Monetary
The Fed’s unorthodox monetary policy will likely continue to underpin equity prices in the coming 9-12 months. Specifically, according to Leo Krippner’s shadow short rates (SSR) estimate, the shadow fed funds rate is now negative, which is tailwind for the SPX (SSR shown inverted, top panel). Falling interest rates are a boon to equities via a rising price-to-earnings multiple (SSR shown inverted, bottom panel). Also, while the Fed would never admit to it, it is trying to devalue the US dollar and reflate the global economy, which will indirectly boost S&P 500 revenues. As a reminder, 40% of SPX sales are internationally sourced and thus a falling greenback is a welcoming sign for S&P 500 turnover (middle panel). Bottom Line: We remain constructive on the prospects of the broad equity market on a cyclical time horizon. Please refer to this Monday’s Weekly Report for more details.
Highlights Treasuries: Despite surging issuance, long-dated Treasury yields will move only slightly higher this year, driven by a modest recovery in global demand. There is also a risk that a second wave of COVID infections will send yields to new lows. We recommend keeping portfolio duration close to benchmark while hedging the risk of higher yields by entering duration-neutral curve steepeners. Negative Rates: The Fed will not cut rates into negative territory any time soon. Investors who are able to do so should go short fed funds futures contracts that are priced for negative rates. EM Sovereigns: US bond investors should avoid USD-denominated EM sovereign debt and focus instead on US corporate credit rated Ba and higher. Of the EM countries with large USD bond markets, Mexican debt looks most attractive on a risk/reward basis. Don’t Expect A Taper Tantrum The big announcement in bond markets last week was the Treasury department detailing its plans for note and bond issuance in the second and third quarters. Of course, with the CARES act injecting $2.8 trillion into the economy, investors were already prepared for a big step up in issuance.1 But the numbers are striking nonetheless, particularly at the long-end of the curve. Overall note and bond issuance will reach $910 billion in Q3, roughly equal to the 2010 peak as a percent of GDP (Chart 1). Issuance beyond the 10-year point of the curve (i.e. the 30-year bond and new 20-year bond) will far exceed its financial crisis highpoint (bottom panel). Many bond investors are understandably worried that surging issuance will put significant upward pressure on yields in the coming months. Long-maturity Treasury yields jumped after the Treasury’s announcement on Wednesday before reversing all of that bounce the following day. But despite the mild market reaction, many bond investors are understandably worried that surging issuance will put significant upward pressure on yields in the coming months, especially with the Fed paring its pace of Treasury purchases (Chart 2). Chart 1Gross Treasury Issuance Chart 2Fed Buying Fewer Treasuries Our base case outlook is that Treasury yields will be marginally higher by the end of the year, and the yield curve will be steeper.2 However, we do not foresee a Taper Tantrum-style bond market rout. Treasury supply will continue to expand in the months ahead. But on the flipside, the Fed’s forward rate guidance will remain very dovish. If investors believe that short-dated interest rates will stay pinned near zero for a long time, fear of significant losses will remain low and Treasury demand will keep pace with supply, even at the long-end of the curve. Chart 3No Taper Tantrum In 2020 Yes, the Fed has scaled back its pace of Treasury purchases during the past few weeks, removing a significant source of demand from the market. However, it has also given no indication that it intends to lighten up on monetary stimulus broadly speaking. Based on the Fed’s dovish posture, we can be sure that if surging issuance leads to undesirably high term premiums at the long-end of the Treasury curve, the Fed will quickly ramp purchases back up to squash them. In general, our view is that all dramatic bond sell-offs are caused by the market suddenly pricing in a much more hawkish Fed reaction function. This can be driven by surprisingly strong economic growth and inflation, or by investors collectively changing their assessments of how the Fed will react. In this regard, the 2013 Taper Tantrum is an interesting case study. The Treasury curve bear-steepened dramatically in 2013 after Fed Chair Ben Bernanke laid out the Fed’s plan for winding down asset purchases. But this is not a simple story of bond yields rising because the market reacted to less demand in the form of Fed purchases. Rather, yields rose so much because Bernanke signaled to investors that the overall stance of monetary policy was much less accommodative than they had previously thought. Notice that gold fell sharply during this period (Chart 3), not because of less direct demand for Treasuries but because a more hawkish Fed meant less long-run inflation risk. The dynamic is illustrated very clearly by the CRB Raw Industrials / Gold ratio (Chart 3, bottom panel). The ratio is highly correlated with long-dated Treasury yields, meaning that for yields to shoot higher we need to see either a surge in global demand (i.e. CRB commodity prices) or a hawkish shift in the Fed’s reaction function (i.e. a drop in the gold price). If, as we expect, global demand improves only modestly this year and the Fed remains steadfastly dovish, upside in both the CRB/Gold ratio and long-maturity Treasury yields will be limited. Bottom Line: Despite surging issuance, long-dated Treasury yields will move only slightly higher this year, driven by a modest recovery in global demand. There is also a risk that a second wave of COVID infections will send yields to new lows. We recommend keeping portfolio duration close to benchmark while hedging the risk of higher yields by entering duration-neutral curve steepeners. Don’t Bet On Negative Rates Table 1Fed Funds Futures The massive amount of new issuance was not the only exciting development in fixed income markets last week. Short-dated yields also started to price-in the possibility of negative interest rates in the US! Table 1 shows the price of different fed funds futures contracts (as of Monday morning) and what funds rate those prices imply for each contract’s maturity month. We also show the return you would earn by taking an unlevered short position in each contract and holding to maturity, assuming that the actual fed funds rate remains unchanged. We assume that the fed funds rate will stay at its current level (0.05%) because the Fed has made it very clear that a negative policy rate is not an option that will be considered. As evidence, we present some excerpts from recent Fed communications. Fed Chair Jerome Powell from his March 15 press conference:3 So, as I’ve noted on several occasions, really, the Committee – as you know, we did a year-plus-long study of our tools and strategies and communications. And we, really, at the end of that, and also when we started out, we view forward guidance and asset purchases – asset purchases and also different variations and combinations of those tools as the basic elements of our toolkit once the federal funds rate reaches the effective lower bound – so, really, forward guidance, asset purchases, and combinations of those. You know, we looked at negative policy rates during the Global Financial Crisis, we monitored their use in other jurisdictions, we continue to do so, but we do not see negative policy rates as likely to be an appropriate policy response here in the United States. The Fed staff’s assessment of negative interest rates from the October 2019 FOMC minutes:4 The briefing also discussed negative interest rates, a policy option implemented by several foreign central banks. The staff noted that although the evidence so far suggested that this tool had provided accommodation in jurisdictions where it had been employed, there were also indications of possible adverse side effects. Moreover, differences between the US financial system and the financial systems of those jurisdictions suggested that the foreign experience may not provide a useful guide in assessing whether negative interest rates would be effective in the United States. FOMC participants’ assessment of negative interest rates from the October 2019 minutes:5 All participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States. Participants commented that there was limited scope to bring the policy rate into negative territory, that the evidence on the beneficial effects of negative interest rates abroad was mixed, and that it was unclear what effects negative interest rates might have on the willingness of financial intermediaries to lend and on the spending plans of households and businesses. Participants noted that negative interest rates would entail risks of introducing significant complexity or distortions to the financial system. In particular, some participants cautioned that the financial system in the United States is considerably different from those in countries that implemented negative interest rate policies, and that negative rates could have more significant adverse effects on market functioning and financial stability here than abroad. Notwithstanding these considerations, participants did not rule out the possibility that circumstances could arise in which it might be appropriate to reassess the potential role of negative interest rates as a policy tool. It is always possible that the Fed’s view of negative interest rates will change in the future. However, this won’t happen any time soon. The Fed still has other zero-lower-bound policy options it can deploy before it gets desperate enough to re-consider negative rates. The Fed still has other zero-lower-bound policy options it can deploy before it gets desperate enough to re-consider negative rates. For example, one logical next step would be to bring back the Evans Rule. That is, specify economic targets (related to unemployment and inflation) that must be met before the Fed will consider lifting rates. If that sort of forward guidance is deemed insufficient, the Fed could adopt a plan recently advocated by Governor Lael Brainard and start to cap short-maturity bond yields.6 If it wants more stimulus after that it could gradually move further out the curve, capping bond yields for longer and longer maturities. According to the FOMC minutes, this sort of Yield Curve Control policy had more support among participants at the October 2019 FOMC meeting than did negative interest rates:7 A few participants saw benefits to capping longer-term interest rates that more directly influence household and business spending. In addition, capping longer-maturity interest rates using balance sheet tools, if judged as credible by market participants, might require a smaller amount of asset purchases to provide a similar amount of accommodation as a quantity-based program purchasing longer-maturity securities. However, many participants raised concerns about capping long-term rates. Some of those participants noted that uncertainty regarding the neutral federal funds rate and regarding the effects of rate ceiling policies on future interest rates and inflation made it difficult to determine the appropriate level of the rate ceiling or when that ceiling should be removed; that maintaining a rate ceiling could result in an elevated level of the Federal Reserve’s balance sheet or significant volatility in its size or maturity composition; or that managing longer-term interest rates might be seen as interacting with the federal debt management process. By contrast, a majority of participants saw greater benefits in using balance sheet tools to cap shorter-term interest rates and reinforce forward guidance about the near-term path of the policy rate. Bottom Line: The Fed will not cut rates into negative territory any time soon. Investors who are able to do so should go short fed funds futures