financials by 25.6%, Utilities by 13.2%, Energy by 8.3% and Materials by 2.5%, while underweight Tech by 23%, Healthcare by 12.7%, and Consumer Discretionary by 10%. REITs is in pure Growth, while Utilities and Telecom are in pure Value, and Energy has very little representation in Growth. In our global sector allocation, we favor Tech, REITs, Energy, and Healthcare, while underweight Utilities, Consumer Discretionary and Telecoms, and neutral on Financials and Materials. As such, maintaining a neutral stance on Value vs. Growth is consistent with our sector positioning. Government Bonds Maintain slight underweight duration. After 35 years, the secular bull market in government bonds is over. Even with Treasury yields skyrocketing since the Trump victory, the path of least resistance for yields is upward (Chart 22). Yields should grind higher slowly as inflation rises and growth indicators continue to improve. Bullish sentiment has dropped considerably, but there is further downside potential. Additionally, fiscal stimulus from Japan and further rate hikes from the Fed will provide considerable tailwinds. Overweight TIPS vs. Treasuries. Despite still being below the Fed's target, with headline and core CPI readings of 1.6% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 23). This continued rise is a result of cost-push inflation driven by faster wage growth. Trump's increased spending and protectionist trade policies are both inflationary. As real GDP growth should remain around 2% annualized and the labor market continues to tighten, this effect will only intensify. Valuations have become less attractive but very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Overweight JGBs. The BoJ has ramped up its commitment to exceeding 2% inflation by expanding its monetary base and locking in 10-year sovereign yields at zero percent. Additionally, the end of the structural decline in interest rates suggests global bonds will perform poorly going forward. During global bond bear markets, low-beta Japanese government debt has typically outperformed (Chart 24). This will likely hold true again as global growth improves and Japanese authorities increase fiscal stimulus while maintaining their cap on bond yields. Chart 22Maintain Slight Underweight Duration Chart 23Inflation Uptrend Intact Chart 24Overweight JGBs Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 25). Over the last quarter, the rate of deterioration actually slowed, with all six ratios improving slightly. Nevertheless, the trend toward weaker corporate health has been firmly established over the past eleven quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. In the absence of a recession, spread product will usually outperform. U.S. growth should accelerate in 2017, with consumer confidence being resilient, fiscal spending expected to increase, and the drag from inventories unwinding. Monetary conditions are still accommodative and the potential sell-off from the rate hike should be milder than it was in December 2015 (Chart 26). Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. However, there are two key risks to our view. The end of the structural decline in interest rates presents a substantial headwind to investment grade performance. Since 1973, median and average returns were slightly negative during months where long-term yields rose. During the blow-off in yields in the late 1970s, corporate debt performed very poorly. However, yields had reached very high levels. Secondly, valuations are unattractive, with OAS spreads at their lowest in about one and a half years (Chart 27). Chart 25Balance Sheets Deteriorating Chart 26Still Accommodative Chart 27Expensive Valuations Commodities Secular Perspective: Bearish We reiterate our negative long-term outlook on the commodity complex on the back of a structural downward shift in global demand led primarily by China's transition to a services-driven economy. With this slack in demand, global excess capacity has sent deflationary impulses across the globe, limiting upside in commodity prices.11 Chart 28OPEC To The Rescue Cyclical Perspective: Neutral A divergent outlook for energy and base metals gives us a neutral view for aggregate commodities over the cyclical horizon (Chart 28). Last month's OPEC deal supports our long-standing argument of increasing cuts in oil supply, which will support energy prices. However, metal markets suffer from excess supply. A stronger U.S. dollar will continue to be a major headwind over the coming months. Energy: OPEC's agreement to cut production by 1.2 mb/d has spurred a rally in the crude oil price, as prospects for tighter market conditions next year become the base case. However, with the likelihood that the dollar will strengthen further in coming months, oil will need more favorable fundamentals to rise substantially in price from here. Base Metals: The U.S. dollar has much greater explanatory power12 than Chinese demand in price formation for base metals. The recent rally in base metals is overdone with metals prices decoupling from the dollar; we expect a correction in the near-term driven by further dollar strength. Metal markets remain oversupplied as seen by rising iron ore and copper inventories. We remain bearish on industrial and base metals. Precious Metals: Gold, after decoupling from forward inflation expectations in H1 2016 - rising while inflation expectations were weak - has converged back in line with the long-term inflation gauge. Our expectation of higher inflation, coupled with rising geopolitical uncertainties, remain the two key positives for the gold price. However, our forecast of U.S. dollar