contracts that are priced for negative rates. For example, a short position in the June 2021 fed funds futures contract will earn an unlevered 6.5 bps if the fed funds rate remains unchanged and the position is held to maturity. No Buying Opportunity Yet In EM Sovereigns When assessing the outlook for the US dollar denominated sovereign debt of emerging markets we consider two main factors: Valuation, relative to both US Treasuries and US corporate credit. The outlook for EM currencies versus the dollar. Ideally, we want to move into EM sovereign debt when spreads look attractive relative to the domestic investment alternatives and when EM currencies are on the cusp of rallying versus the dollar. Valuation At first blush, value looks like it has improved considerably for EM sovereigns. The average spread on the Bloomberg Barclays EM Sovereign index is 167 bps wider than it was at the beginning of the year and the spread differential with the duration-matched Ba-rated US corporate bond index is elevated compared to the recent past (Chart 4). However, widening has been driven by a select few distressed countries (e.g. Ecuador, Argentina and Lebanon). When we strip those out and look only at the investment grade EM sovereign index (Chart 4, panels 3 & 4), the average spread looks relatively tight compared to a duration-matched position in Baa-rated US corporate credit. Chart 4Only A Few EMs Look Cheap Because country-specific trends often exert undue influence on the overall index, we find it helpful to look at value on a country-by-country basis. Chart 5A shows the average option-adjusted spread for major countries included in the Bloomberg Barclays EM Sovereign index. This chart makes no adjustments for credit rating or duration, and as such we see the lower-rated nations (Turkey, South Africa, Brazil) offering the widest spreads. Chart 5B shows each country’s spread relative to a duration and credit rating matched position in US corporate credit. Viewed this way, the most attractive opportunities lie in Mexico, Saudi Arabia, UAE, Colombia, Qatar and South Africa. Chart 5AUSD-Denominated EM Sovereign Debt By Country: Spread Versus Treasuries Chart 5BUSD-Denominated EM Sovereign Debt By Country: Spread Versus US Credit Currency Outlook Chart 6EM Currencies Are Linked To Global Growth Currency is important for EM sovereign spreads because a stronger local currency literally makes US dollars cheaper for the EM nation to acquire. This, in turn, makes its USD-denominated debt easier to service, leading to tighter spreads. Chart 6 shows that EM Sovereign excess returns versus US Treasuries closely track EM currency performance. We also observe a strong link between EM currencies and high-frequency global growth indicators like the CRB Raw Industrials commodity price index (Chart 6, bottom panel). Based on this, we would only expect EM currencies to strengthen when global demand starts to pick up. Further, as our Emerging Market strategists wrote in a recent report, EM central banks are behaving differently during this recession than they have in past downturns.8 In the past, EMs would often run relatively tight monetary policies in order to fend off currency depreciation in the hopes of preventing capital outflows. This time, EM central banks are cutting rates aggressively, allowing their currencies to depreciate but supporting domestic demand. This is bearish for EM currencies and sovereign spreads in the near-term, but will probably lead to stronger economic recovery down the road. At the country level, we assess how vulnerable each country’s currency is to further depreciation by looking at its ratio of exports to foreign debt obligations.9 This ratio is a measure of US dollars coming in over a 12-month period relative to 12-month US dollar debt obligations. It has a relatively tight correlation with the dollar-denominated sovereign spread (Chart 7A). Low-rated countries, like Turkey and South Africa, have relatively low export coverage of foreign debt obligations, while Russia and South Korea have relatively strong debt coverage. Combining Valuation & Currency Outlook Chart 7B shows the same measure of currency vulnerability on the horizontal axis, but shows EM spreads relative to duration and credit rating matched US corporate credit on the vertical axis. Here, we see that Russia offers poor valuation, but a relatively safe currency. Meanwhile, Colombia offers an attractive spread but has a poor currency outlook. In this chart, Mexico stands out as the most attractive on a risk/reward basis. Chart 7AEM Sovereign Spread Versus Currency Vulnerability Chart 7BEM Sovereign Spread Over US Credit Versus Currency Vulnerability You will notice that the three Middle Eastern countries that stood out as having attractive spreads in Chart 5B are not shown in Charts 7A and 7B. This is because some data are unavailable, and also because those countries operate with currency pegs. Despite attractive spreads in those countries, we would not advise long-run positions in the USD-denominated sovereign debt of Saudi Arabia, Qatar or UAE. As our EM strategists wrote in a recent Special Report, if oil prices remain structurally low in the coming years (~$40 range), pressure will grow for Saudi Arabia to break its currency peg and allow some depreciation.10 The same holds true for Qatar and UAE. A bet on those countries’ sovereign spreads today amounts to a bet on higher oil prices. Despite attractive spreads, we would not advise long-run positions in the USD-denominated sovereign debt of Saudi Arabia, Qatar or UAE. Bottom Line: US bond investors should avoid USD-denominated EM sovereign debt and focus instead on US corporate credit rated Ba and higher. Of the EM countries with large USD bond markets, Mexican debt looks most attractive on a risk/reward basis. Appendix: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. Right now, that means we are overweight corporate bonds rated Ba and higher, Aaa-rated Agency and non-agency CMBS, Aaa-rated consumer ABS and municipal bonds. We are underweight residential mortgage-backed securities and corporate bonds rated B and lower. The below Table tracks the performance of these different bond sectors since the Fed’s March 23 announcement. We will use this Table to monitor bond market correlations and evaluate our strategy's success. Table 2Performance Since March 23 Announcement Of Emergency Fed Facilities Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the size and potential efficacy of the CARES act please see Bank Credit Analyst Special Report, “The Global COVID-19 Fiscal Response: Is It Enough?”, dated April 30, 2020, available at bca.bcaresearch.com 2 Please see US Bond Strategy Portfolio Allocation Summary, “The Policy-Driven Bond Market”, dated May 5, 2020, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20200315.pdf 4 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 5 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 6 https://www.federalreserve.gov/newsevents/speech/brainard20191126a.htm 7 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 8 Please see Emerging Markets Strategy Weekly Report, “EM Domestic Bonds And Currencies”, dated April 23, 2020, available at ems.bcaresearch.com 9 For more information on this ratio please see Emerging Markets Strategy Special Report, “EM: Foreign Currency Debt Strains”, dated April 22, 2020, available at ems.bcaresearch.com 10 Please see Emerging Markets Strategy Special Report, “Saudi Riyal Devaluation: Not Imminent But Necessary”, dated May 7, 2020, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights ECB: The ECB disappointed markets last week who expected an increase in the size of its asset purchase schemes given the recent increase of Italian bond yields. For now, the central bank remains focused on preventing a European credit crunch through increased use of bank funding measures like TLTROs – although a renewed selloff in BTPs would likely change the minds of the “Italy hawks” on the ECB Governing Council. Euro Area High-Yield: Valuations for euro area junk bonds improved somewhat during the COVID-19 selloff, but spreads do not offer much protection from the coming surge in default losses. Remain underweight euro area high-yield corporates in global fixed income portfolios. Feature Chart 1Will Growth Trump Liquidity For Euro Area Junk Bonds? Over the past week, investors heard from the three major developed market central banks – the Federal Reserve, the European Central Bank (ECB) and the Bank of Japan (BoJ). The Fed and BoJ did little to seriously impact financial markets, offering only strengthened forward guidance on already hyper-easy policy settings along with some expansion of existing asset purchase programs (involving municipal bonds for the Fed, JGBs and Japanese corporate bonds for the BoJ). The ECB was the most interesting of the three, because of what was NOT done – namely, an increase in the amount of asset purchases – and what it implies about the policy debate within the central bank on how to deal with Italy. The hit to the euro area economy from the COVID-19 lockdowns has been sharp and brutal, pushing the entire region quickly into deep recession (Chart 1). Given such a severe hit to growth, and with policy interest rates already at zero (or even negative), the only avenue for the ECB to deliver more stimulus is through expanding its balance sheet through asset purchases and liquidity provision to banks. This makes the ECB’s next moves on its balance sheet critical for determining the future path of European risk assets like equities and high-yield corporate bonds – the latter of which we discuss later in this report. A Cautious Next Step From The ECB Chart 2An Unprecedented Economic Collapse The need for the ECB to do something at last week’s monetary policy meeting was obvious. Real GDP for the entire region is estimated to have contracted -3.8% on a year-over-year basis in the first quarter of the year. At the country level, large declines occurred in France (-5.8%), Italy (-4.7%) and Spain (-5.2%) that were far greater than seen during the 2009 recession. The decline was broad-based across industries as well, with the European Commission’s (EC) business confidence indices collapsing in April for manufacturing, services, retail and construction (Chart 2). The bottom has also fallen out on the EC price expectations indices, suggesting that outright deflation across the euro area is just around the corner. The ECB last week provided what were called “alternative scenarios” for the impact of COVID-19 on euro area growth. We presume these are meant to be an alternative to the most recent set of ECB economic projections that were published in March that now look wildly optimistic given the COVID-19 lockdowns. The revised scenarios now call for a real GDP contraction in 2020 of anywhere from -5% to -12%, with only a partial recovery of those losses in 2021.1 The central bank also provided an estimate of the output loss by industry from COVID-19 related lockdowns (Table 1) – a staggering -60% for retail, transportation, accommodation and food services and -40% for manufacturing and construction. Table 1The Lockdown Has Been Painful For Europe Against this horrendous growth and inflation backdrop, with forecasts being slashed, the expectation was that the ECB would ramp up the size of its bond buying programs to try and ease financial conditions further. That would help cushion the growth downturn and attempt to put a floor under collapsing inflation expectations (Chart 3). Yet at last week’s monetary policy meeting, the ECB announced the following: No changes in policy interest rates No increase in the size of the Asset Purchase Program (APP) from the existing €120bn or Pandemic Emergency Purchase Program (PEPP) from the existing €750bn For existing targeted long-term refinancing operations (TLTROs) between June 2020 and June 2021, interest rates were lowered by -25bps A new long-term refinancing operation for euro area banks was introduced called the Pandemic Emergency Long Term Refinancing Operation (PELTRO), which would offer liquidity to euro area banks on a monthly basis until December, at an interest rate of -0.25%. The increased use of LTROs was an easier way for the ECB Governing Council to avoid a potential credit crunch if euro area banks become more risk averse. The ECB clearly wants to take no chances on banks reining in loan activity. The latest ECB Bank Lending Survey, released just two days before last week’s policy meeting, showed a modest tightening of standards for bank loans to businesses in the first quarter of 2020. This was most visible in Germany and Italy, with France actually showing a slight decline in the net percentage of banks tightening lending standards (Chart 4). The survey also showed that euro area banks expected a significant net easing of lending standards in response to the loan guarantees and liquidity support measures announced by European governments to mitigate the impact of COVID-19 lockdowns. Chart 3Expanding The Balance Sheet Is The Only Tool The ECB Has Left Chart 4The ECB Wants To Avoid A Credit Crunch With bank lending growth across the entire euro area having already increased to 4.9% on a year-over-year basis in March, the fastest pace in two years, the ECB clearly wants to take no chances on banks reining in loan activity - even if those loans are merely for stressed companies tapping existing credit lines, or taking advantage of government loan guarantees to minimize layoffs in a deep recession. Another surge in Italian bond yields in the next few months would likely trigger an increase in the size of the PEPP. However, there was likely an additional reason why the ECB chose the LTRO route over ramping up asset purchases – internal political divisions over Italy. Chart 5Italian Financial Stability Remains Critical For The ECB There remain some on the ECB Governing Council that do not wish to keep buying more BTPs, thus giving Italy a blank check to run even larger budget deficits. The unique nature of the COVID-19 outbreak has somewhat loosened those biases against the highly indebted countries of southern Europe, as evidenced by the inclusion of Greek bonds in the PEPP shopping list. Yet there are still many within the ECB, and within the governments of the “hard money” countries of the euro area, who would prefer to see Italy get monetary support for greater deficit spending through ECB vehicles with conditionality like Outright Monetary Transactions (OMT). Given these internal divisions over Italy, an increase in the size of the existing asset purchase schemes will only take place if there is a major increase in Italian risk premiums that threatens the financial stability of the entire euro area. On that front, risk indicators like the BTP-Bund spread and credit default spreads on Italian banks have risen over the past month, but remain well below the stressed levels witnessed during the Global Financial Crisis and the European Debt Crisis (Chart 5). Additionally, Italian bank stocks have actually been outperforming their euro area peers since early 2019, while the Italy-Germany spread curve is not inverted (2-year spreads higher than 10yr spreads) as occurred in 2011 when investors feared Italy would crash out of the euro. With Italian government yields still at relatively low and manageable levels, even as the highly-indebted Italian government has stated that its budget deficit will surge to -10% of GDP to provide stimulus to a virus-ravaged economy, there is no pressure on the ECB to increase the size of the PEPP that was just announced less than two months ago. Yet even with all the internal divisions, another surge in Italian bond yields in the next few months would likely trigger an increase in the size of the PEPP to prevent a broader tightening of euro area financial conditions. For this reason, we continue to recommend a strategic (6-12 months) overweight stance on Italian government bonds within global fixed income portfolios. Bottom Line: The ECB disappointed markets last week who expected an increase in the size of its asset purchase schemes given the recent increase of Italian bond yields. For now, the central bank remains focused on preventing a European credit crunch through increased use of bank funding measures like TLTROs – although a renewed selloff in BTPs would likely change the minds of the “Italy hawks” on the ECB Governing Council. A Quick Look At Euro Area High-Yield Valuation We recently upgraded our recommended investment stance on euro area investment grade corporate bonds to neutral.2 This shift was based on the ECB increasing the amount of its corporate bond purchases as part of its COVID-19 monetary easing measures, coming after the Fed announced its own new programs to buy US investment grade corporates. With the major central banks providing direct support to higher quality corporates, the left side of the return distribution for those bonds eligible for these purchase programs has effectively been reduced. This warrants a higher weighting for those bonds in investor portfolios. For high-yield corporates, the story is more nuanced. Both the Fed and ECB have announced that investment grade bonds purchased in their bond buying programs, which are then subsequently downgraded to below investment grade, can stay on the balance sheet of those programs. This makes Ba-rated junk bonds – the highest credit tier below investment grade – a relatively more attractive bet within the overall high-yield universe, both in the US and Europe. Although the lack of a direct central bank bid still makes high-yield corporates a riskier bet in a recessionary environment where default losses will surely increase. This means rather than just “buying what the central banks are buying”, we must rely on more traditional metrics to determine if high-yield bonds offer value. To evaluate the attractiveness of euro area high-yield corporates, we use three different approaches that use relative value to other credit markets, or more intrinsic value based on potential credit losses. Relative spreads vs. euro area investment grade One way to assess the value of euro area high-yield is to compare its credit spread to that of higher-rated euro area investment grade corporate bonds. Since movements in both spreads are highly correlated, as they both benefit from accelerating euro area economic growth (and vice versa), any change in spreads between the two could represent a relative value opportunity. Currently, the option-adjusted spread (OAS) of the euro area high-yield benchmark index (635bps) is 449bps over that of the investment grade index (186bps), using Bloomberg Barclays index data (Chart 6). While this is a relatively wide spread differential for the years since the 2008 financial crisis, it is not a particularly large gap during a recession that is likely to be deeper than the 2009 downturn. The same argument holds when looking at the ratio of the euro area high-yield OAS to the investment grade OAS, which is only at average levels for the post crisis period (3rd panel). 12-month breakeven spreads One of our favorite credit valuation tools is the 12-month breakeven spread, which measures the amount of spread widening over a one-year horizon that would make the total return of a corporate bond equal to that of a duration-matched government bond. We apply that calculation to data for an entire spread product sector, like investment grade or high-yield, to determine a breakeven spread for that sector. We then look at the percentile ranks of the breakeven spread versus its own history to determine if that particular fixed income sector looks relatively attractive. Rather than just “buying what the central banks are buying”, we must rely on more traditional metrics to determine if high-yield bonds offer value. On that basis, euro area high-yield corporates, across all credit tiers, offer somewhat attractive spreads, with 12-month breakevens in the upper half of the historical distribution (Chart 7). US high-yield, by comparison, offers far more attractive spreads with 12-month breakevens in the upper quartile of their historical distribution across all credit tiers. Only the riskiest Caa-rated bonds are in the top 25% of the distribution in the euro area (Chart 8). Chart 6In The Euro Area, HY Is Not That Cheap Versus IG Chart 712-Month Breakeven Spreads For Euro Area HY Are Now More Attractive ... Chart 8… But Not Versus US High-Yield The overall attractiveness of US high-yield versus euro area equivalents can also be seen when comparing the benchmark index yields in common currency terms. For the overall indices, euro area junk bond yields, hedged into USD dollars, offer a yield of 7.8%, virtually equal to the 8.0% yield in the US (Chart 9), although more material differences do exist within credit tiers. Chart 9A Comparison Of Junk Bond Yields In The Euro Area & The US Default-adjusted spreads The other metric that we use to assess the value of high-yield corporate bonds is default-adjusted spreads. This measure takes the high-yield index OAS and subtracts credit losses to determine an “excess” spread. We look at the current default-adjusted spread versus its long-run average to determine if high-yield spreads offer an attractive valuation cushion relative to expected credit losses. To determine the credit losses, we need the default rate, and the recovery rate given default, for the overall high-yield market. For defaults, we will use the output of our euro area default rate model (Chart 10). The model uses four variables: lending standards for businesses from the ECB bank lending survey, high-yield ratings downgrades as a share of all rating actions, euro area real GDP growth, and the median debt-to-equity ratio for a sample of issuers in the euro area high-yield space. All the variables are advanced such that the model produces a one-year-ahead forecast of expected high-yield defaults.3 Our high-yield model is projecting that the euro area default rate will climb to 11% by the end of 2020, before declining to 8% mid-2021 as the euro area economy recovers from the 2020 recession. For the euro recovery rate, we are using a range based on the historical experience during recessions (30%) and recoveries (45%). Using our default rate model projection, and that range of recovery rates, we can produce a range of euro area default-adjusted spreads. Euro area high-yield spreads do not offer much of a spread cushion to absorb expected default losses over the next year. Thus, euro area junk bonds are expensive. In Chart 11, we show the history of the euro area default adjusted spread. We have added the long run average (358bps) and the +/1 standard deviation of the spread. Spreads at or lower than -1 standard deviation are considered expensive (i.e. the high-yield index spread is too low relative to credit losses), and vice versa. The shaded box in the bottom right corner of the chart represents our forecasted default-adjusted spread for the next year. Chart 10Our Model Says The Euro Area Default Rate Will Surpass 10% Chart 11Euro Area HY Default-Adjusted Spreads Do Not Offer Compelling Value Chart 12An Aggressive Overweight Stance On Risk Assets Is Still Not Warranted Our projected spread range over the next twelve months is 218bps to -112bps, well below the long-run average and at the low end of the historical distribution. We conclude from this analysis that current euro area high-yield spreads do not offer much of a spread cushion to absorb expected default losses over the next year. Thus, euro area junk bonds are expensive. Given the lack of a compelling valuation argument under all our metrics, we are leaving our recommended investment stance on euro area high-yield bonds at underweight. We continue to focus our recommended global spread product allocations on overweights in markets where there is direct and explicit support from policymaker purchase programs: US investment grade bonds with maturity of less than five years, US Ba-rated high-yield bonds, and UK investment grade corporates. This selectively overweight investment stance on global credit is warranted from a risk management perspective, as well. Our “Pro-Risk Checklist” of indicators that would lead us to recommend a more aggressive stance on risk assets in general, and spread product in particular, is still flashing a cautious message (Chart 12). The US dollar continues to strengthen (exacerbating global deflation and dollar funding pressures); the VIX index of US equity volatility has fallen below our threshold of 40, but not by much; and the number of new global (ex-China) COVID-19 cases is showing mixed results, falling in the US and Italy but increasing elsewhere. Bottom Line: Valuations for euro area junk bonds improved somewhat during the COVID-19 selloff, but spreads do not offer much protection from the coming surge in default losses. Remain underweight euro area high-yield corporates in global fixed income portfolios. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The alternative ECB growth forecasts can be found here: https://www.ecb.europa.eu/pub/economic-bulletin/focus/2020/html/ecb.ebbox202003_01~767f86ae95.en.html 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Buy What The Central Banks Are Buying", dated April 14, 2020, available at gfis.bcaresearch.com. 3 For real GDP growth, we use Bloomberg consensus forecasts for the next four quarters in the model. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The air is thick with denunciations of the Fed’s new round of aggressive interventions … : In financial circles, it’s beginning to sound like the winter of 2008-9 all over again, as respected thought leaders with enviable track records decry bailouts. … but we are firmly resolved to keep judgments about what central banks ought to do out of our analysis of the market impacts of their actions: “Dogmatic” is about the worst thing one BCA researcher can call another. The Fed’s expanded lending remit may simply be the logical evolution of the Debt Supercycle: The Debt Supercycle may have reached its natural limit, but policy makers won’t surrender such a cherished tool without a fight. Capitalism isn’t entirely dead, and the Fed isn’t the Coast Guard or the Forest Service: The new approach is meant to protect society, not individuals who get themselves into idiosyncratic trouble. Feature We will be holding a webcast next Monday, May 11th at 10:00 a.m. Eastern time in lieu of publishing a Weekly Report. Please join us with your questions to make it a fully interactive event. We will resume our regular publication schedule on the 18th. Here we go again. A potentially catastrophic recession has arrived, and the Fed has embarked on a series of unprecedented actions to try to shield the economy from it. Its goal is to stave off hysteresis, whereby a cyclical downturn, left unchecked, gives rise to a structural albatross that weighs on long-run growth. Just how much a central bank ought to interpose itself between the economy and its participants can be a matter of fierce debate, as it was in November 2010, when 23 members of the broader economic community, including three elite investors and a handful of respected economists, signed an open letter to Ben Bernanke, urging him to abandon QE2 (Box 1). Box 1 A Central Bank Can’t Win Open Letter to Ben Bernanke November 15, 2010 We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment. We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus. We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy. The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either US or global economic problems.1 Dire forecasts about the effects of the Fed's unconven-tional GFC interventions have not come to pass and have since been emulated by other major central banks. No one bats a thousand when predicting the future, but the authors of the letter could not have been further off the mark when they warned about currency debasement and inflation. Monetary policy has not yet been normalized in the way anyone would have defined it at the time, but other central banks have overcome their aversion to QE, pursuing it as avidly as the Fed (Chart 1). One should also note that some of the author-investors were not disinterested observers. QE signaled an extended period of easy monetary conditions that was likely to narrow distinctions among individual companies, undermining stock-picking processes that had produced outperformance against a conventional monetary policy backdrop. Chart 1What Was Once Unthinkable Has Become Routine Moral Hazard Inflation and the dollar are well down the list in the latest round of denunciations, which are principally occupied with moral hazard. In his outlook last week, Guggenheim Investments’ CIO Scott Minerd warned that the Fed’s purchases of corporate debt establish a new precedent that will have a persistent half-life, if QE is any guide. By socializing credit risk, he asserts, the purchases mark the end of US free-market capitalism as we have always known it. Two weeks before, Howard Marks argued that capitalist principles are being undermined by the Fed’s programs, if not entirely overthrown: Most of us believe in the free-market system as the best allocator of resources. Now it seems the government is happy to step in and take the place of private actors. We have a buyer and lender of last resort, cushioning pain but taking over the role of the free market. When people get the feeling that the government will protect them from unpleasant financial consequences of their actions, it’s called “moral hazard.” There’s an old saying … to the effect that “capitalism without bankruptcy is like Catholicism without hell.” It appeals to me strongly. Markets work best when participants have a healthy fear of loss. It shouldn’t be the role of the Fed or the government to eradicate it. We have never been enamored of the concept of the Fed put because we don’t think it is terribly relevant for any individual investment decision maker, and relying on it could be hazardous to one’s health. First, the Fed put is absolutely not an at-the-money put, or even a put with a strike price that is only slightly out of the money. It doesn’t do an investor much good if the Fed doesn’t ride to the rescue until his/her position is 30% underwater. Second, the Fed doesn’t care if any individual entity fails. It only acts to protect the overall financial system and the broad economy. An individual entity that gets into trouble cannot count on the Fed to throw it a lifeline. The Fed is not the Coast Guard or the Forest Service, which will go to great lengths to rescue a foolhardy or unskilled pilot or hiker who gets in over his or her head in rough weather. It cares only about the collective, and the only way an individual entity can count on receiving aid is if everyone else runs into trouble at the same time. That collective insurance policy may promote some operational risk-taking at the margin, but we wouldn’t want to rely on it. How could an overleveraged company possibly know that a critical mass of other companies will get into trouble at the same time? The Fed put doesn’t apply to the first entity to fail, or to entities in industries that are not seen as critical. It could surely encourage investors to lend to entities of dubious quality, but timing is everything there, too. The less-than-pristine borrower will have to hold on long enough to be somewhere in the middle of the pack of failing entities to qualify for a life preserver. The Trouble With The Austrians We lean to the view that moral hazard, as promoted by Fed policies, is largely in the eye of the beholder. The ability to perceive moral hazard seems to be related to one’s propensity for moral indignation. Austrian School devotees (Box 2) regularly have that propensity in spades. Box 2 An Austrian’s Lonely Lot The Austrian School of Economics most saliently parts company with neoclassical economics in its adamant opposition to government intervention and its fraught relationship with credit. Instead of intervening to counter business cycles, Austrians would prefer to let busts run their course so as to cleanse the economy of the excesses embedded in booms. They occupy the Mellonian, purge-the-rottenness-out-of-the-system end of the continuum in opposition to the Debt Supercycle’s unconditional forgiveness. Austrians regard banking and credit with some measure of suspicion, as Austrian Business Cycle Theory holds that artificially low interest rates are the raw material of destabilizing booms. Encouraged by central bankers seeking to steer an economy out of recession with a bare minimum of discomfort, borrowers take on debt to invest in projects that may not be able to pay their own way were it not for intervention. Once rates rise after policy accommodation fades, the economy slows and the extent of the malinvestment is revealed. The Debt Supercycle prescribes more of the hair of the dog to alleviate the suffering from malinvestment. The debt overhang is thereby never eliminated; it instead continues to silt up, requiring larger and larger interventions. Unchecked, the degree of intervention required to keep the plates spinning will eventually exceed capacity. Austrians despise the existence of such an arrangement, but it is so thoroughly entrenched in the reigning orthodoxy that an investor who becomes emotionally invested in opposing it is at risk of serially tilting at windmills. There is nothing wrong with the Austrian School per se. We rather like its outsider status, and actively seek heterodox inputs and perspectives so as to stay out of the ruts of the well-worn consensus path. Even its pessimistic bent has its uses; investors are surely exposed to enough cheerleading. Its prescriptions are so bracing, however, that a little goes a long way and real-world users should handle them with care. A popular pair of You Tube videos of actors portraying Keynes and Hayek dueling via raps about their respective ideologies (Keynes: I want to steer markets/Hayek: I want them set free!) provide an entertaining example of the Austrian-inspired investor’s dilemma. Keynes, drink after drink in hand, is the exuberant life of the party, while the sallow Hayek stares into the bottom of his glass, unable to capture any other partygoers’ attention. The simple conceit animating the video – Keynesianism is fun; Austrians are dour scolds – resonates deeply with elected officials, even if they never studied Economics. Voters love free drinks, but hate being told to eat their vegetables. There are no atheists in foxholes, and there are no Austrians in crises. When push comes to shove, government officials will do what they can to alleviate economic pain. The Austrian School, therefore, is a poor guide to the path that policy is likely to take. It also has the problematic effect of introducing an element of moral judgment into what should be a purely objective sphere. Investors should maintain a laser-like focus on what is most likely to happen and strive to suppress extraneous notions about what should happen. The Debt Supercycle’s Second Act Chart 3The End Of An Era? Call us jaded, but after 20-plus years in the business, the Austrians, with their fusty rectitude and gold-standard nostalgia, have come to seem like utopians. We prefer to borrow a page from public choice theory, and assume that elected and appointed officials respond to incentives just as surely as individuals outside of government. Legislators will pull fiscal levers to keep the party going and extend their own tenures, while the Fed will do its utmost to preserve its discretion to steer the economy as it sees fit. From that perspective, the Fed’s pull-out-all-the-stops approach to protecting markets and the economy simply looks like a logical evolution of the Debt Supercycle (Box 3). Now that a decade of zero and near-zero rates has failed to stimulate private sector borrowing (Chart 3), our colleague Martin Barnes has written that the Debt Supercycle is played out. Changing consumer preferences (Chart 4) and regulatory measures reining in banks’ lending capacity have impeded the credit