appreciation will limit upside potential for the precious metal. Currencies Key Themes: USD: Much of the post-Trump rally in the dollar can be explained by the sharp rally in U.S. bond yields (Chart 29). We expect more upside in U.S. real rates relative to non-U.S. rates, driven by the U.S.'s narrower output gap and the stronger position of its household sector. As labor market slack continues to lessen and wage pressures rise, the Fed will be careful not to fall behind the curve; this will add upward pressure to the dollar. Chart 29Dollar Continues It's Dominance Euro: Since the euro area continues to have a wider output gap than the U.S., the euro will face additional downward pressure on the back of diverging monetary policy. As the slack diminishes, the ECB will respond appropriately - we believe the euro has less downside versus the dollar than does the yen. Yen: Although the Japanese economy is nearing fully employment, the Abe administration continues to talk about additional stimulus. As inflation expectations struggle to find a firm footing despite the stimulus, the BOJ is explicitly aiming to stay behind the curve. Additionally, with the BOJ pegging the 10-year government bond yield at 0% for the foreseeable future, we expect further downward pressure on the currency. EM: We expect more tumult for this group as rising real rates have been negative for EM assets in this cycle. EM spreads have widened in response to rising DM yields which has led to more restrictive local financial conditions. The recovery in commodity prices has been unable to provide any relief to EM currencies - a clear sign of continued weak fundamentals (rising debt, excess capacity and low productivity). Commodity currencies will face more downside driven by their tight correlation with EM equities (0.82) and with EM spreads. Alternatives Overweight private equity / underweight hedge funds. Global growth is fairly stable and has the potential to surprise on the upside. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a considerable boost to returns. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 30). Overweight direct real estate / underweight commodity futures. Commercial real estate (CRE) assets are in a "goldilocks" scenario: Growth is sufficient to generate sustainable tenant demand without triggering a new supply cycle. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 31). Overweight farmland & timberland / underweight structured products. The trajectory of Fed policy, the run-up in equity prices and the weak earnings backdrop have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, structured products tend to outperform during recessions, which is not our base case (Chart 32). Chart 30PE: Tied To Real Growth Chart 31Commodities: A Secular Bear Market Chart 32Structured Products Outperform In Recessions Risks To Our View Our main scenario is for stronger growth, higher inflation and an appreciating dollar in 2017, leading to equities outperforming bonds. Where could this go wrong? Growth stagnates. U.S. growth could fail to pick up as expected: the stronger dollar will hurt profits, which might lead to companies cutting back on hiring; higher interest rates could affect the housing market and consumer discretionary spending; companies may fail to increase capex, given their low capacity utilization ratio (Chart 33). In Europe, systemic banking problems could push down credit growth which is closely correlated to economic growth. Emerging markets might see credit events caused by the stronger dollar and weaker commodities prices. Political risks. An unconventional new U.S. President raises uncertainty. How much will Trump emphasize his more market-unfriendly policies, such as tougher immigration control, tariffs on Chinese and Mexican imports, and interference in companies' decisions on where to build plants? His more confrontational foreign policy stance risks geopolitical blow-ups. Elections in France, the Netherland and Germany in 2017 could produce populist government. The Policy Uncertainty Index currently is high and this historically has been bad for equities (Chart 34). Chart 33Maybe Companies Won't Increase Capex Chart 34Policy Uncertainty Is High Synchronized global growth. If the growth acceleration were not limited to the U.S. but were to spread, this might mean that the dollar would depreciate, particularly as it is already above fair value (Chart 35). In this environment, given their inverse correlation with the dollar (Chart 36), commodity prices and EM assets might rise, invalidating our underweight positions. Chart 35Dollar Already Above##br## Fair Value Chart 36How Would EM And Commodities Move##br## If USD Weakens? 1 We discuss them in the "What Our Clients Are Asking," section of this Quarterly Portfolio Outlook. 2 Non-accelerating inflation rate of unemployment - the level of unemployment below which inflation tends to rise. 3 Please see "How Will The Strong USD Impact Global Earnings," in the What Our Clients Are Asking section of this Quarterly Portfolio Outlook. 4 Please see Global Asset Allocation, "Monthly Portfolio Update: The Meaning of Trump," dated November 30, 2016, available at gaa.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency", dated November 30, 2016, available at gps.bcaresearch.com. 6 According to National Institute of Economic Research.com. 7 Please see Global Asset Allocation Strategy Special Report, "Asset Allocation In A Low-Return World, Part IV: Industry Groups," dated October 25, 2015, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation,"Monthly Portfolio Update," dated November 30, 2016 available at gaa.bcaresearch.com 9 Please see Global Asset Allocation Special Report,"Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com 10 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. 11,12 Please see Global Asset Allocation Special Report, "Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com Recommended Asset Allocation