channel, sharply degrading the Fed’s conventional policy arsenal. Central bankers want to remain in the thick of the action as much as any other bureaucrats, and it follows that the Fed has expanded its remit with unconventional measures that maintain its relevance. Chart 4Consumer Preferences Have Changed Since The GFC Box 3 The Debt Supercycle Longtime BCA clients are familiar with the Debt Supercycle concept, which holds that postwar Fed stimulus provoked successive waves of household and corporate borrowing to reflate the economy following recessions. Managing the economy with countercyclical fiscal and monetary policy has helped make recessions less frequent and less severe than they had been under the laissez faire prewar approach (Chart 2). Chart 2Intervention Has Helped Tame Cyclical Oscillations The only rub was that serial interventions to promote a quickening in the flow of new credit left the economy with an ever-increasing stock of debt. The prewar recessions were vicious, but bank and business failures allowed for frequent balance sheet resets that purged the economy of its boom excesses. The Debt Supercycle effectively sacrificed modest increments of structural stability for cyclical stability. Structural instability rose in step with the stock of debt, driving up the potential long-run cost of cyclical slumps, making the preservation of the Debt Supercycle increasingly imperative. Investment Implications We do not think investors should adjust to the new central banking orthodoxy by loading their portfolios with risk to embrace the Fed put. That put only applies to markets collectively, and cannot be seen as insurance for any single economic entity or asset portfolio. It would also be a mistake to renounce risk, however, by refusing to participate in a rigged game that violates Austrian principles. Investors should simply recognize that the new monetary orthodoxy calls for central banks to throw the kitchen sink at major economic threats. That suggests that shorts or underweights in risk assets based on macro vulnerabilities should be covered or closed without delay once a preset downside target has been reached. It seems that investors had 2009 in mind when they dove back into risk assets upon the Fed’s March 23rd announcement of its mix of revised and brand-new lending facilities and the March 27th passage of the CARES Act.2 No one wants to miss a big policy-induced bounce. Buy what the Fed is buying, and don't stress over it. Investors should buy what the Fed’s buying while its purchase programs and lending facilities are operating. That subset includes agency CMBS, AAA-rated CMBS, AAA-rated ABS, investment grade corporate debt and newly fallen angels in the BB-rated tier. Though they’ve already had a hearty bounce, agency mortgage REITs offer an equity vehicle for playing the Fed-purchase theme, as do the SIFI banks, which are the biggest indirect beneficiary of reduced default rates. We expect Guggenheim’s admonition that the Fed’s support of corporate borrowers will have a long half-life will prove to be accurate. As our Chief Global Fixed Income strategist put it at last week’s meeting to review long-term virus impacts, “Everyone on this call may be retired before a central banker ever utters the word ‘taper’ again.” That may not be the backdrop this free-markets devotee would choose, but it’s the backdrop all of us will have for the foreseeable future, and we’re determined to make the most of it. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1https://www.hoover.org/research/open-letter-ben-bernanke. Accessed April 28, 2020. 2 Please see the April 14, 2020 US Investment Strategy/US Bond Strategy Special Report, "Alphabet Soup: A Summary of the Fed’s Anti-Virus Measures," available at www.bcaresearch.com.
Highlights The six-month increase in European bank credit flows amounts to an underwhelming $70 billion, compared to a record high $660 billion in the US and $550 billion in China. Underweight European domestic cyclicals versus their peers in the US and China. Specifically, underweight euro area banks versus US banks. Overweight equities on a long-term (2 years plus) horizon. The mid-single digit return that equities are offering makes them attractive versus ultra-low yielding bonds. But remain neutral equities on a 1-year horizon, until it becomes clear that we can prevent a second wave of the pandemic. Fractal trade: long bitcoin cash, short ethereum. Feature Chart I-1Bank Credit 6-Month Flow Up $70 Bn ##br##In The Euro Area… Chart I-2…But Up $700 Bn ##br##In The US Governments and central banks are dishing out an alphabet soup of stimulus. The question is: how much is reaching those that need it? Our preferred approach to assessing monetary stimulus is to focus on the evolution of bank credit flows and bond yields over a six-month period. Bank Credit Flows Have Surged In The US And China, Not In Europe On our preferred assessment, Europe’s monetary stimulus is underwhelming compared with that in the US and China. The six-month increase in US bank credit flows, at $660 billion, is the highest in a decade and not far from the highest ever. In China, the equivalent six-month increase is $550 billion. But in the euro area, the six-month increase in bank credit flows amounts to an underwhelming $70 billion (Charts I-1 - Chart I-4). Chart I-3Bank Credit 6-Month Flow Up $550 Bn In China… Chart I-4...And Up ##br##Globally Admittedly, US firms are drawing on pre-arranged bank credit lines rather than taking out new loans. Furthermore, the link between bank credit flows and final demand might be compromised during the current economic shutdown. For example, if firms are borrowing to pay workers who are not producing any output, then the transmission of a credit flow acceleration to a GDP acceleration would be weakened. Europe’s monetary stimulus is underwhelming compared with that in the US and China. Nevertheless, some bank credit flows will still reach the real economy. And the US and China are creating more bank credit flows than Europe. Focus On The Deceleration Of The Bond Yield Turning to the bond yield, it is important to focus not on its level, and not on its decline. Instead, it is important to focus on its deceleration. The focus on the deceleration of the bond yield sounds counterintuitive, but it results from a fundamental accounting identity. The next two paragraphs may seem somewhat technical but read them carefully, as they are important for understanding the transmission of stimulus. GDP is a flow. It measures the flow of goods and services produced in a quarter. Hence, GDP receives a contribution from the flow of credit. The flow of credit, in turn, is established by the level of bond yields. When we talk about stimulating the economy, we mean boosting the GDP growth rate from, say, -1 percent to +1 percent, which is an acceleration of GDP. This acceleration in the GDP flow must come from an acceleration in the flow of credit. This acceleration in the flow of credit, in turn, must come from a deceleration of bond yields. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Banks tend to perform better after bond yields have decelerated. The good news is that in the US and China, bond yields have decelerated; the bad news is that in Europe, they have not. Over the past six months, the 10-year bond yield has decelerated by 40 bps in the US and by 65 bps in China. Yet in France, despite the coronavirus crisis, the 10-year bond yield has accelerated by 60 bps (Charts I-5 - Chart I-8).1 Chart I-5The Bond Yield Has Accelerated ##br##In The Euro Area... Chart I-6...Decelerated ##br##In The US... Chart I-7...Decelerated In China... Chart I-8...And Decelerated Globally European bond yields are struggling to decelerate because of their proximity to the lower bound to bond yields, at around -1 percent. The inability to decelerate the bond yield constrains the monetary stimulus that Europe can apply compared to the US and China, whose bond yields are much further from the lower bound constraint. Compared to Europe, the US and China have much stronger decelerations in their bond yields and much stronger accelerations in their bank credit flows. This suggests underweighting European domestic cyclicals versus their peers in the US and China. Specifically, banks tend to perform better after bond yields have decelerated; and they tend to perform worse after bond yields have accelerated. On this basis, underweight euro area banks versus US banks (Chart I-9). Chart I-9Banks Perform Better After Bond Yields Have Decelerated, Worse After Bond Yields Have Accelerated Long-Term Asset Allocation Is Straightforward, Shorter-Term Is Not The level of the bond yield, or of so-called ‘financial conditions’, does not drive the short-term oscillations in credit flows. To repeat, it is the acceleration and deceleration of the bond yield that matters. Yet when it comes to the long-term valuation of assets, the level of the bond yield does matter, and when the bond yield is ultra-low it matters enormously. An ultra-low bond yield justifies a much lower prospective return on competing long-duration assets, like equities. The reason is that when bond yields approach their lower bound, bond prices can no longer rise, they can only fall. This higher riskiness of bonds justifies an abnormally low (or zero) ‘risk premium’ on equities. In this world of ultra-low numbers – for both bond yields and equity risk premiums – the low to mid-single digit long-term return that equities are offering makes them attractive versus bonds (Chart I-10). Chart I-10Equities Are Offering Mid-Single Digit Long-Term Returns But this long-term valuation argument only works for those with long-term investment horizons. What does long-term mean? There is no clear dividing line, but we would define long-term as two years at the very minimum. For a one-year investment horizon, the much more important question is: what will happen to 12-month forward earnings (profits)? In the stock market recessions of 2008-09 and 2015-16, the stock market reached its low just before forward earnings reached their low. Assuming the same holds true in 2020-21, we must establish whether forward earnings are close to their low or not. In 2008-09, world forward earnings collapsed by 45 percent. In the current recession, which is putatively worse, world forward earnings are down by less than 20 percent to date. To have already reached the cycle low in forward earnings with only half the decline of 2008, the current recession needs to be much shorter than the 2008-09 episode (Chart I-11 and Chart I-12). Chart I-11In The Global Financial Crisis, Forward Earnings Collapsed By 45 Percent Chart I-12In The Current Crisis, Forward Earnings Are Down 20 Percent. Is That Enough? Whether this turns out to be the case or not hinges on the pandemic and our response to it. A controlled easing of lockdowns will boost growth as more of the economy comes back to life. But too rapid an easing of lockdowns will unleash a second wave of the pandemic, requiring a second wave of economic shutdowns, a double dip recession and a new low in the stock market. Hence, if you have a long-term (2-year plus) investment horizon, the choice between equities and bonds is very straightforward: overweight equities. On this long-term horizon, German and Swedish equities are especially attractive versus negative-yielding bonds. On a 1-year investment horizon, the key question is: can we avoid a second wave of the pandemic? But if you have a 1-year investment horizon, the choice is less straightforward, because it hinges on whether we can avoid a second wave of the pandemic or not. Until it becomes clear that governments will not reopen economies too quickly, remain neutral equities on the 1-year horizon. Fractal Trading System* This week’s recommended trade is a pair-trade within the cryptocurrency asset-class. Long bitcoin cash / short ethereum. Set the profit target at 21 percent with a symmetrical stop-loss. The 12-month rolling win ratio now stands at 61 percent. Chart I-13Bitcoin Cash Vs. Ethereum When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 In the US, the 10-year bond yield has declined by 120 bps in the past six months compared with 80 bps in the preceding six months, which equals a deceleration of 40 bps; in China, the 10-year bond yield has declined by 73 bps in the past six months compared with 18 bps in the preceding six months, which equals a deceleration of 65 bps; but in France, the 10-year bond yield has increased by 12 bps in the past six months compared with a 48 bps decline in the preceding six months, which equals an acceleration of 60 bps. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Yesterday we published a Special Report titled EM: Foreign Currency Debt Strains. We are upgrading our stance on EM local currency bonds from negative to neutral. Before upgrading to a bullish stance, we would first need to upgrade our stance on EM currencies. We recommend receiving long-term swap rates in Russia, Mexico, Colombia, China and India. EM central banks’ swap lines with the Fed could be used to fend off short-term speculative attacks on EM currencies. Nevertheless, they cannot prevent EM exchange rates from depreciation when fundamental pressures warrant weaker EM currencies. For the rampant expansion of US money supply to produce a lasting greenback depreciation, US dollars should be recycled abroad. This is not yet occurring. Domestic Bonds: A New Normal Chart I-1Performance Of EM Domestic Bonds In The Last Decade In recent years, our strategy has favored the US dollar and, by extension, US Treasurys over EM domestic bonds. Chart I-1 demonstrates that the EM GBI local currency bond total return index in US dollar terms is at the same level as it was in 2011, and has massively underperformed 5-year US Treasurys. We are now upgrading our stance on EM local currency bonds from negative to neutral. Consistently, we recommend investors seek longer duration in EM domestic bonds while remaining cautious on the majority of EM currencies. Before upgrading to a bullish stance on EM local bonds, we would first need to upgrade our stance on EM currencies. Still, long-term investors who can tolerate volatility should begin accumulating EM local bonds on any further currency weakness. Our upgrade is based on the following reasons: First, there has been a fundamental shift in EM central banks’ policies. In past global downturns, many EM central banks hiked interest rates to defend their currencies. Presently, they are cutting rates aggressively despite large currency depreciation. This is the right policy action to fight the epic deflationary shock that EM economies are presently facing. There has been a fundamental shift in EM central banks’ policies. They are cutting rates aggressively despite large currency depreciation. Historically, EM local bond yields were often negatively correlated with exchange rates (Chart I-2, top panel). Similarly, when EM currencies began plunging two months ago, EM local bond yields initially spiked. However, following the brief spike, bond yields have begun dropping, even though EM currencies have not rallied (Chart I-2, bottom panel). This represents a new normal, which we discussed in detail in our October 24 report. Overall, even if EM currencies continue to depreciate, EM domestic bond yields will drop as they price in lower EM policy rates. Second, the monetary policy transmission mechanism in many EMs was broken before the COVID-19 outbreak. Even though central banks in many developing countries were reducing their policy rates before the pandemic, commercial banks’ corresponding lending rates were not dropping much (Chart I-3, top panel). Chart II-2EM Local Bond Yields And EM Currencies Chart I-3EM ex-China: Monetary Transmission Has Been Impaired Further, core inflation rates were at all time lows and prime lending rates in real terms were extremely high (Chart I-3, middle panels). Consequently, bank loan growth was slowing preceding the pandemic (Chart I-3, bottom panel). The reason was banks’ poor financial health. Saddled with a lot of NPLs, banks had been seeking wide interest rate margins to generate profit and recapitalize themselves. With the outburst of the pandemic and the sudden stop in domestic and global economic activity, EM banks’ willingness to lend has all but evaporated. Chart I-4 reveals EM ex-China bank stocks have plunged, despite considerable monetary policy easing in EM, which historically was bullish for bank share prices. This upholds the fact that the monetary policy transmission mechanism in EM is broken. Mounting bad loans due to the pandemic will only reinforce these dynamics. Swap lines with the Fed cannot prevent EM exchange rates from depreciation when fundamental pressures – global and domestic recessions – warrant weaker EM currencies. In brief, EM lower policy rates will not be transmitted to lower borrowing costs for companies and households anytime soon. Loan growth and domestic demand will remain in an air pocket for some time. Consequently, EM policy rates will have to drop much lower to have a meaningful impact on growth. Third, there is value in EM local yields. The yield differential between EM GBI local currency bonds and 5-year US Treasurys shot up back to 500 basis points, the upper end of its historical range (Chart I-5). Chart I-4EM ex-China: Bank Stocks Plunged Despite Rate Cuts Chart I-5The EM Vs. US Yield Differential Is Attractive Bottom Line: Odds favor further declines in EM local currency bond yields. Fixed-income investors should augment their duration exposure. We express this view by recommending receiving swap rates in the following markets: Russia, Mexico, Colombia, India and China. This is in addition to our existing receiver positions in Korean and Malaysian swap rates. For more detail, please refer to the Investment Recommendations section on page 8. Nevertheless, absolute-return investors should be cognizant of further EM currency depreciation. EM Currencies: At Mercy Of Global Growth Chart I-6EM Currencies Correlate With Commodities Prices The key driver of EM currencies has been and remains global growth. The latter will remain very depressed for some time, warranting patience before turning bullish on EM exchange rates. We have long argued that EM exchange rates are driven not by US interest rates but by global growth. Industrial metals prices offer a reasonable pulse on global growth. Chart I-6 illustrates their tight correlation with EM currencies. Even though the S&P 500 has rebounded sharply in recent weeks, there are no signs of a meaningful improvement in industrial metals prices. Various raw materials prices in China are also sliding (Chart I-7). In a separate section below we lay out the case as to why there is more downside in iron ore and steel as well as coal prices in China. Finally, the ADXY – the emerging Asia currency index against the US dollar – has broken down below its 2008, 2016 and 2018-19 lows (Chart I-8). This is a very bearish technical profile, suggesting more downside ahead. This fits with our fundamental assessment that a recovery in global economic activity is not yet imminent. Chart I-7China: Commodities Prices Are Sliding Chart I-8A Breakdown In Emerging Asian Currencies What About The Fed’s Swap Lines? A pertinent question is whether EM central banks’ foreign currency reserves and the Federal Reserve’s swap lines with several of its EM counterparts are sufficient to prop up EM currencies prior to a pickup in global growth. The short answer is as follows: These swap lines will likely limit the downside but cannot preclude further depreciation. With the exception of Turkey and South Africa, virtually all mainstream EM banks have large foreign currency reserves. On top of this, several of them – Brazil, Mexico, South Korea and Singapore– have recently obtained access to Fed swap lines. Their own foreign exchange reserves and the swap lines with the Fed give them an option to defend their currencies from depreciation if they choose to do so. However, selling US dollars by EM central banks is not without cost. When central banks sell their FX reserves or dollars obtained from the Fed via swap lines, they withdraw local currency liquidity from the system. As a result, banking system liquidity shrinks, pushing up interbank rates. This is equivalent to hiking interest rates. The Fed’s outright money printing is the sole reason to buy EM risk assets and currencies at the moment. Yet, EM fundamentals – namely, its growth outlook – remain downbeat. Hence, the cost of defending the exchange rate by using FX reserves is both liquidity and credit tightening. In such a case, the currency could stabilize but the economy will take a beating. Since the currency depreciation was itself due to economic weakness, such a policy will in and of itself be self-defeating. The basis is that escalating domestic economic weakness will re-assert its dampening effect on the currency. Of course, EM central banks can offset such tightening by injecting new liquidity. However, this could also backfire and lead to renewed currency depreciation. Bottom Line: EM central banks’ swap lines with the Fed are primarily intended to instill confidence among investors in financial markets. They could be used to fend off short-term speculative attacks on EM currencies. Nevertheless, they cannot prevent EM exchange rates from depreciation when fundamental pressures – global and domestic recessions – warrant weaker EM currencies. What About The Fed’s Money Printing? Chart I-9The Fed Is Aggressively Printing Money The Fed is printing money and monetising not only public debt but also substantial amounts of private debt. This will ultimately be very bearish for the US dollar. Chart I-9 illustrates that the Fed is printing money much more aggressively than during its quantitative easing (QE) policies post 2008. The key difference between the Fed’s liquidity provisions now and during its previous QEs is as follows: When the Fed purchases securities from or lends to commercial banks, it creates new reserves (banking system liquidity) but it does not create money supply. Banks’ reserves at the Fed are not a part of broad money supply. This was generally the case during previous QEs when the Fed was buying bonds mostly – but not exclusively – from banks, therefore increasing reserves without raising money supply by much. When the Fed lends to or purchases securities from non-banks, it creates both excess reserves for the banking system and money supply (deposits at banks) out of thin air. The fact that US money supply (M2) growth is now much stronger than during the 2010s QEs suggests the recent surge in US money supply is due to the Fed’s asset purchases from and lending to non-banks, which creates money/deposits outright. The rampant expansion of US money supply will eventually lead to the greenback’s depreciation. However, for the US dollar to depreciate against EM currencies, the following two conditions should be satisfied: 1. US imports should expand, reviving global growth, i.e., the US should send dollars to the rest of the world by buying goods and services. This is not yet happening as domestic demand in America has plunged and any demand recovery in the next three to six months will be tame and muted. 