Highlights The valuation discount on Italian banks still seems insufficient for the sector's excess NPLs. We expect a better long-term buying opportunity sometime next year. Stay underweight the MIB and IBEX versus the Eurostoxx600. Stay underweight the Eurostoxx600 versus the S&P500. Long Italian BTPs versus French OATs has quickly achieved its profit target. Now prefer long Spanish Bonos versus French OATs. Feature Assessing The Value In Italian Banks Investment reductionism says that the valuation of a bank distils down to three things: The expected size of the bank's assets. In the standard banking model, the dominant asset is the bank's loan book. The expected profitability of the bank's assets. In the standard banking model, the dominant driver of profitability is the net interest margin (the difference between the interest rate received on loans and the interest rate paid on deposits). The expected amount of equity capital required against the bank's assets. The equity capital must absorb the bank's loan losses but it also receives the profits. Increasing the amount of equity capital dilutes the profits over a larger number of shares, and thereby lowers the bank's share price. Chart of the WeekSpain And France have Raised €100bn Of Bank Equity Capital... Italy Has Not Today, the potential reward of owning Italian banks is that they trade at a large valuation discount. Admittedly, growth in assets and profit margins is likely to be anaemic. But Italian banks trade on a price to forward earnings multiple of less than 10. Not only does this seem cheap in absolute terms, it is a 25% discount to other European banks (Chart I-2). Chart I-2Italian Banks Trade At A Significant Discount Chart I-3Italian Bank NPLs Have Increased Sharply But the risk of owning Italian banks is that they still carry €170bn of un-provisioned non-performing loans (NPLs), which is likely to require a large - and dilutive - increase in equity capital. NPLs have increased much more sharply in Italy than in Spain or France (Chart I-3). But the more significant difference is that Italian banks have not yet raised equity capital as a cushion against their rising NPLs. Since 2009, Spanish banks and French banks have both increased their equity capital by more than €100bn. Over this same period, Italian banks have actually shrunk their equity capital (Chart of the Week). Given that Italian bank equity capital stands at €150bn, today's 25% valuation discount is pricing a dilutive increase in equity capital of around €50bn. Will this be a sufficient cushion? Chart I-4How Much Equity Capital Do Italian Banks Require? Our assessment is that it still might be insufficient. Our prudent benchmark is that the Italian banking sector lifts its equity capital to NPL multiple to the lowest coverage that the Spanish banking sector reached in recent years (Chart I-4). That would require Italy to emulate Spain and France and raise closer to €100bn of fresh bank equity capital. Also beware that if an undercapitalized bank cannot raise sufficient equity capital privately in the markets, there is a danger that its investors could suffer heavy losses. This is because the EU rules on state aid for banks changed at the start of 2016. The EU Bank Recovery and Resolution Directive (BRRD) allows a government to step in with a 'precautionary' capital injection only after a first-loss 'bail-in' of the bank's equity and bond holders. Hence, Italian banks are a potential buy if you believe €50bn of extra equity capital will fully alleviate concerns about the large stock of un-provisioned NPLs... and if you believe that the sector's plan to raise equity capital in the market will avoid any major mishap. Given global banks' strong recent bounce, we expect a better long-term buying opportunity sometime next year. Value Doesn't Help Pick Equity Markets Chart I-5Italy's MIB Looks Cheap The headline cheapness of Italian banks inevitably makes Italy's MIB look relatively cheap too (Chart I-5), especially given the Italian stock market's overweighting to banks. Some people suggest sector-adjusting stock market valuations to neutralize the dominating sector skews, thereby creating a truer picture of relative valuation. Adjusted for these sector skews, is a stock market cheap or expensive? This question may be of interest to academics, but it has very little practical relevance for stock market selection. Compared to France's CAC, Italy's MIB and Spain's IBEX are indeed cheaper mainly because of their large overweight to banks. But this cannot change the inescapable fact that this defining large overweight to banks is precisely what drives MIB and IBEX relative performance. Likewise, compared to the S&P500, the Eurostoxx600 is much cheaper mainly because of its overweight to banks combined with its large underweight to technology. But this cannot change the inescapable fact that this defining overweight to banks combined with large underweight to technology is precisely what drives Eurostoxx600 versus S&P500 relative performance. For the sceptics, the charts on page 5 should leave no doubt that everything else is largely irrelevant. The recent outperformance of banks is just a manifestation of the Trump reflation trade, nothing more, nothing less (Chart I-6). Indeed, most of the moves in financial markets over the past month reduce to the same trade in one guise or another. This reflation trade has gone too far too fast, and we would now lean against it. An underweight to banks necessarily means underweighting the MIB and IBEX (Charts I-7 and I-8). Chart I-6The Trump Reflation Trade Has Lifted Banks Chart I-7Banks Drive The MIB Relative Performance Chart I-8Banks Drive The IBEX Relative Performance An underweight to banks and overweight to technology necessarily means underweighting the Eurostoxx600 versus the S&P500 (Charts I-9 and I-10). Chart I-9Banks Versus Technology... Chart I-10...Drive Eurostoxx600 Versus S&P500 Assessing The Value In French, Spanish And Italian Bonds Turning to bonds, the market has deemed that Italian BTPs and Spanish Bonos are more risky investments than French OATs. Therefore BTPs and Bonos require a yield premium over OATs. But what exactly is this yield premium for? In the unlikely event that a large euro area country like Italy or Spain defaulted on its sovereign euro-denominated debt, the monetary union as it stands would be unable to withstand the losses. The euro would likely break up, causing each country to redenominate its bonds into its own new currency, which would then rise or fall against the other new currencies. Today's yield premium on BTPs and Bonos over OATs is simply the expected value of the (annualised) loss that would be suffered in that eventuality. And this expected loss equals the product of two terms: the annual probability of euro break up and the expected depreciation of a new Italian lira (or new Spanish peseta) versus a new French franc after such a break up In turn, the expected depreciation of the lira or peseta versus the franc would broadly equal the respective economy's accumulated competitiveness shortfall versus France. Which leads to a powerful conclusion. Spain has rapidly eroded its competitiveness shortfall versus France, and is on course for full convergence within a couple of years (Chart I-11). If the second term of the above product becomes zero, so too must the product itself. Meaning the yield premium on Bonos over OATS must converge to zero - irrespective of whether the euro survives or not. Chart I-11Spainish Competitiveness Will Soon Reconverge With French Competitiveness Stay long Spanish Bonos versus French OATs. In the case of Italy, a substantial shortfall in competitiveness versus France (and now Spain) does exist, justifying a structural yield premium in BTPs. But recently, this premium widened further because of a larger first term in the above product - a perceived increase in the annual probability of euro break up after the no vote in Italy's referendum on constitutional reform, and Prime Minister Renzi's subsequent resignation. However, as we argued in Italy: Asking The Wrong Question,1 fears of the political repercussions of a no vote were overdone. As the market has come to realise this, the BTP yield premium has quickly retraced most of its recent widening. Our long Italian BTP versus French OATs bond pair trade has achieved its profit target in just 10 days, and we are now closing it (see section below). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on December 1, 2016 and available at eis.bcaresearch.com Fractal Trading Model* This week's recommended trade is to buy gold. Long Gold * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Long Italian Government Bonds / Short French Government Bonds The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br## - Interest Rate Expectations
The previous Insight showed that businesses remain a weak link for the banking sector, as C&I loan demand has cooled and the corporate sector is the primary source of credit quality concerns following the multi-year credit binge. As such, our preference to play rising interest rates and a modest steepening in the yield curve is through the consumer finance group. Valuations remain dirt cheap, and have not discounted the widening in credit card net interest margins close to historic peaks. That is a far cry from banks, where net interest margins have improved, but only slightly and from still razor thin levels. Importantly, consumers have room to re-leverage after years of de-leveraging, an outcome predicted by the improvement in consumer income expectations. The bottom line is that the consumer finance group provides a cleaner play than banks on the sudden bullish sentiment shift in the overall financial sector. The ticker symbols for the stocks in this index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI.
The scope of the revaluation in banks stocks on hopes for reduced regulatory constraints and the modest yield curve steepening has surprised us, but it would be dangerous to equate share price strength with the perception that underlying activity has reaccelerated. Indeed, the chart shows that overall bank loan growth is steadily decelerating, led by a cooling in C&I credit creation to its lowest rate since the great recession. While credit growth is far from recessionary levels, it is diverging negatively from what bank stocks might suggest. Importantly, banks have been adding to cost structures in recent months, and our gauge of bank sector productivity (bank loans/bank employment) is receding on a growth rate basis. This suggests that there could be a setback if fourth quarter profits do not validate the share price move. Rather than chase the bank group, our preference to play strength in the financial sector is through the asset manager and consumer finance groups, see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5BANKX-JPM, WFC, BAC, C, USB, PNC, BBT, STI, MTB, FITB, KEY, CFG, RF, HBAN, CMA, ZION, PBCT.