2. US investors should channel US dollars to EM to purchase EM financial assets. In recent weeks, foreign flows have been returning to EM due to the considerable improvement in EM asset valuations. However, the sustainability of these capital flows into EM remains questionable. The main reasons are two-fold: (A) there is huge uncertainty on how efficiently EM countries will be able handle the economic and health repercussions of the pandemic; and (B) global growth remains weak and, as we discussed above, it has historically been the main driver of EM risk assets and currencies. Bottom Line: The Fed’s outright money printing is the sole reason to buy EM risk assets and currencies at the moment. Yet, EM fundamentals – namely, its growth outlook – remain downbeat. Overall, we recommend investors to stay put on EM risk assets and currencies in the near-term. Investment Recommendations Chart I-10China: Bet On Lower Long-Term Yields We have been recommending receiving rates in a few markets such as Korea and Malaysia. Now, we are widening this universe to include Russia, Mexico, Colombia, China, and India. In China, the long end of the yield curve offers value (Chart I-10, top panel). The People’s Bank of China has brought down short rates dramatically but the long end has so far lagged (Chart I-10, bottom panel). We recommend investors receive 10-year swap rates. Fixed-income investors could also bet on yield curve flattening. The recovery in China will be tame and the PBoC will keep interest rates lower for longer. Consequently, long-dated swap rates will gravitate toward short rates. We are closing three fixed-income trades: In Mexico, we are booking profits on our trade of receiving 2-year / paying 10-year swap rates – a bet on a steeper yield curve. This position has generated a 152 basis-point gain since its initiation on April 12, 2018. In Colombia, our bet on yield curve flattening has produced a loss of 28 basis points since January 17, 2019. We are closing it. In Chile, we are closing our long 3-year bonds / short 3-year inflation-linked bonds position. This trade has returned 2.0% since we recommended it on October 3, 2019. For dedicated EM domestic bond portfolios, our overweights are Russia, Mexico, Peru, Colombia, Korea, Malaysia, Thailand, India, China, Pakistan and Ukraine. Our underweights are South Africa, Turkey, Brazil, Indonesia and the Philippines. The remaining markets warrant a neutral allocation. Regarding EM currencies, we continue to recommend shorting a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chinese Steel, Iron Ore And Coal Markets: Heading South Chart II-1Steel, Iron Ore And Coal Prices: More Downside Ahead? Odds are that iron ore, steel and coal prices will all continue heading south (Chart II-1). Lower prices will harm both Chinese and global producers of these commodities. Steel And Iron Ore The oversupplied conditions in the Chinese steel market will become even more aggravated over the next three to six months. First, Chinese output of steel products has not contracted even though demand plunged in the first three months of the year, creating oversupply. Despite falling steel prices and the demand breakdown resulting from the COVID-19 outbreak, Chinese crude steel output still grew at 1.5% and its steel products output only declined 0.6% between January and March from a year ago (Chart II-2). Chart II-2Steel Products Output In China: Still No Contraction The profit margin of Chinese steel producers has compressed but not enough to herald a sizable cut in mainland steel production. Despite oversupply, Chinese steel producers are reluctant to curtail output to prevent layoffs. This year, there will be 62 million tons of new steel production capacity while 82 million tons of obsolete capacity will be shut down. As the capacity-utilization rate (CUR) of the new advanced production capacity will be much higher than the CUR on those soon-to-be-removed capacities in previous years, this will help lift steel output. Second, Chinese steel demand has plummeted, and any revival will be mild and gradual over the next three to six months. Construction accounts for about 55% of Chinese steel demand, with about 35% coming from the property market and 20% from infrastructure. Additionally, the automobile industry contributes about 10% of demand. All three sectors are currently in deep contraction (Chart II-3). Looking ahead, we expect that the demand for steel from property construction and automobile production will revive only gradually. Overall, it will continue contracting on a year-on-year basis, albeit at a diminishing rate than now. While we projected a 6-8% rise in Chinese infrastructure investment for this year, most of that will be back-loaded to the second half of the year. In addition, modest and gradual steel demand increases from this source will not be able to offset the loss of demand from the property and automobile sectors. The oversupplied conditions in the Chinese steel market will become even more aggravated over the next three to six months. Reflecting the disparity between weak demand and resilient supply, steel inventories in the hands of producers and traders are surging, which also warrants much lower prices (Chart II-4). Chart II-3Deep Contraction In Steel Demand From Major Users Chart II-4Significant Build-Up In Steel Inventories Chart II-5Chinese Iron Ore Imports Will Likely Decline In 2020 Regarding iron ore, mushrooming steel inventories in China and lower steel prices will eventually lead to steel output cutbacks in the country. This will be compounded by shrinking steel production outside of China, dampening global demand for iron ore. Besides, in China, scrap steel prices have fallen more sharply than iron ore prices have. This makes the use of scrap steel more appealing than iron ore in steel production. Chinese iron ore imports will likely drop this year (Chart II-5). Finally, the global output of iron ore is likely to increase in 2020. The top three producers (Vale, Rio Tinto and BHP) have all set their 2020 guidelines above their 2019 production levels. This will further weigh on iron ore prices. Coal Although Chinese coal prices will also face downward pressure, we believe that the downside will be much less than that for steel and iron ore prices. Coal prices have already declined nearly 27% from their 2019 peak. They recently declined below 500 RMB per ton – the lower end of a range that the government generally tries to maintain. Prices had not dropped below this level since September 2016. In the near term, prices could go down by another 5-10%, given that record-high domestic coal production and imports have overwhelmed the market (Chart II-6). Coal prices have already declined nearly 27% from their 2019 peak. They recently declined below 500 RMB per ton – the lower end of a range that the government generally tries to maintain. However, there are emerging supportive forces. China Coal Transport & Distribution Association (CCTD), the nation’s leading industry group, on April 18, called on the industry to slash production (of both thermal and coking coal) in May by 10%. It also proposed that the government should restrict imports. The CCTD stated that about 42% of the producers are losing money at current coal prices. The government had demanded producers make similar cuts for a much longer time duration in 2016, which pushed coal to sky-high prices. The outlook for a revival in the consumption of electricity and, thereby, in the demand for coal is more certain than it is for steel and iron ore. About 60% of Chinese coal is used to generate thermal power. Finally, odds are rising that the government will temporarily impose restrictions on coal imports as it did last December – when coal imports to China fell by 70% as a result. Investment Implications Companies and countries producing these commodities will be hurt by the reduction of Chinese purchases. These include, but are not limited to, producers in Indonesia, Australia, Brazil and South Africa. Iron ore and coal make up 10% of total exports in Brazil, 6% in South Africa, 18% in Indonesia and 32% in Australia. Investors should avoid global steel and mining stocks (Chart II-7). Chart II-6Chinese Coal Output And Imports Are At Record Highs Chart II-7Avoid Global Steel And Mining Stocks For Now We continue to recommend shorting BRL, ZAR and IDR versus the US dollar. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Dear Client, Please join me and my fellow BCA Strategists Caroline Miller and Arthur Budaghyan for a live webcast tomorrow, Friday, April 24 at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8:00 PM HKT) where we will discuss the outlook for developed and emerging market equities over the immediate (0-3 month) and cyclical (12 month) horizon. In lieu of our regular report next week, we will be sending you a Special Report from my colleague Jonathan LaBerge. Jonathan will discuss the global fiscal response to the COVID-19 pandemic, and will provide some perspective on whether the response will be enough to prevent an "L-shaped" economic outcome. I hope you find the report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Theoretically, the pandemic could raise the long-term fair value of equities – as proxied by the present value of future cash flows – if it causes the discount rate to fall by more than enough to offset the decline in corporate earnings. While such a seemingly bizarre outcome is not our base case, it cannot be easily dismissed, especially since the evidence suggests that real long-term interest rates have fallen a lot more since the start of the pandemic than have earnings estimates. We consider a number of challenges to this claim, including: current earnings estimates are too optimistic; long-term interest rates are being distorted by QE and other factors; and the equity risk premium will be higher in a post-pandemic world. While all these counterarguments have merit, none of them are airtight. Even if the pandemic ultimately boosts stock prices, the path to new highs will be a bumpy one. In the near term, a slew of bad economic data could cause another bout of market turbulence. Nevertheless, over a 12-month horizon, investors should continue to overweight equities relative to cash and bonds. The plunge in front-end oil futures this week was a timely reminder of the extent to which the pandemic has suppressed crude demand. Oil prices should bounce back later this year as global growth recovers, the dollar weakens, and more oil supply is taken offline. A Counterintuitive Scenario Chart 1EPS Growth Scenarios Could the pandemic end up raising the long-term fair value of equities – as proxied by the present value of future cash flows – compared with a scenario in which the virus never emerged? Such an outcome sounds far-fetched but could occur if the pandemic causes the discount rate to fall by more than enough to offset the decline in corporate earnings. How likely is such an outcome? To get a sense of the answer, let us consider a simple example where, prior to the pandemic, cash flows to shareholders were expected to grow by 2% per annum, the risk-free interest rate was 2%, and the equity risk premium was 5% (implying a discount rate of 7%). Let us suppose that the pandemic temporarily reduces corporate profits by 60% in 2020, 40% in 2021, and 20% in 2022 relative to the aforementioned baseline, with earnings returning to trend beyond then (Chart 1, Scenario 1). All things equal, an earnings shock of this magnitude would reduce the present value of corporate profits by 5.4%. For the present value to return to its original level, the discount rate would have to fall by 27 bps. How does this example square with reality? While it is impossible to know what would have happened in the absence of the pandemic, we can observe that S&P 500 EPS estimates have so far fallen by 22% for 2020 and 11% for both 2021 and 2022 since the start of the year. Meanwhile, the 30-year TIPS yield – a proxy for long-term real interest rates – has fallen by 75 bps, and is down 138 bps since the beginning of 2019. Based on this comparison, one can conclude that the decline in rate expectations has been large enough to offset the drop in projected earnings. Four Counterarguments The discussion above makes a number of assumptions that could easily be challenged. Let us consider four counterarguments to the claim that the pandemic has increased the long-term fair value of equities. As we shall see, while all four counterarguments are valid, none of them are bulletproof. Bottom-up earnings estimates are too optimistic. As estimates come down, so will stock prices. Calculations of long-term risk-free rates are being distorted by QE and other factors. If a more cautious mindset results in a lower risk-free rate, it should also result in a higher equity