Highlights Duration: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. Corporate Bonds: The macro back-drop is turning marginally more positive for corporate spreads. C&I lending standards are no longer tightening and bank stocks have rallied significantly. Corporate Bonds: Spreads are too tight at the moment, even for an improving economic environment. Remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now. We are actively looking to add exposure to corporate credit from more attractive levels. Feature There is no question that the U.S. economy is on a firm footing heading into the New Year. Third quarter real GDP growth came in at a robust 3.2%, and the Atlanta and New York Fed tracking models currently forecast fourth quarter growth of 2.6% and 2.7%, respectively. This represents a marked acceleration from the average growth rate of 1.1% witnessed during the first two quarters of 2016. Forward-looking survey data are also pointing in the right direction. The ISM non-manufacturing survey reached 57.2 in November, its highest level since October 2015, while the expectations component of the University of Michigan Consumer Sentiment survey reached 88.9 in December, its highest level since January 2015 (Chart 1). The question for bond investors is how much of this good news is already reflected in Treasury yields. Higher Treasury yields and a stronger dollar have already led to a material tightening in some broad indexes of financial conditions, enough to exert a meaningful drag on U.S. growth (Chart 2). In fact, according to the Fed's FRB/US model, the recent interest rate and dollar moves could be expected to shave 1% from GDP over the next eight quarters. Chart 1Economic Tailwinds Chart 2Financial Conditions Must Ease The natural conclusion is that while some upside in Treasury yields is justified by an improving economic outlook, the bond selloff has proceeded too quickly and must pause in the near-term to prevent financial conditions from exerting an excessive drag on growth. Sentiment and positioning indicators also confirm that the uptrend in yields appears stretched (Chart 2, bottom two panels). As such, last week we tactically shifted our recommended portfolio duration allocation from 'below benchmark' to 'at benchmark'.1 We expect Treasury yields will grind higher next year, reaching a range of 2.8% to 3% by the end of 2017, but the selloff will proceed more gradually, in line with the acceleration in economic growth. A More Uncertain World The premise that the bond selloff has proceeded too quickly is confirmed by our Global PMI models of the 10-year Treasury yield. We track two versions of our Global PMI model. One is a 2-factor model based only on the Global PMI index and a survey of bullish sentiment toward the U.S. dollar. The intuition behind this model is that improving global growth contributes to a higher fair value Treasury yield. However, for a given level of global growth, increasingly bullish dollar sentiment applies downward pressure to yields. This is because a stronger dollar represents a tightening of monetary conditions, so that all else equal, a stronger dollar means we should expect fewer Fed rate hikes. The current fair value reading from this 2-factor model is 2.26%, meaning that the 10-year Treasury yield at 2.49% appears somewhat cheap (Chart 3). The second version of our Global PMI model is a 3-factor model which adds the Global Economic Policy Uncertainty Index (EPUI) as a third independent variable. All else equal, an increase in uncertainty about the economic outlook should depress the term premium in long-dated Treasury yields. The data appear to back-up this assertion, as the EPUI is negatively correlated with the 10-year Treasury yield over time. With the addition of the EPUI, our 3-factor model explains 84% of the variation in the 10-year Treasury yield since 2010, compared to 80% from our 2-factor model. The EPUI spiked last month, and as such, this version of the model suggests that fair value for the 10-year Treasury yield is only 1.82% (Chart 4). Chart 32-Factor Global PMI Model Chart 43-Factor Global PMI Model There are probably good reasons to overlook last month's spike in policy uncertainty. For one, the EPUI, created by Baker, Bloom and Davis,2 is largely constructed from algorithms that scan newspaper articles for keywords. They do not attempt to distinguish between economic news with bond-bearish or bond-bullish implications. Second, we have found that large spikes in uncertainty that do not coincide with deterioration in economic growth tend to mean-revert fairly quickly. This past summer's Brexit vote being a prime example. As a counterpoint, however, the negative correlation between the EPUI and the 10-year Treasury yield is quite robust (Chart 5), and historically, incidents of spiking policy uncertainty and rising Treasury yields have been few and far between. Since 1991, there have been 42 instances when the monthly increase in the EPUI exceeded one standard deviation. In those 42 months, the 10-year Treasury yield increased only 36% of the time, with last month's 53 basis point rise being by far the largest on record. We tend to view the reading from the 2-factor model as the more reasonable assessment of fair value in the current environment. But the spike in policy uncertainty does underscore why we should view the recent bond selloff skeptically. The recent selloff has, to a large extent, been predicated upon promises of fiscal stimulus that have yet to be delivered, from a President-elect who has shown himself to be highly unpredictable. In this environment, near-term caution is clearly warranted. Of course, this week the market's focus will at least temporarily turn away from fiscal policy and toward the Fed. We expect that the Fed will announce a 25 basis point increase in the fed funds rate tomorrow, but also that participants' interest rate projections will not change meaningfully. The FOMC will likely be much slower to react to promises of fiscal stimulus than the market. With the Fed's projected near-term path for interest rates already mostly discounted by the market (Chart 6), we could see a "dovish hike" from the Fed tomorrow coinciding with the near-term top in Treasury yields. Chart 5Economic Policy Uncertainty & Treasury Yields Chart 6A "Dovish Hike" Is In The Price Bottom Line: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. A More Favorable Environment For Credit We frequently point to three main indicators that we use to assess the current stage of the credit cycle: Our Corporate Health Monitor (CHM) Monetary conditions relative to equilibrium C&I bank lending standards In a report3 published earlier this year we found that the performance of bank stocks relative to the overall market is another useful indicator (Chart 7). While the credit cycle is still very much in its late stages, recently, our indicators have been sending marginally more positive signals. The CHM remains deep in 'deteriorating health' territory and non-financial corporate balance sheets continue to lever-up aggressively. However, the indicator did inch slightly closer to 'improving health' territory in the third quarter due to an improvement in all six of its components (Chart 8). Make no mistake, trends in corporate balance sheet leverage are not supportive for corporate spreads. In fact, as we will explore in a future report, the recent divergence between rising leverage and tightening spreads is nearly unprecedented during the past 40 years. But at the margin, recent trends are less worrisome. Chart 7Credit Cycle Indicators Chart 8Corporate Health Monitor Components Box1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole. These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Second, although monetary conditions appear very close to our estimate of equilibrium, the recent steepening of the yield curve suggests that the market is revising its estimate of monetary equilibrium higher, leading to a de-facto easing of monetary conditions. In the long-run, with the Fed in the midst of a hiking cycle, this sort of easing is unlikely to persist. But, as we argued in a recent report,4 the bear steepening curve environment could continue in the first half of next year as the Fed is slow to respond to an improving economy. Third, C&I bank lending standards have fallen back to unchanged after having tightened for four consecutive quarters. This likely reflects less stress in the energy sector now that oil prices have rebounded. Fourth, bank stocks have rallied strongly alongside the steepening yield curve. To the extent that higher bank stock prices reflect lower future commercial loan delinquencies, then this trend should be viewed positively from the perspective of credit investors. To test the idea that bank stock performance might help us trade the corporate bond market, we take a look at the past six credit cycles, going back to 1975 (Chart 9). The bottom panel of Chart 9 shows the percent drawdown in relative bank equity performance from its peak during the most recent credit cycle. We define credit cycles as the periods between when the CHM crosses into 'improving health' territory. For example, we define the most recent credit cycle as beginning when the CHM fell into 'improving health' territory in 2002 and ending when it fell into 'improving health' territory in 2009. Shaded regions in Chart 9 show periods when the CHM is in 'deteriorating health' territory. Chart 9Bank Equity Drawdown & Corporate Bond Performance If we construct a trading strategy using the CHM alone, we can get fairly good results. We find that investment grade corporate bonds underperform duration-equivalent Treasury securities in 3 out of 6 instances, over a 12-month investment horizon, following the time when the CHM first crosses into deteriorating health territory, for an average excess return of -1.2% (Table 1). Table 1Corporate Bond Trading Rules: 12-Month Investment Horizon However, we find that this result can be improved if we also incorporate bank stock price performance. If we were to only reduce corporate bond exposure when the CHM was in deteriorating health territory and after the drawdown in bank equities exceeded 20%, then the position is still profitable in 3 out of 6 instances, but for a more negative average return of -1.9%. Further, if we were to wait for the drawdown in bank equities to surpass 30%, then the hit rate on our position improves to 3 out of 5 and the average return falls to -4.6%. We find similar results if we use a 6-month investment horizon (Table 2). In the current cycle, the drawdown in bank stocks breached 25% in February but has since reversed course, and it has not yet reached the 30% threshold. Our analysis suggests that corporate bond underperformance tends to persist for some time even after the drawdown in bank stocks exceeds 30%. Table 2Corporate Bond Trading Rules: 6-Month Investment Horizon Chart 10Corporate Spreads Are Too Low Bottom Line: The macro back-drop is turning marginally more positive for corporate spreads. We remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now, due to poor starting valuation (Chart 10). But we are looking for an opportunity to upgrade from more attractive spread levels in the next couple of months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Too Far Too Fast, But The Bond Bear Is Still Intact", dated December 6, 2016, available at usbs.bcaresearch.com 2 For further details on the construction of this index please see www.policyuncertainty.com 3 Please see U.S. Bond Strategy Weekly Report, "Lighten Up On Duration", dated February 16, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
After the Trump election victory, we immediately upgraded our financial sector view to neutral to protect against the benefit of rising interest rates and the potential for a clear asset preference shift in favor of stocks over bonds. Trump's inflationist policy rumblings have kickstarted a steep advance in the total return of equity vs. bonds (E/B). BCA's strategists believe that this trend has long-term staying power. The E/B ratio has an excellent track record in heralding the relative performance of the S&P asset manager & custody bank (AMCB) index. If investors shift assets from bond products and into equity mutual funds and ETFs, from the current extremely depressed skew (bottom panel), then there is scope for cyclical profit margin upside at asset management firms. Current valuations do not fully discount such a shift, and we recommend an overweight position in the S&P AMCB index. The ticker symbols for the stocks in this index are: BLBG: S5AMGT - BK, BLK, STT, TROW, AMP, NTRS, BEN, IVZ, AMG.
Highlights ECB QE has pushed the euro area's Target2 banking imbalance to an all-time high. Thereby, QE has raised the cost of euro break-up. The ECB must dial down QE because the Target2 banking imbalance is directly related to the size of asset purchases. Core euro area sovereign bonds offer poor relative value in the government bond universe. Long Italian BTPs / short French OATs is now appropriate as a tactical position. Italian bank investors might have to suffer more pain before Brussels ultimately allows a public rescue. Feature "We've eliminated fragmentation in the euro area." Mario Draghi, speaking on October 20, 2016 Mario Draghi is wrong. QE was meant to reduce economic and financial fragmentation within the euro area. But in one important regard, it has done the exact opposite. In an un-fragmented monetary union, banking system liquidity would be spread evenly across the euro area. Unfortunately, the trillions of euros of QE liquidity created by the ECB has concentrated in four northern European countries: Germany, the Netherlands, Luxembourg and Finland (but interestingly, not France). This extreme fragmentation is captured in the euro area's Target2 banking imbalance (Box I-1), which is now at an all-time high (Chart of the Week). Box 1: What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability. Target2 balances therefore show the cumulative net payment flows within the euro area. Chart of the WeekQE Has Pushed The Euro Area's Target2 Imbalance To An All-Time High To be absolutely clear, this geographical polarization of bank liquidity is not deposit flight in the strictest sense (Chart I-2). Investors are simply using the ECB's €80bn of monthly bond purchases to offload their Italian, Spanish and Portuguese bonds to the central bank, and hold the received cash in banks in perceived haven countries. Nevertheless, ECB QE has unwittingly facilitated a geographical polarization of bank liquidity more extreme than in the darkest days of 2012 (Chart I-3). Chart I-2No Funding Stresses At The Moment Chart I-3Target2 Imbalances Are The Result Of QE QE Has Exposed Euro Area Banking Fragmentation To understand how this polarization has arisen, it is necessary to grasp how Eurosystem accounting works. The following section is necessarily technical, but stick with it because it is important. The ECB delegates its QE sovereign bond purchases to the respective national central bank (NCB): the Bundesbank buys German bunds, the Bank of France buys OATs, the Bank of Italy buys BTPs, and so on. When the Bank of Italy buys a BTP from, say, an Italian investor, the investor gives up the bond, but simultaneously receives a corresponding asset - cash. If the investor then deposits this cash at an Italian bank, say Unicredit, then Unicredit would have a new liability - the investor deposit. But in line with Eurosystem accounting, Unicredit would simultaneously receive a corresponding credit at its NCB, the Bank of Italy.1 Completing the accounting circle, the Bank of Italy would now have a new liability - the Unicredit claim, but it would also have a corresponding asset - the BTP that it has just bought. Therefore, all three accounts would be in perfect balance (see Figure I-1). Figure I-1Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Unicredit Now consider what happens if the Italian investor deposits the cash not at Unicredit, but at a German bank, say Commerzbank. In this case, it would be the Bundesbank that had a new liability - the Commerzbank claim. However, the Bundesbank would not have a corresponding asset. Conversely, the Bank of Italy would have a new asset - the BTP, but without a corresponding liability. In order to balance these Eurosystem accounts, the Bundesbank would accrue a Target2 asset vis-à-vis the ECB, while the Bank of Italy would accrue an equal and opposite Target2 liability (see Figure I-2). Figure I-2Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Commerzbank Essentially, the Target2 imbalance captures the mismatch between a Bundesbank liability denominated in 'German' euros and a corresponding Bank of Italy asset denominated in 'Italian' euros. Aggregated over the whole euro area, these imbalances now amount to more than €1 trillion. Does any of this Eurosystem accounting gymnastics really matter? No, as long as the monetary union holds together and the 'German' euro equals the 'Italian' euro. But if Germany and Italy started using different currencies, then suddenly the Target2 imbalances would matter enormously. This is because the Bundesbank liability to Commerzbank would be redenominated into Deutschemarks, while the Bank of Italy asset would be redenominated into lira. Hence, the ECB might end up with much larger liabilities than assets. In which case, any shortfall would have to be borne by the ECB's shareholders - essentially, euro area member states pro-rata to GDP. The ECB Must Dial Down QE Unlike in the depths of the euro debt crisis, the current Target2 imbalances do not reflect deposit flight. Rather, they are the direct result of ECB QE. Nonetheless, the indisputable fact is that QE has increased the cost of euro break-up. And another six or more months of QE will just add to this cost. Some people might argue that by increasing the cost of a divorce, an actual split becomes less likely. But this reasoning is weak. As we have seen in this year's polling victories for Brexit and President-elect Trump, the biggest risk comes from a populist backlash against the status quo. And populist backlashes do not stop to do detailed cost benefit analysis. Although the ECB is unlikely to broadcast the unintended side-effects of its policy, it must be acutely aware that the costs of QE are rising while its benefits are diminishing. Given that the Target2 imbalances are directly related to the size of asset purchases, the ECB needs to indicate its intention to dial down QE purchases. And if it does need to loosen policy again in the future, it might be better off emulating the Bank of Japan - in targeting a yield rather than an asset purchase amount. The 6-9 month investment implication is that core euro area sovereign bonds offer poor relative value in the government bond universe. And within the core euro area, perhaps French OATs offer the least relative value. OATs are priced as haven sovereign bonds, yet interestingly Target2 imbalances suggest that banking liquidity flows do not regard France as a haven in the same way as Germany (Chart I-4 and Chart I-5). Chart I-4French OATs Are Priced ##br##As Haven Bonds... Chart I-5...But Banking Liquidity Flows Do Not ##br##Regard France As A Haven Another implication is that the euro should be stable or stronger against a basket of other developed economy currencies. Indeed, expect euro/pound to lurch up in the first half of next year when the U.K. government triggers Article 50 of the Lisbon Treaty to formally begin Brexit negotiations. Only then will the EU27 reveal its own negotiating strategy, and it is highly unlikely to be a sweet deal for the U.K. Italian Referendum Result: A Postscript The financial markets have shrugged off the Italian public's resounding "no" to constitutional reform, and rightly so. The current constitution, created in the aftermath of the Second World was designed to prevent a repeat of a populist like Benito Mussolini gaining power. Irrespective of whether the next General Election is in 2017 or 2018, the no vote actually reduces political tail-risk. A tactical position that is long Italian BTPs and short French OATs is now appropriate. As we discussed last week in Italy: Asking The Wrong Question the bigger issue is how Italy will unburden its banks of its non-performing loans (NPLs). Monte de Paschi's efforts at raising equity are baby steps in the right direction. But Monte de Paschi's €23 billion of sour loans2 are just the tip of Italy' NPL iceberg, which sizes up at €320 billion in gross terms and €170 billion net of provisions. These numbers, expressed as a share of GDP, show striking parallels with peak NPLs in Spain's banking system (Chart I-6 and Chart I-7). Spain ultimately unburdened its banks with a government bailout. Italy may have to do the same. But this will require Brussels to let Italy bend the EU's new bail-in rules for troubled and failing banks. Chart I-6Spain Unburdened Its Banks ##br##With A Government Bailout... Chart I-7...Italy May Ultimately##br## Do The Same The danger for investors is that Italian bank equity and bond holders might have to suffer more pain before Brussels relents. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Unicredit and all other commercial banks use their accounts at their NCLs to make interbank payments. 2 MPS NPLs amount to €45bn in gross terms and €23bn net of provisions. Fractal Trading Model* Bucking the synchronized sell-off in global bonds, Greek sovereign bonds have actually rallied strongly in the last three months. But this rally could be near exhaustion, warranting a countertrend position. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
The financials sector has cheered President-elect Trump's anticipated policy changes as if they will all be enacted within very short order. While the yield curve has steepened modestly, the widening pales in comparison with the violence of the relative performance rise in financial share prices. We caution against extrapolating recent sector gains. If yields rise much further, they will be in danger of moving ahead of the rate of GDP growth, as the latter is unlikely to benefit from any fiscal stimulus for at least a few quarters. Financials (and the broad market), have trouble when this measure of liquidity tightens. The financial sector is already facing a cooling in the pace of credit creation and a decline in credit quality: financials sector ratings migration is steadily deteriorating. The bottom line is that the upward spike in financials sector relative performance is due for a breather, and only neutral weightings are recommended.