risk premium (ERP). A higher ERP would push up the discount rate, reducing the fair value of the stock market. The pandemic could lead to a variety of investor-negative outcomes, including further deglobalization, higher corporate taxes, and the loss of policy maneuverability during the next downturn. Let us examine all four of these counterarguments in turn. 1. Are Earnings Estimates Too Optimistic? BCA’s US equity strategists expect S&P 500 companies to generate $104 in EPS this year and $162 in 2021. A simple weighted-average of these estimates implies a forward 12-month EPS of $123, compared with the current consensus of $140. Could the pandemic end up raising the long-term fair value of equities? Granted, consensus estimates for any given calendar year usually start high and drift lower over time, reflecting the overoptimistic bias of bottom-up analysts (Chart 2). Nevertheless, the gap between where consensus is today and where we think it will end up is large enough that further negative revisions could still weigh on stocks. As evidence, note that stock prices tend to move in the same direction as earnings revisions and 12-month ahead earnings estimates (Chart 3). Chart 2Are Earnings Estimates Too Optimistic? Chart 3Negative Earnings Revisions Will Weigh On Stocks In The Near Term The discussion above suggests that stocks could face some downward pressure in the near term, reflecting the tendency for investors to myopically focus on earnings over the next 12 months. This does not, however, negate the possibility that the pandemic could raise the long-term present value of future cash flows. After all, even the earnings projections from our equity strategists are much more benign than those in the stylized example of a 60%, 40%, and 20% decline in EPS for the next three years. In fact, to get something that fully offsets the decline in real yields since the start of the year requires a scenario that not only assumes a 60%, 40%, and 20% drop in earnings, but also assumes that profits remain 10% lower forever relative to the baseline (Chart 1, Scenario 2). 2. Are Estimates Of Long-Term Risk-Free Rates Distorted To The Downside? Chart 4Rate Expectations Have Come Down So far, we have argued that earnings are unlikely to fall by enough over the next few years to counteract the steep drop in long-term interest rates. But, perhaps the problem is not with the earnings projections? Perhaps the problem is with the estimates of the long-term risk-free rate? Conceptually, long-term government bond yields should incorporate the market’s expectation of how short-term interest rates will evolve over the life of the bond plus a “term premium.” The inelegantly named term premium is a catch-all, unobservable variable that captures everything that affects bond yields other than changes in rate expectations. Term premia have fallen in global bond markets since the start of the year, partly because central banks have ramped up bond buying programs with the express intent of pushing down long-term yields. Nevertheless, rate expectations have also come down, as can be gleaned from forward contracts linked to expected overnight rates (Chart 4). This suggests that expectations of lower rates have played an important role in explaining the decline in bond yields. In any case, it is not clear why one should control for the term premium in calculating discount rates. If the idea is to compare bonds with stocks, then one should look at bond yields directly, rather than trying to ascertain what yields would hypothetically be in the absence of various distortions – especially if these distortions are unlikely to go away anytime soon. You can’t eat hypothetical profits. 3. Projecting The Equity Risk Premium If overly optimistic earnings estimates and a distorted risk-free rate cannot fully counteract the claim that the pandemic has raised the long-term fair value of equities, what about the third driver of present value calculations: the equity risk premium (ERP)? While the ERP cannot be observed directly, it is possible to infer it by looking at the difference between the long-term earnings yield and the real bond yield. Under some simplifying assumptions, the earnings yield provides a good estimate of the long-term real total return to holding stocks.1 To the extent that the earnings yield has risen this year, while the risk-free rate has fallen, one can infer that the equity risk premium has gone up. However, there is no money in observing today’s equity risk premium; the money is in projecting it. The equity risk premium can shift a lot over the course of the business cycle. This is why the stock-to-bond ratio moves so closely with, say, the ISM manufacturing index (Chart 5). Chart 5Stock-To-Bond Ratio And Economic Growth Go Hand-In-Hand Like many financial market variables, the ERP has tended to be mean reverting. Today, the ERP is above its long-term average both in the US and the rest of the world, which suggests that it may decline over time (Chart 6). If that were to happen, stocks would almost certainly outperform bonds. Chart 6Favor Equities Over Bonds Over A 12-Month Horizon Yet, in an environment where caution reigns supreme, might the ERP stay elevated? After all, if risk-free bond yields remain low because people are more reluctant to spend, wouldn’t that mean that investors will continue to demand an additional premium to holding stocks? Perhaps, but this assumes that bonds will retain their safe-haven characteristics. There are two reasons to think that these characteristics may fray in a post-pandemic world. First, with policy rates now close to zero in most markets, there is a limit to how much further bond yields can decline. This means that bond prices will not rise much even if the recession lasts much longer than expected (Table 1). Table 1Bonds Won't Provide Much Of A Hedge Even In A Severe Recession Scenario Second, looking further out, highly indebted governments may try to dissuade central banks from raising rates even once unemployment has fallen back to normal levels. This could lead to higher inflation, imperiling bond investors. While such an outcome would not necessarily be good for stocks, equities will be more insulated than bonds because nominal profits tend to rise more quickly in an environment of higher inflation. As such, one could plausibly argue that the equity risk premium should not be any higher, and conceivably should be lower, in a post-pandemic world. 4. Unintended Consequences Chart 7Global Trade Was Already Stalling While it is too early to say with any confidence what the long-term effects of the pandemic will be, it is certainly possible that they will be momentous. Globalization had already stalled before the eruption of the Sino-US trade war (Chart 7). It could go into reverse if trade tensions remain elevated and countries increasingly focus on ensuring that they have enough domestic capacity to produce various essential goods. Support for pro-business, laissez-faire policies could also wane further. Prior to the pandemic, BCA’s geopolitical team gave President Trump a 55% chance of being re-elected. Now, with the economy in shambles, they only give him a 35% chance. If the Democrats take control of the White House and both Houses of Congress, Trump’s corporate tax cuts are sure to be watered down if not fully reversed. The pandemic could also limit the ability of policymakers to respond to the next downturn. Interest rates cannot be cut further and high debt levels may limit fiscal maneuverability, especially for countries that do not have access to their own printing press. To be sure, there could be some silver linings. Many lessons have been learned over the past few months. If another pandemic were to occur, we will be better prepared. Meanwhile, gratuitous business travel will be curtailed now that people have grown more comfortable with videoconferencing. And just like the space race inspired a generation of scientists and engineers, the pandemic could motivate more young people to pursue a career in medical research. Investment Conclusions While not our base case, we would subjectively assign a 25% probability to an outcome where the pandemic ends up raising the long-term present value of corporate cash flows by pushing down the discount rate by more than enough to offset the near-term drop in profits. Chart 8Don't Rush Into Growth Stocks Just Yet, As Value Stocks Are Still Cheap Even if the pandemic leaves stocks lower than they otherwise would have been, the current equity risk premium is high enough to warrant overweighting global equities over bonds on a 12-month horizon. Of course, stocks are unlikely to sail smoothly to new highs on the back of lower interest rates alone. As we discussed last week in a reported entitled “Still Stuck in The Tree,” it will be difficult to dismantle ongoing lockdown measures until a mass-testing regime is put in place, something that is still at least a few months away at best.2 With the data on the economy and corporate earnings set to disappoint in the near term, stocks could give up some of their recent gains. Thus, while we are still bullish on equities on a long-term horizon, we are more cautious on a short-term, 3-month horizon. Drilling further down, the decline in long-term rates this year is likely to create winners and losers across all asset classes. Some of the winners and losers are fairly straightforward to identify. For instance, growth stocks, whose market value hinges on anticipated cash flows that may not be realized until far into the future, gain relatively more from lower rates than value stocks. Banks, which are overrepresented in value indices, have suffered from the flattening of yield curves and lower rates in general. That said, given that value stocks currently trade at a multi-decade discount to growth stocks, we would not recommend that clients chase growth stocks at this juncture (Chart 8). Other winners and losers from lower rates may be less readily discernible. For example, consider the US dollar. The greenback benefited over the past few years from the fact that US rates were higher than those abroad. That rate differential has narrowed significantly recently as the Fed brought interest rates down to zero (Chart 9). Yet, the dollar has managed to remain well bid thanks to safe-haven flows into the Treasury market. Looking out, if the Fed succeeds in easing dollar funding pressures, as we expect will be the case, the dollar will weaken. Chart 9Rate Differentials Are No Longer A Tailwind For The US Dollar The plunge in near-term oil futures this week was a reminder of the extent to which the pandemic has suppressed crude demand. Transportation accounts for over half of global oil usage. Going forward, the combination of a weaker dollar, increased supply discipline, and a rebound in global growth in the second half of this year will help lift oil prices (Chart 10). Our energy analysts see WTI and Brent returning to $38/bbl and $42/bbl, respectively, by the end of the year following the drumming they received this week (Chart 11).3 Chart 10Commodity Prices Usually Rise When The Dollar Weakens Chart 11Oil Prices Expected To Recover Oil prices tend to be strongly correlated with inflation expectations (Chart 12). As inflation expectations rise, real rates could fall further, giving an additional boost to equity valuations. Chart 12Inflation Expectations And Oil Prices Tend To Move Closely Together Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 For a more in-depth discussion on this, please see Global Investment Strategy Special Report, “TINA To The Rescue,” dated August 23, 2019. 2 Please see Global Investment Strategy Weekly Report, “Still Stuck In The Tree,” dated April 16, 2020. 3 Please see Commodity & Energy Strategy Weekly Report, “USD Strength Restrains Commodity Recovery,” dated April 23, 2020; Special Alert, “WTI In Free Fall,” dated April 20, 2020; and Weekly Report, “US Storage Tightens, Pushing WTI Lower,” dated April 16, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores