Trade / BOP
Feature Chart I-1Lebanese Bond Yields Have Surged To Precarious Levels In a May 2018 Special Report, we warned that a devaluation and government default were only a matter of time in Lebanon. The country's sovereign US dollar bond yields have now reached a whopping 21% and local currency interest rates stand at 18% (Chart I-1). On the black market, the Lebanese pound is already trading 12% below its official rate. A public run on banks and bank deposit moratorium, as well as public debt default and a massive currency devaluation are now unavoidable. A Classic Case Of EM Bank Run And Currency Devaluation… The current state of Lebanon’s balance of payments (BoP) is disastrous: The current account (CA) deficit has oscillated between 10% and 20% of GDP in the past 10 years (Chart I-2). This wide CA deficit has been funded by speculative portfolio flows into local currency government bonds, sovereign bonds and bank deposits. However, since the middle of 2018 these inflows have dried up. In turn, to defend the currency peg to the US dollar and avoid a currency depreciation in the face of the BoP deficit, the Central Bank of Lebanon (BDL) has been depleting its foreign exchange (fx) reserves, i.e., the central bank has been financing the BoP deficit (Chart I-3). Chart I-2Lebanon's Chronic Current Account Deficit Chart I-3Lebanon: The BoP Has Been Deteriorating Substantially BDL’s gross fx reserves – including gold – have dropped from $48 billion in 2018 to its current level of $43 billion. We estimate that BDL’s net foreign exchange reserves excluding commercial banks’ US dollar deposits at BDL are at just $26 billion. This amount is insufficient in light of the panic-induced outflows the country and the banking system are experiencing.1 As a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon. Chart I-4Depositors’ Are Heading For The Exit Worryingly, as a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon.2 Moreover, after opening their doors, Lebanese commercial banks are now imposing unofficial capital controls – they are paying US dollar deposits in local currency only and are no longer providing dollar-denominated credit lines to businesses and importers. This will only intensify the panic among depositors. Chart I-4 illustrates that local currency deposits have already been declining while US dollar deposits have been slowing, and will likely begin contracting soon. In short, capital outflows will intensify in the coming weeks as people and businesses quickly realize that banks cannot meet their demand for deposits. Critically, we suspect Lebanese commercial banks are short on US dollars to meet people’s demand for the hard currency. Commercial banks’ net foreign currency assets stand at negative $70 billion or 127% of GDP. They hold, roughly, somewhere around $20 billion worth of US dollars in the form of liquid and readily available deposits (in banks abroad and deposits in the central bank) versus $124 billion worth of dollar deposits. Over the years, Lebanese commercial banks have been an attractive place for investors and residents to park their US dollars given the high interest rate paid by the banks. In turn, Lebanese commercial banks have been converting these US dollar deposits into local currency in order to buy government bonds. With domestic bonds yielding well above the rates on US dollar deposits - and given the exchange rate peg to the dollar - commercial banks have been de facto playing the carry trade. In addition, commercial banks also lent some of these dollars directly to the private sector. With the economy collapsing and the widening dollar shortage, banks will not be able to either collect their dollar loans or purchase dollars in the market. Without new dollar funding – which is very likely to persist – banks will fail to meet the demand for dollars. As a result, a bank run is imminent. At this point, the sole option is for the central bank to keep pushing local interest rates higher to discourage capital flight and a run on the banks. Yet, at 18% and surging, interest rates will suffocate the Lebanese economy and the property market. This will dampen sentiment further and cause a bank run. Bottom Line: A bank run is brewing and bank moratorium as well as currency devaluation are inevitable. …As Well As Public Debt Default Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Chart I-5Public Debt Dynamics Are Toxic Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Commercial banks own 37% of outstanding government debt. This will come on top of skyrocketing private-sector non-performing loans and will push banks into outright bankruptcy. Lebanon’s fiscal and public debt dynamics have reached untenable levels. The fiscal deficit stands at 10% of GDP and total public debt stands at 150% of GDP (Chart I-5). Surging government borrowing costs will push interest payments as a share of government aggregate expenditures to extremely high levels. These are unsustainable fiscal and debt arithmetics (Chart I-6). Meanwhile, government revenues will decline as growth falters (Chart I-6, bottom panel). The pillars of the Lebanese economy – private credit growth and construction activity – have been already collapsing (Chart I-7). Chart I-6Surging Interest Rates Will Make Public Debt Servicing Impossible Chart I-7Lebanon: Domestic Economy Has Been Collapsing Bottom Line: The Lebanese government will be forced to default on both local currency and dollar debt. This will be the final nail in the coffin of the Lebanese banking system. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1 BDL does not publish its holding of net foreign exchange reserves. However, other estimates of BDL’s net fx reserves are even lower. Please refer to the following paper: Financial Crisis In Lebanon, by Toufic Gaspard and the following article: Lebanon Warned on Default and Recession as Its Reserves Decline. 2 Banks shut down allegedly as a result of the ongoing civil disobedience that was sparked by the government’s reckless decision to tax WhatsApp's call service. The protests quickly escalated to a country-wide uprising, causing the government to resign on October 29.
Highlights The slowdown in global industrial activity appears to have bottomed. This, along with an apparent shared desire for a ceasefire in the Sino-US trade war, points toward a measured recovery in manufacturing and global trade, which will contribute to higher iron-ore and steel demand beginning in 1H20. A trade-war ceasefire, should it endure, will reduce global economic uncertainty. Along with continued monetary accommodation from systematically important central banks, reduced economic uncertainty will boost global growth and industrial-commodity demand generally by allowing the USD to weaken. We expect Beijing policymakers to remain focused on keeping GDP growth above 6.0% p.a. To that end, we believe a boost in infrastructure spending next year is likely, which also will be bullish for steel demand. Given China’s growing share of global steel production, we expect price differentials for high-grade iron ore – most of which comes from Brazil – to widen as steel demand increases next year. Given this view, we are initiating a strategic iron-ore spread trade at tonight’s close: Getting long December 2020 high-grade (65% Fe) futures traded on the Singapore Exchange vs. short the benchmark-grade (62% Fe) December 2020 futures traded on the CME. We recommend a 20% stop-loss on this recommendation. Feature Iron ore and steel demand will get a lift from the rebound our proprietary Global Industrial Activity (GIA) index has been forecasting for the past few months (Chart of the Week). The GIA index is designed to pick up changes in Chinese industrial activity, given its outsized influence on world industrial output, and also makes use of trade data, FX rates, and global manufacturing data. The rebound we are expecting will get a fillip from an apparent shared desire for a ceasefire in the Sino-US trade war, which, based on media reports, is close to being agreed. Should this ceasefire prove to be durable, it would contribute to a lowering of global economic policy uncertainty (GEPU), which, as we have shown recently, has kept the USD well bid to the detriment of industrial-commodity demand.1 Chart of the WeekBCA GIA Index Pick-Up Points To Higher Global Steel Demand While we do expect economic uncertainty to decline next year, it will remain elevated due to continued Sino-US trade tensions – even if a “phase-one” deal is agreed – ongoing hostilities in the Persian Gulf, and popular discontent with the political status quo globally. As global economic uncertainty fades, the USD broad trade-weighted index for goods (TWIBG) will fall, which will bolster EM GDP growth, and a recovery in global trade next year (Chart 2). If, as media reports suggest, this so-called “phase-one” agreement includes a relaxation – or complete removal – of tariffs by the US on Chinese imports, we would expect manufacturing activity to pick up as Chinese manufacturers spin-up capacity to meet demand. A reduction in tariffs also will lessen the deadweight loss they imposed on US households, which will support higher consumption.2 Chart 2Reduced Global Economic Uncertainty Bolsters Global Trade Volumes, EM GDP That said, economic uncertainty still remains high. This uncertainty is destructive of demand and will remain a key risk factor in 2020. While we do expect economic uncertainty to decline next year, it will remain elevated due to continued Sino-US trade tensions – even if a “phase-one” deal is agreed – ongoing hostilities in the Persian Gulf, and popular discontent with the political status quo globally. China’s Steel Demand Holds Up In Trade War China accounts for more than half of global steel production and consumption, and the lion’s share of seaborne iron-ore consumption (Chart 3). This makes its steel industry critically important to the global economy, and a key barometer of industrial activity worldwide. With global industrial activity bottoming and moving higher, and the USD expected to weaken, we expect iron ore demand and steel production in China to move higher next year as domestic and global demand for steel rises. China’s apparent steel demand held up fairly well during the slowdown observed in manufacturing and in commodity demand growth globally, averaging 8% y/y growth ytd (Chart of the Week, bottom panel). It now appears to be stalling in the wake of the global manufacturing slowdown. In addition, Chinese credit stimulus remains weak, contrary to expectations. However, with global industrial activity bottoming and moving higher, and the USD expected to weaken, we expect iron ore demand and steel production in China to move higher next year as domestic and global demand for steel rises.3 Chart 3China Dominates Global Steel Production and Consumption Chart 4Construction, Real Estate Strength Offset Lower Chinese Auto Production Greater demand for steel by the construction and real estate sectors offset lower consumption by the automobile industry in China this year, as manufacturing and trade slowed globally (Chart 4). Overall, apparent demand is still growing (Chart 5), which will continue to support iron ore imports, even though domestic production of low-grade ore picked up as steelmakers’ margins tightened earlier in the year (Chart 6). Chart 5China"s Apparent Steel Demand Growth Holds Up During Industrial Slowdown Chart 6China Iron Ore Imports Remain Stout Chinese imports from Brazil have rebounded following the Brumadinho tailings dam collapse in January at Vale’s Córrego do Feijão iron ore mine, which killed close to 300 people. The collapse in margins from steel mills combined with outages to Brazil and Australia high-grade ore exports led to a rise in imports and domestic production of low-grade iron ore. High-Grade Iron Ore Favored; Policy Uncertainty Persists Our overall view for industrial commodities – iron ore, steel, base metals and crude oil – is constructive but not wildly bullish going into next year. Our oil view, for example, calls for a rally in the average price of crude oil next year of ~ 10% from current levels for Brent crude oil, the world benchmark. While we expect global monetary stimulus to offset much of the tightening of financial conditions brought on by the Fed’s rate hikes last year, and China’s de-leveraging campaign of 2017-18, elevated economic uncertainty will keep the USD better bid that it otherwise would be absent the Sino-US trade war and global economic policy uncertainty. This translates into weaker commodity demand, generally, as a strong USD raises local-currency costs for consumers and lowers local-currency production costs for producers. At the margin, both push commodity prices lower. On a relative basis, we expect the more efficient, less-polluting technology likely will be called on to meet higher steel demand – in China and globally – next year, which means higher-grade iron ore will be favored by Chinese steel mills as profitability improves. For iron ore and steel in particular, environmental considerations also are important, given the Chinese government's “Blue Skies Policy” aimed at reducing the country’s high levels of air pollution.4 This policy has led to the forced retirement of older, highly polluting steelmaking capacity, which has been replaced with newer, less-polluting technology that favors high-grade iron ore. However, the application of regulations designed to reduce pollution has been uneven, and still relies on local compliance, which has been spotty. We expect demand for high-grade ore will increase as global manufacturing and trade also recovers. On a relative basis, we expect the more efficient, less-polluting technology likely will be called on to meet higher steel demand – in China and globally – next year, which means higher-grade iron ore will be favored by Chinese steel mills as profitability improves. The restoration of high-grade exports from Brazil means this ore will be available. It is worthwhile noting that these steelmakers account for an increasing share of global capacity. For this reason, we expect demand for high-grade ore will increase as global manufacturing and trade also recovers (Chart 7). Given our view, at tonight’s close we will get long December 2020 high-grade iron-ore futures (65% Fe) traded on the Singapore Exchange vs. short benchmark-grade iron-ore futures (62% Fe) traded on the CME. Both are quoted in USD/MT and settle basis Chinese port-delivery (CFR) indexes in cash. Given the uncertain nature of the durability and depth of the ceasefire currently being negotiated by the US and China, we will keep a stop-loss on this position of 20%. Bottom Line: China’s steel demand has held up relatively well despite the global slowdown in manufacturing and trade. Given our expectation for a pick-up in global growth – in response to global monetary and fiscal stimulus and lower economic uncertainty in the wake of a ceasefire in the Sino-US trade war – we expect Chinese steel demand to resume growing. This will support iron ore prices, particularly for high-grade ores. On the back of this expectation, we are recommending an iron-ore spread trade, going long high-grade futures vs. short benchmark-grade iron ore futures. Chart 7High-Grade Iron Ore Should Outperform Strategically Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Market Round-Up Energy: Overweight. Bloomberg reported China is looking to invest between $5-$10 billion in the Saudi Aramco IPO through various vehicles. Such an investment would give China a deeper stake in the Kingdom’s oil industry, and a hedge to price shocks. In addition, it could open the way for deeper investment in the Saudi oil and petchems industries. For KSA, as we have argued in the past, a deepening of China’s investment and involvement in the Kingdom’s economy would diversify the states that have a vested interest in ensuring its safety.5 We will be updating our analysis of China’s pivot to the Middle East, and KSA’s pivot to Asia next week. Separately, we the last of our Brent backwardation trades – i.e., long December 2019 Brent vs. short December 2020 Brent – was closed last week with a gain of 110.8%. Base Metals: Neutral. Copper prices are up 6% vs. last month, supported by supply-side worries in Chile and, more recently, easing trade tensions. Cyclically, we believe copper prices are turning up – spurred by easy monetary conditions and fiscal stimulus directed at infrastructure and construction spending. Most of our key commodity-demand indicators have bottomed and are suggesting EM demand growth will move up. This supports a year-end base metal rally. Precious Metals: Neutral. A risk-on sentiment fueled by expectation the U.S. and China will sign a trade deal weighs on gold’s safe-haven demand. Prices fell 2% since last week. Additionally, U.S. 10-year bond yields shot higher – pushing gold prices lower – on Tuesday following a stronger-than-expect ISM services PMI data release. Gold-backed ETF holdings reached a new record in September at 2,855 MT (up 377 MT ytd), surpassing the December 2012 peak. A reversal in investors’ sentiment towards gold could send prices down. Ags/Softs: Underweight. The USDA reported that 52% of the U.S. corn has been harvested, a 13 percentage point increase relative to last week, yet the figure came shy of analysts’ expectation and far below the 2014-2018 average of 75%. On a weekly basis, corn prices are still down 2% due to drier weather forecast. Soybean harvest did better reaching 75%, and meeting expectations. Soybean price is almost unchanged on a weekly basis, despite having edged higher earlier in the week on the back of rising expectations the US and China will agree on a ceasefire in the ongoing trade war. Footnotes 1 We measure this uncertainty using the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index. This is a GDP-weighted index of newspaper headlines containing a list of words related economic uncertainty. Newspapers from 20 countries representing almost 80% of global GDP are scoured for reports reflecting economic uncertainty. Please see our October 17 and October 31, 2019, reports Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth and Global Financial Conditions Support Higher Commodity Demand for the original research on this topic. Both are available at ces.bcaresearch.com. 2 We discuss deadweight losses to US households arising from the tariffs in Waiting To Get Long Copper, In China’s Steel Slipstream, published August 29, 2019. It is available at ces.bcaresearch.com. 3 BCA Research’s China Investment Strategy expects China’s business cycle likely will bottom in 1Q20 of next year, rather than in 4Q19. This aligns with our expectation. Please see China Macro And Market Review, published November 6, 2019. It is available at cis.bcaresearch.com. 4 We examined the implications of China’s “Blue Skies” policy in China's Anti-Pollution Resolve Critical To Iron Ore Markets, published April 4, 2019. It is available at ces.bcaresearch.com. 5 We discuss these issues in our Special Report entitled ضد الواسطة published November 16, 2018. The Arabic title of the report translates as "Against Wasta." Wasta means reciprocity in formal and informal dealings. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
Highlights An expansion in the Federal Reserve’s balance sheet will increase dollar liquidity. This should be negative for the greenback, barring a recession over the next six to 12 months. Interest rate differentials have largely moved against the dollar. The biggest divergences are versus the more export-dependent NOK, SEK and GBP. A weak dollar will supercharge the gold uptrend. Gold will also benefit from abundant liquidity, and persistently low/negative real rates. Remain short USD/JPY. The path to a lower yen is via an overshoot, as the BoJ will need a shock to act more aggressively. The Bank of Canada left rates on hold, but may be hard-pressed to continue meeting its inflation mandate amid a widening output gap. Go long AUD/CAD for a trade. Feature Chart I-1A Well-Defined Channel The DXY index has been trading within a very narrow band this year, defined by the upward-sloped channel drawn from the February lows (Chart I-1). At 97, the DXY index is just a few ticks away from the lower bound of this channel, which could be tested in the coming weeks. A decisive break below will represent an important fundamental shift, since it will declare the winner in the ongoing battle between deteriorating global growth and easing financial conditions. Global Growth And The Dollar One of the defining features of the currency landscape last year was that U.S. interest rates became too tight relative to underlying conditions. This tightened dollar liquidity both domestically and abroad. Chart I-2 plots the neutral rate of interest in the U.S. relative to the fed funds target rate. A widening gap suggests underlying financing conditions are low relative to the potential growth rate of the economy. Not surprisingly, this also tends to track the yield curve pretty closely, assuming long-term rates are a proxy for the economy’s structural growth rate, while short-term rates reflect borrowing costs. For economic agents, a narrowing spread suggests a rising risk of capital misallocation, as the gap between the cost of capital and return on capital closes. This is most evident for banks through their net interest margins. At the epicenter of this shrinking spread are the Fed’s macroeconomic policies. These include raising interest rates (especially in the face of a trade slowdown) and/or shrinking its balance sheet. These are the very policies that also tend to strengthen the greenback. The result is a rise in the velocity of international U.S. dollars, pushing up offshore rates and lifting the cost of capital for borrowing countries. A widening gap between U.S. neutral rate of interest and fed funds target rate suggests underlying financing conditions are low relative to the potential growth rate of the economy. This has been the backdrop for the dollar for much of the past two years. The good news is that more recently, the Fed has been quick to rectify the situation. The funding crisis among U.S. domestic banks will be resolved through repurchase agreements and a resumption of the Fed's bond purchases. Chart I-3 shows that the interest rate the Fed pays on excess reserves may soon exceed the effective fed funds rate, meaning the liquidity crisis among U.S. banks may soon be over. Correspondingly, banks’ excess reserves should start rising anew. The drop in rates and the easing in funding conditions have been partly sniffed out by a steepening yield curve (Chart I-3, bottom panel). This will incentivize banks to lend, which in turn, will boost U.S. money supply. As the economy recovers and demand for imports (machinery, commodities, consumer goods) rises, this will widen the current account deficit and increase the international supply of dollars. This should further calm dollar offshore rates, helping short-circuit any negative feedback loops that might have hampered growth in the past. Chart I-2The Fed Has Pivoted Chart I-3Easing Liquidity Strains The message from both global fixed-income markets and international stocks is that we may have reached a tipping point, where easing in financial conditions is sufficient to end the manufacturing recession. This is especially the case given this week’s breakout in the S&P 500, the Swedish OMX, and the Swiss Market Index (Chart I-4) – indices with large international exposure and very much tied to the global cycle. Such market cycles also tend to correspond with a weaker dollar, especially when the return on capital appears marginally higher outside the U.S. (Chart I-5). Chart I-4A Few Equity Breakouts Chart I-5Europe And EM Leading The Rally Chart I-6Less Stress In Offshore USD Funding Bottom Line: Rising dollar liquidity appears to have started greasing the international financial supply chain. One way to track if dollar funding is becoming more abundant is through the convenience yield, or cross-currency basis swap.1 This measures the difference in yield between an actual Treasury bond and a synthetic one trading in the offshore market. On this basis, we are well below the panic levels observed over the past decade (Chart I-6). Interest Rate Differentials And International Flows If the rise in global bond yields reflects a nascent pickup in growth, then the message from interest rate differentials has been clear: This growth pickup will be led by non-U.S. markets, similar to the message from international equities. Should the nascent pickup in global growth morph into a synchronized recovery, this will go a long way in further eroding the U.S.’ yield advantage. More specifically, the currencies that have borne the brunt of the manufacturing slowdown should also experience the quickest reversals. This is already being manifested in a very steep rise in their bond yields vis-à-vis those in the U.S. (Chart I-7A and Chart I-7B). For example, yields in Norway, Sweden, Switzerland and Japan have risen by an average of 75 basis points versus those in the U.S. since the bottom. Should the nascent pickup in global growth morph into a synchronized recovery, this will go a long way in further eroding the U.S.’ yield advantage. Chart I-7AInterest Differentials And Exchange Rates Chart I-7BInterest Differentials And Exchange Rates International investors might still find U.S. bond markets attractive in an absolute sense, but the currency risk is just too big a potential blindside at the current juncture. Markets with the potential for currency appreciation such as Australia, Canada, Norway or even the European periphery within Europe might be better bets. Flow data highlights just how precarious being long U.S. dollars is. As of last August, overall flows into the U.S. Treasury market have been negative, which may have contributed to the bottom in bond yields. Net foreign purchases by private investors are still positive at an annualized US$166 billion, but the momentum of these flows is clearly rolling over. This is more than offset by official net outflows that are running at $314 billion (Chart I-8). As interest rate differentials have started moving against the U.S., so has foreign investor appetite for Treasury bonds. More importantly, private purchases have not been driven on a net basis by foreign entities, but by U.S. domestic concerns repatriating capital on the back of the 2017 Trump tax cuts. On a rolling 12-month basis, the U.S. was repatriating back close to net $US400 billion in assets, or about 2% of GDP. Given that the tax break was a one-off, flows have since started to ease, contributing to the ebb in Treasury purchases (Chart I-9). Chart I-8A Growing Dearth Of Treasury Buyers Chart I-9Repatriation Flows Are Ebbing Meanwhile, while U.S. residents have been repatriating capital domestically, foreign investors have been fleeing U.S. equity markets at among the fastest pace in recent years. On a rolling 12-month total basis, the U.S. saw an exodus of about US$200 billion in equity from foreigners earlier this year, the largest on record. Foreigners are still net buyers of about $265 billion in U.S. securities (mostly agency bonds), but the downtrend in purchases in recent years is evident. Bottom Line: Flows into U.S. assets are rapidly dwindling. This may be partly because as the S&P 500 makes new highs amid lofty valuations, long-term investors are slowly realizing that future expected returns will pale in comparison to history. Given that being long Treasurys and the dollar remains a consensus trade (Chart I-10), international investors run the risk of a potential blindside from a sharp drop in the dollar. Chart I-10Unfavorable Dollar Technicals Dollar Reserve Status And Gold The decline in the dollar may not mark the ultimate peak in the bull market that began in 2011, but at least it will unveil some of the underlying forces that have been chipping away at the dollar’s reserve status over the past few years. China has risen within the ranks to become the number one contributor to the U.S. trade deficit over the past few years. At the same time, Beijing has been destocking its holding of Treasurys, if only as retaliation against past U.S. policies, or perhaps to make room for the internationalization of the RMB. In a broader sense, there has been an underlying shift in the global economy away from dollars and towards a more diversified basket of currencies. This makes sense, given that a growing proportion of trading – be it in crude, natural gas, bulk commodities or even softs – is being done outside U.S. exchanges. Gold continues to outperform Treasurys, which has historically been an ominous sign for the U.S. dollar. Ever since the end of the gold/dollar link in the early ‘70s, bullion has stood as a viable threat to dollar liabilities. With the Fed about to embark on a renewed expansion of its balance sheet, we may have just triggered one of the necessary catalysts for a selloff in the U.S. dollar. This means that holding gold in dollars may become more profitable compared to other currencies (Chart I-11). Given that being long Treasurys and the dollar remains a consensus trade, international investors run the risk of a potential blindside from a sharp drop in the dollar. The one tectonic shift that has happened over the past decade is that central banks have become net gold buyers, holding 20% of all gold that has ever been mined. If that number were to rise to say 25% or even 30%, it could have the potential to propel the gold price up towards $2800/oz (Chart I-12). If you think such an idea is far-fetched, just ask the Swiss, who a few years ago called a referendum to increase their gold holdings from 7% of total reserves to 20%, or Russia that has seen its gold holdings rise from 2% to over 20% of total reserves. Chart I-11Watch Gold In ##br##USD Terms Chart I-12What If Central Banks Bought Gold More Aggressively? Bottom Line: Reserve diversification out of U.S. dollars is a trend that has been underway for a while now, and unlikely to change anytime soon. Gold will be a big beneficiary of this tectonic shift. A Few Trade Ideas If the dollar eventually weakens, the more export-dependent economies should benefit the most from a rebound in global growth, and by extension their currencies should be the outperformers. Within the G-10 universe, there would notably be the European currencies led by the Swedish krona, the Norwegian krone and the pound. The countries currently experiencing the steepest rise in interest rate differentials vis-à-vis the U.S. could be a prelude to which currencies will outperform (previously mentioned Chart I-7A). We expect commodity currencies to also hold firm, but this awaits further confirmation of more pronounced Chinese stimulus, which so far has not yet materialized. The Canadian dollar should also be a beneficiary from dollar weakness, with a technical formation that looks categorically bearish USD/CAD (Chart I-13). Should the 1.30 level be breached, the next level of support is around the 2017 lows of 1.20. The BoC left rates unchanged this week, but the dovish tone from Governor Stephen Poloz was a big reminder that no central bank wants to tolerate a more expensive currency for now. Looser fiscal policy and rising oil prices will eventually become growth tailwinds. Chart I-13A USD/CAD Breakout Or Breakdown? Chart I-14Canadian House Prices However, we will favor the Aussie over the loonie since the downturn in the Australian housing market appears much further advanced compared to Canada. And with macro-prudential measures already implemented in Vancouver and Toronto, there is a rising risk that Montreal could follow suit (Chart I-14). Historically, policy divergences between the Reserve Bank of Australia and the BoC have followed the relative growth profiles of their biggest export markets, and the message so far is that the RBA is well ahead of the curve in its dovish bias (Chart I-15). Go long AUD/CAD for a trade. Chart I-15Buy AUD/CAD Finally, the Bank Of Japan left interest rates unchanged but signaled it was willing to ease should the path towards their 2% inflation target be in question. As the central bank that has been pursuing the most aggressive monetary stimulus over the last few years, it is fair to say this week’s policy meeting was a non-event. The yen will continue to be buffeted by powerful deflationary tailwinds that are holding the Japanese economy hostage, as well as global economic uncertainty. In the event that global growth picks up, the yen will depreciate at the crosses, but can still rise versus the dollar. This puts long yen bets in a “heads I win, tails I don’t lose much” scenario. Bottom Line: Go long AUD/CAD and stay short USD/JPY. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Arvind Krishnamurthy and Hanno Lustig, “Mind the Gap in Sovereign Debt Markets: The U.S. Treasury basis and the Dollar Risk Factor,” Stanford University, August 29, 2019. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mixed: Preliminary GDP growth slowed to 1.9% quarter-on-quarter from 2% in Q3. PCE slowed to 1.5% quarter-on-quarter in Q3. Core PCE, on the other hand, increased to 2.2%. New home sales contracted by 0.7% month-on-month in September, while pending home sales grew by 1.5% month-on-month. The trade deficit narrowed marginally by $2.7 billion to $70.4 billion in September. Initial jobless claims increased by 5K to 218K for the week ended October 25th. The DXY index fell sharply after the Fed's press conference, ending with a loss of 0.6% this week. On Wednesday, the Fed cut interest rate by 25 bps for the third time this year to 1.75%, as widely expected. The fading interest rate differential will continue to be a headwind for the U.S. dollar. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been firm: GDP growth in the euro area slowed marginally to 1.1% year-on-year in Q3, down from 1.2% in the previous quarter. On a quarter-on-quarter basis, the growth was unchanged at 0.2%. Headline inflation in the euro area slowed slightly to 0.7% year-on-year in October. Core inflation however, increased to 1.1% year-on-year. Retail sales in Germany grew by 3.4% year-on-year in September, up from 3.1% in the previous month. EUR/USD increased by 0.5% this week amid broad dollar weakness. The current debate among central bankers in the Eurozone is whether ultra accommodative monetary policy is still warranted. This espouses the view that at least, to some members of the ECB, the neutral rate of interest in the Eurozone is higher than perceived. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-6JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly positive: Headline inflation was unchanged at 0.4% year-on-year in October. Core inflation however, increased marginally to 0.7% year-on-year in October. Retail sales soared by 9.1% year-on-year in September in anticipation of the consumption tax hike. Industrial production grew by 1.1% year-on-year in September, compared to a contraction of 4.7% year-on-year the previous month. Consumer confidence increased marginally to 36.2 from 35.5 in October. The yen appreciated by 0.5% this week against the U.S. dollar. The BoJ left its policy rate unchanged this Thursday, while reassuring markets that more stimulus could be added if needed in the future. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mixed: On the housing front, nationwide house prices increased by 0.4% year-on-year in October. Mortgage approvals increased marginally to 65.9K in September. Money supply (M4) grew by 4% year-on-year in September, up from 3.3% in the previous month. GfK consumer confidence fell further to -14 in October. The pound appreciated by almost 1% against the U.S. dollar this week. The E.U. has agreed on yet another Brexit extension until January 31st. An earlier exit is also possible if the U.K. so chooses. Meanwhile, the U.K. economy is holding up quite well despite the cloud of uncertainty. We remain tactically long GBP/JPY. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: Headline inflation increased to 1.7% year-on-year in Q3, up from 1.6% in the previous quarter. HIA new home sales grew by 5.7% month-on-month in September. Building permits contracted by 19% year-on-year in September. However on a monthly basis, it grew by 7.6% in September. AUD/USD surged by 1.2% this week. During a speech this Monday, RBA Governor Philip Lowe ruled out the possibility of negative interest rates in Australia, and urged businesses to start investing given historically low interest rates. Going forward, we expect the Aussie dollar to rebound amid a global growth recovery. New Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Building permits increased by 7.2% month-on-month in September. Business confidence came in at -42.4 in October. This was an improvement from -53.5 in the previous month. The activity outlook fell further to -3.5 from -1.8 in October. The New Zealand dollar soared by 0.9% against the USD this week. While we expect the kiwi to outperform the USD amid global growth recovery, it will likely underperform its pro-cyclical peers. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in the Canada have been firm: GDP grew by 0.1% month-on-month in August. Bloomberg Nanos confidence index fell marginally to 57.4 for the week ended October 25th. The Canadian dollar has depreciated by 0.7% against the U.S. dollar, making it the worst performing G-10 currency this week. The BoC decided to keep interest rates on hold this Wednesday, with relatively strong domestic growth and inflation on target. While growth in Canada has surprised to the upside, it might not prove sustainable. We are shorting the Canadian dollar this week against the Australian dollar. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15HF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mixed: KOF leading indicator increased to 94.7 in October, up from 93.9 in the previous month. ZEW expectations fell further to -30.5 in October. The Swiss franc has increased by 0.7% against the U.S. dollar this week. Domestic fundamentals remain strong in Switzerland, but are at risk from the global growth slowdown. As a safe-haven currency, a rising gold-to-oil ratio points to a higher franc. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales increased by 0.8% year-on-year in September. USD/NOK is flat this week amid broad dollar weakness. The Norwegian krone has diverged from the ebb and flow of energy prices, and is currently trading around two standard deviations below its fair value. While energy prices have recently been soft, the selloff in the Norwegian krone is exaggerated. We are looking to short CAD/NOK. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Consumer confidence rebounded to 92.7 in October. Retail sales increased by 2.6% year-on-year in September. Trade balance of goods shifted back to a surplus of SEK 2 billion in September, following the deficit of SEK 5.5 billion in August. Both imports and exports increased by SEK 6.6 billion and SEK 14.1 billion month-on-month, respectively. USD/SEK fell by 0.6% this week. The Swedish krona is much undervalued. A cheap krona should help to improve the balance of payments dynamics in Sweden. We expect the krona to bounce back sharply once global growth shows more signs of recovery amid a U.S.-China trade war détente. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Martin Barnes and I spent last week visiting clients in Hong Kong and Singapore in celebration of BCA’s 70th anniversary. Martin has been with BCA Research for 32 years and has been a keen observer of market trends for much longer than that. It is always fascinating to hear his thoughts on the state of world affairs. I have spent this week visiting clients in Sydney and Melbourne. I made the case that global growth will accelerate next year. Stronger growth will pull down the U.S. dollar, while pushing up bond yields, equities, and commodity prices. EM and European stocks will begin to outperform their global benchmark. Cyclical equity sectors (including financials) will outperform defensives. What follows are my answers to some of the most common questions I have been receiving. Best regards, Peter Berezin, Chief Global Strategist Feature Q: What makes you confident that global growth will rebound? A: Three things. First, global financial conditions have eased significantly thanks largely to the dovish pivot of most central banks. Reflecting this development, credit growth has picked up. This should support economic activity in the months ahead (Chart 1). Second, the manufacturing downturn seems to be running its course, as excess inventories continue to be liquidated (Box 1). As we have noted before, manufacturing cycles tend to last about three years, with 18 months of weaker growth followed by 18 months of stronger growth (Chart 2). Given that the current downturn began in the first half of 2018, we are probably approaching a bottom in growth. Chart 1Lower Rates Should Help Spur Growth Chart 2A Fairly Regular Three-Year Manufacturing Cycle Third, while there will be plenty of bumps along the road, trade tensions are likely to continue easing. As a self-described master negotiator, President Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement with China a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will only improve after he is re-elected. For their part, the Chinese would rather grapple with Trump now than risk either having to negotiate with him during his second term (when he will be unconstrained by re-election pressures) or having to negotiate with Elizabeth Warren (who may insist on including stringent environmental and human rights provisions in any trade deal). Better the devil you know than the devil you don’t, as they say. Q: Will a ceasefire between the U.S. and China really be enough to boost business confidence? Don’t we need to see an outright rollback of tariffs? A: We do not know if any tariffs will be rolled back as part of the “phase 1” deal that is currently being negotiated. Right now, the U.S. has only agreed to cancel the previously announced October 15th tariff hike on $250 billion of Chinese imports. A Reuters news story earlier this week indicated that China is also asking the U.S. scrap its plan to levy tariffs on $156 billion of Chinese imports on December 15th and to abolish the 15% tariffs on $125 billion in imports which were imposed on September 1st.1 Chart 3China Is No Longer As Dependent On Trade With The U.S. As It Once Was While the removal of some tariffs would be a positive development, it is not a necessary condition for a global growth revival. Remember that U.S. exports to China account for only 0.5% of GDP while Chinese exports to the U.S. account for 3.4% of GDP (Chart 3). The numbers are even smaller when measured in value-added terms. That does not mean that the trade war is irrelevant. An out-of-control trade war could cause the global supply chain to break down, leading to significant economic disruptions. To the extent that a détente greatly reduces the odds of such an outcome, it justifies a meaningful upgrade to the probability-weighted economic outlook. Q: What’s your read on the Chinese economy right now? A: China’s growth data have been mixed. The Caixin manufacturing purchasing managers’ index rose to 51.7 in October, the best reading since December 2016. The new orders subcomponent reached the highest level since September 2013. Export orders rose back above 50, registering the largest month-on-month increase of any of the subcomponents. In contrast, the “official” National Bureau of Statistics (NBS) manufacturing PMI, which mainly samples larger, state-owned companies, remained below 50 and sank to the lowest level since February. The NBS nonmanufacturing PMI also weakened. It is worth noting that unlike most of the industries tracked by the NBS, the construction sector PMI moved back above 60 in October. This is consistent with industry data showing that sales of reinforced steel bars, a good proxy for property construction, have accelerated. Electricity consumption has also picked up, which often bodes well for industrial output (Chart 4). Policy has generally remained supportive: Bank reserve requirements have been cut. Benchmark interest rates should come down over the coming months. Credit growth surprised on the upside in September. While the acceleration in credit formation has been more muted this past year than in 2015-16, the credit impulse has nevertheless moved off its late-2018 lows. The Chinese credit impulse leads global growth by about nine months (Chart 5). Chart 4A Positive Sign For Chinese Growth Momentum Chart 5The Chinese Credit Cycle Should Support Global Growth Chart 6China Stepped Up Fiscal Stimulus In 2019 Less noticed is the fact that fiscal policy has been eased significantly. According to the IMF, the augmented budget deficit – which includes spending through local government financing vehicles and other off-balance sheet expenditures – is on track to reach nearly 13% of GDP in 2019, a bigger deficit than during the depth of the Great Recession (Chart 6). Looking out, we expect Chinese growth to rebound next year as the global manufacturing downturn ends and trade war tensions subside. Q: How much of a growth rebound can we expect in Europe? A: The slowdown in the euro area has been concentrated in Italy and Germany. In contrast, growth in Spain and France has held up relatively well (Chart 7). Looking out, Italian growth should rebound thanks to the 270 bps decline in 10-year bond yields that has taken place since October 2018 (Chart 8). German growth should also recover on an improvement in world trade and a stabilization in global auto production and demand. Chart 7Euro Area Growth: The Good, The Bad, And The Ugly Chart 8Lower Yields Should Lift Italian Growth Q: Will we see fiscal stimulus in Europe? A: Yes. Fiscal policy remains quite tight in the euro area, but it is starting to loosen at the margin. The fiscal thrust should reach 0.4% of GDP this year, the highest level since 2010 (Chart 9). We expect further modest fiscal easing in 2020, even against a backdrop of stronger domestic economic growth. Chart 9Euro Area Fiscal Stimulus Will Also Boost Growth Chart 10Germany's Competitive Advantage Against The Rest Of The Euro Area Is Deteriorating Germany has been reluctant to increase its own budget deficit in the past. However, there are at least two reasons why this attitude may slowly change. First, there are growing calls within Germany for more spending on public infrastructure, including on ”green” measures to mitigate climate change. The fact that Germany can issue debt at negative rates only incentivizes fiscal easing. If you can get paid to issue debt, why not do it? Second, relatively fast wage growth has caused Germany to become less competitive against its neighbors over the past eight years. As a result, Germany’s trade surplus with the rest of the euro area has fallen in half (Chart 10). A shrinking trade surplus will require a bigger budget deficit to compensate for the loss of aggregate demand. Q: Is A “No Deal” Brexit still a risk? A: No. Westminster and the British Supreme Court have both rebuked Prime Minister Boris Johnson’s threat of a “no deal” Brexit. This means that the only outcome that would unsettle markets – a disorderly U.K. exit from the EU – is practically off the table. Two options remain: An orderly Brexit in which an eventual trade deal minimizes tariffs, or another referendum. There is no appetite for a no-deal exit. Furthermore, if another referendum on EU membership were held today, the remain side would probably win (Chart 11). Chart 11Brexit Angst: A Case Of Bremorse Q: Is the Fed done cutting rates? A: Yes. The FOMC statement removed the promise to “act as appropriate to sustain the expansion” and replaced it with a more neutral pledge to “monitor the implications of incoming information for the economic outlook”. If there were any ambiguity left about what this meant, Chair Powell squelched it by noting in his press conference that “monetary policy is in a good place” and “the current stance of policy [is] likely to remain appropriate.” This week’s “insurance cut” brings the total for this year to 75 bps. This is exactly the same amount of easing the Fed delivered in 1995/96 and 1998 — two episodes that are widely seen as successful mid-cycle course corrections. Today’s strong employment report and uptick in the ISM manufacturing index provide further evidence that the U.S. economy is on the right track. If U.S. and global growth continue to pick up as we expect, there will not be any need to cut rates further. Q: When can we expect the Fed to start hiking rates again? Chart 12Inflation Expectations Are Too Low A: Probably not until December 2020 at the earliest. This is partly because the Fed will want to stay out of the political fray leading up to the presidential election (perhaps wishful thinking). Arguably more important, the Fed, along with most market participants, has convinced itself that the neutral rate of interest is very low. If that is truly the case, raising rates is a risky strategy because it could cause growth to weaken at a time when inflation expectations are still below the Fed’s comfort zone (Chart 12). In his recent press conference, Powell seemed to go out of his way to stress that he would not make the same mistake he did last October when he said rates were “a long way from neutral”. Most notably, he said this week that the FOMC “would need to see a really significant move up in inflation that is persistent before we even consider raising rates to address inflation concerns.” Q: How worried should equity investors be about the prospect of President Warren? A: While Elizabeth Warren would not be a welcome treat for shareholders, she probably would not be a disaster either. Right now she is trying to elbow Bernie Sanders out of the race in order to lock up the “progressive” vote. Thus, it is not surprising that she has dialed up the far-left rhetoric. If Warren succeeds in securing the Democratic Party nomination, she will pivot to the centre. Remember this is the same person who said last year she was “a capitalist” and “I love what markets can do… They are what make us rich, they are what create opportunity.”2 Considering that financial sector reform has been the focus of Warren’s academic and legislative career, bank shareholders are understandably worried about what a Warren presidency would entail. They probably shouldn’t be. Banks today operate more like staid utilities than the reckless casinos they were prior to the financial crisis. A lot of the rules and regulations that Warren champions have already been implemented in one guise or another. In fact, it would not be a stretch to say that had these rules been in place 15 years ago, the share prices of many financial institutions would be a lot higher today (especially the ones that went under!). Lastly, one should keep in mind that the U.S. political system has numerous checks and balances. Even if Elizabeth Warren did want to pursue a radical agenda, she would be stymied by moderate Democrats and a Senate which, more likely than not, will remain in Republican control. Q: Taking everything you said on board, how should investors position themselves over the next 12 months? A: Despite the risks facing the global economy, investors should continue to overweight stocks relative to bonds in a balanced portfolio. A rebound in global growth next year will give corporate earnings a lift. As a countercyclical currency, the U.S. dollar is likely to weaken in an environment of improving global growth (Chart 13). The combination of stronger growth and a weaker dollar will boost commodity prices (Chart 14). Chart 13The Dollar Is A Countercyclical Currency Chart 14Dollar Weakness Is A Boon For Commodities Cyclical equity sectors normally outperform defensive sectors when the global economy is strengthening and the dollar is weakening (Chart 15). Chart15ACyclical Stocks Will Outperform If The Dollar Weakens Chart 15BCyclical Stocks Are More Attractive Than Defensives We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 16). Emerging market and European stocks have more exposure to cyclical sectors than U.S. stocks. Thus, it stands to reason that EM and European equities will outperform their U.S. peers over the next 12 months (Chart 17). Chart 16Steeper Yield Curves Will Benefit Financials Chart 17EM And Euro Area Equities Usually Outperform When Global Growth Improves Non-U.S. stocks also have the advantage of being cheaper, even if adjusted for differences in sector weights. U.S. equities currently trade at a forward PE ratio of 18, compared to 13 for non-U.S. stocks. Since interest rates are generally lower outside the U.S., the equity risk premium is especially wide for non-U.S. stocks (Chart 18). Chart 18Equity Risk Premia Remain Quite High Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector U.S. (October 2019): “Finally, despite a renewed rise in input buying, the stronger increase in new business meant firms increasingly dipped into stocks to ensure new orders were fulfilled in a timely manner. Therefore, pre-production inventories fell at the quickest rate for three months and stocks of finished goods decreased slightly.” Markit “The [inventory] index contracted for the fifth straight month, but at a slower rate. Improvements in new orders and stocking for the fourth quarter both contributed positively to the index compared to September” ISM (Institute for Supply Management) Germany (October 2019): “However, weighing on the index were faster decreases in employment and stocks of purchases, alongside a more marked improvement in supplier delivery times.” Markit U.K. (October 2019): “A number of firms revisited their Brexit preparations during October, leading to higher levels of input purchasing and a build-up of safety stocks. Growth in inventories of finished goods and purchases were at six-month highs, but remained below the survey-record rates reached during the first quarter.” Markit Japan (October 2019): “A reluctance to hold items in stocks was also signalled by simultaneous draw-downs to pre- and post-production inventories during the latest survey period. In fact, rates of depletion in both cases accelerated during the month, with stocks of finished goods falling at the fastest rate since survey data were first collected 18 years ago.” Markit Canada (October 2019): “Latest data signalled a marginal accumulation of preproduction inventories across the manufacturing sector. In contrast, stocks of finished goods were depleted for the first time in three months. A number of survey respondents commented on efforts to boost cash flow by streamlining their post-production inventories.” Markit China (October 2019): “Improved client demand led firms to expand their purchasing activity, with the rate of growth the quickest since February 2018. This contributed to a further rise in stocks of inputs, albeit marginal. Inventories of finished goods meanwhile declined amid reports of the greater use of stocks to fulfil orders.” Markit Taiwan (October 2019): “Stocks of both pre- and postproduction goods contracted at accelerated rates, with the latter falling solidly overall.” Markit Korea (October 2019): “Elsewhere, latest survey data highlighted a strong drive towards cost cutting, with firms clearing their existing stocks of both inputs and finished goods at accelerated rates.” Markit India (October 2019): “Both pre- and post-production inventories decreased in October. The fall in the latter was sharper and the quickest in 16 months.” Markit Russia (October 2019): “Finally, firms reduced their purchasing activity further as they supplemented production through the use of preproduction inventories. Stocks of finished goods also fell amid lower client demand and efforts to run down stores.” Markit Turkey (October 2019): “A muted easing of purchasing activity was recorded in October, while stocks of both purchases and finished goods were scaled back.” Markit Brazil (October 2019): “As a result, stocks of purchases fell at the quickest rate in 16 months. Post-production inventories likewise decreased to the greatest extent since mid-2018 during October. According to panel members, the fall was due to sales growth.” Markit Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1Please see David Lawder, and Andrea Shalal, “U.S., China say they are 'close to finalizing' part of a Phase One trade deal,” Reuters (October 25, 2019); and Alexandra Alper, and Doina Chiacu,"Trump: 'ahead of schedule' on China trade deal," Reuters (October 28, 2019). 2Please see John Harwood, “Democratic Sen. Elizabeth Warren: ‘I am a capitalist’ – but markets need to work for more than just the rich,” CNBC (July 24, 2018). Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Highlights The U.S. and China are moving toward formalizing a trade ceasefire that reduces geopolitical risk in the near term. The risk of a no-deal Brexit is finished – removing a major downside to European assets. Spanish elections reinforce our narrative of general European political stability. Go long 10-year Italian BTPs / short 10-year Spanish bonos for a trade. Geopolitical risks will remain elevated in Turkey, rise in Russia, but remain subdued in Brazil. A post-mortem of Canada’s election suggests upside to fiscal spending but further downside to energy sector investment over the short to medium term. Feature After a brief spike in trade war-related geopolitical risk just prior to the resumption of U.S.-China negotiations, President Trump staged a tactical retreat in the trade war. Chart 1Proxy For Trade War Shows Falling Risk Negotiating in Washington, President Trump personally visited the top Chinese negotiator Liu He and the two sides announced an informal “phase one deal” to reverse the summer’s escalation in tensions: China will buy $40-$50 billion in U.S. agricultural goods while the U.S. will delay the October 15 tariff hike. More difficult issues – forced tech transfer, intellectual property theft, industrial subsidies – were punted to later. The RMB is up 0.7% and our own measures of trade war-related risk have dropped off sharply (Chart 1). We think these indicators will be confirmed and Trump’s retreat will continue – as long as he has a chance to save the 2020 economic outlook and his reelection campaign. Odds are low that Trump will be removed from office by a Republican-controlled senate – the looming election provides the republic with an obvious recourse for Trump’s alleged misdeeds. However, Trump’s approval rating is headed south. While it is around the same level as President Obama’s at this point in his first term, Obama’s started a steep and steady rise around now and ended above 50% for the election, a level that is difficult to foresee for Trump (Chart 2). So Trump desperately needs an economic boost and a policy victory to push up his numbers. Short of passing the USMCA, which is in the hands of the House Democrats, a deal with China is the only way to get a major economic and political win at the same time. Hence the odds of Presidents Trump and Xi actually signing some kind of agreement are the highest they have been since April (when we had them pegged at 50/50). Trump will have to delay the December 15 tariff hike and probably roll back some of the tariffs over next year as continuing talks “make progress,” though we doubt he will remove restrictions on tech companies like Huawei. Still, we strongly believe that what is coming is a détente rather than the conclusion of the Sino-American rivalry crowned with a Bilateral Trade Agreement. Strategic tensions are rising on a secular basis between the two countries. These tensions could still nix Trump’s flagrantly short-term deal-making, and they virtually ensure that some form of trade war will resume in 2021 or 2022, if indeed a ceasefire is maintained in 2020. Both sides are willing to reduce immediate economic pain but neither side wants to lose face politically. Trump will not forge a “grand compromise.” Our highest conviction view all along has been – and remains – that Trump will not forge a “grand compromise” ushering in a new period of U.S.-China economic reengagement in the medium or long term. China’s compliance, its implementation of structural changes, will be slow or lacking and difficult to verify at least until the 2020 verdict is in. This means policy uncertainty will linger and business confidence and capex intentions will only improve on the margin, not skyrocket upward (Chart 3). Chart 2Trump Needs A Policy Win And Economic Boost Chart 3Sentiment Will Improve ... Somewhat The problem for bullish investors is that even if global trade uncertainty falls, and the dollar’s strength eases, fear will shift from geopolitics to politics, and from international equities to American equities (Chart 4). Trump, hit by impeachment and an explosive reaction to his Syria policy, is entering into dangerous territory for the 2020 race. Trump’s domestic weakness threatens imminent equity volatility for two reasons. Chart 4American Outperformance Falls With Trade Tensions Chart 5Democratic Win In 2020 Is Market-Negative First, if Trump’s approval rating falls below today’s 42%, investors will begin pricing a Democratic victory in 2020, i.e. higher domestic policy uncertainty, higher taxes, and the re-regulation of the American economy (Chart 5). This re-rating may be temporarily delayed or mitigated by the fact that former Vice President Joe Biden is still leading the Democratic Party’s primary election race. Biden is a known quantity whose policies would simply restore the Obama-era status quo, which is only marginally market-negative. Contrary to our expectations Biden's polling has not broken down due to accusations of foul play in Ukraine and China. Nevertheless, Senator Elizabeth Warren will gradually suck votes away from fellow progressive Senator Bernie Sanders and in doing so remain neck-and-neck with Biden (Chart 6). When and if she pulls ahead of Biden, markets face a much greater negative catalyst. (Yes, she is also capable of beating Trump, especially if his polling remains as weak as it is.) Chart 6Warren Will Rise To Front-Runner Status With Biden Second, if Trump becomes a “lame duck” he will eventually reverse the trade retreat above and turn into a loose cannon in his final months in office. Right now we see a decline in geopolitical risk, but if the economy fails to rebound or the China ceasefire offers little support, then Trump will at some point conclude that his only chance at reelection is to double down on his confrontation with America’s enemies and run as a “war president.” A cold war crisis with China, or a military confrontation with Iran (or North Korea, Venezuela, or some unexpected target) could occur. But since September we have been confirmed in believing that Trump is trying to be the dealmaker one last time before any shift to the war president. Bottom Line: The “phase one” trade deal is really just a short-term ceasefire. Assuming it is signed by Trump and Xi, it suggests no increase in tariffs and some tariff rollback next year. However, as recessionary fears fade, and if Trump’s reelection chances stabilize, U.S.-China tensions on a range of issues will revive – and there is no getting around the longer-term conflict between the two powers. For this and other reasons, we remain strategically short RMB-USD, as the flimsy ceasefire will only briefly see RMB appreciation. BoJo's Brexit Bluff Is Finished Our U.K. indicator captured a sharp decline in political risk in the past two weeks and our continental European indicators mirrored this move (Chart 7). The risk that the U.K. would fall out of the EU without a withdrawal agreement has collapsed even further than in September, when parliament rejected Prime Minister Boris Johnson’s no-deal gambit and we went long GBP-USD. We have since added a long GBP-JPY trade. Chart 7Collapse In No-Deal Risk Will Echo Across Europe Chart 8Unlikely To See Another Tory/Brexit Rally Like This The risk of “no deal” is the only reason to care about Brexit from a macro point of view, as the difference between “soft Brexit” and “no Brexit” is not globally relevant. What matters is the threat of a supply-side shock to Europe when it is already on the verge of recession. With this risk removed, sentiment can begin to recover (and Trump’s trade retreat also confirms our base case that he will not impose tariffs on European cars on November 14). Since Brexit was the only major remaining European political risk, European policy uncertainty will continue to fall. The Halloween deadline was averted because the EU, on the brink of recession, offered a surprising concession to Johnson, enabling him to agree to a deal and put it up for a vote in parliament. The deal consists of keeping Northern Ireland in the European Customs Union but not the whole of the U.K., effectively drawing a new soft border at the Irish Sea. The bill passed the second reading but parliament paused before finalizing it, rejecting Johnson’s rapid three-day time table. The takeaway is that even if an impending election returns Johnson to power, he will seek to pass his deal rather than pull the U.K. out without a deal. This further lowers the odds of a no-deal Brexit as it illuminates Johnson's preferences, which are normally hidden from objective analysis. True, there is a chance that the no-deal option will reemerge if Johnson’s deal totally collapses due to parliamentary amendments, or if the U.K. and EU have failed to agree to a future relationship by the end of the transition period on December 31, 2020 (which can be extended until the end of 2022). However, the chance is well below the 30% which we deemed as the peak risk of no-deal back in August. Johnson created the most credible threat of a no-deal exit that we are likely to see in our lifetimes – a government with authority over foreign policy determined to execute the outcome of a popular referendum – and yet parliament stopped it dead in its tracks. Johnson does not want a no-deal recession and his successors will not want one either. After all, the support for Brexit and for the Tories has generally declined since the referendum, and the Tories are making a comeback on the prospect of an orderly Brexit (Chart 8). All eyes will now turn toward the impending election. Opinion polls still show that Johnson is likely to be returned to power (Chart 9). The Tories have a prospect of engrossing the pro-Brexit vote while the anti-Brexit opposition stands divided. No-deal risk only reemerges if the Conservatives are returned to power with another weak coalition that paralyzes parliament. Chart 9Tory Comeback As BoJo Gets A Deal Chart 10Brexit Means Greater Fiscal Policy Whatever the election result, we maintain our long-held position that Brexit portends greater fiscal largesse (Chart 10). The agitated swath of England that drove the referendum result will not be assuaged by leaving the European Union – the rewards of Brexit are not material but philosophical, so material grievances will return. Voter frustration will rotate from the EU to domestic political elites. Voters will demand more government support for social concerns. Johnson’s own government confirms this point through its budget proposals. A Labour-led government would oversee an even more dramatic fiscal shift. Our GeoRisk indicator will fall on Brexit improvements but the question of the election and next government will ensure it does not fall too far. Our long GBP trades are tactical and we expect volatility to remain elevated. But the greatest risk, of no deal, is finished, so it does make sense for investors with a long time horizon to go strategically long the pound. The greatest risk, of a no deal Brexit, is finished. Bottom Line: Brexit posed a risk to the global economy only insofar as it proved disorderly. A withdrawal agreement by definition smooths the process. Continental Europe will not suffer a further shock to net exports. The Brexit contribution to global policy uncertainty will abate. The pound will rise against the euro and yen and even against the dollar as long as Trump’s trade retreat continues. Spain: Further Evidence Of European Stability We have long argued that the majority of Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 11). This month’s protests in Barcelona following the Catalan independence leaders’ sentencing are at the lower historical range in terms of size – protest participation peaked in 2015 along with support for independence (Table 1). Table 1October Catalan Protests Unimpressive Our Spanish risk indicator is showing a decline in political risk (Chart 12). However, we believe that this fall is slightly overstated. While the Catalan independence movement is losing its momentum, the ongoing protests are having an impact on seat projections for the upcoming election. Chart 11Catalonians Not Demanding Independence Chart 12Right-Wing Win Could Surprise Market, But No Worries Since the April election, the right-wing bloc of the People’s Party, Ciudadanos, and Vox has been gaining in the seat projections at the expense of the Socialist Party and Podemos. Over the course of the protests, the left-wing parties’ lead over the right-wing parties has narrowed from seven seats to one (Chart 13). If this momentum continues, a change of government from left-wing to right-wing becomes likely. However, a right-wing government is not a market-negative outcome, and any increase in risk on this sort of election surprise would be short-lived. The People’s Party has moderated its message and focused on the economy. Besides pledging to limit the personal tax rate to 40% and corporate tax rate to 20%, the People’s Party platform supports innovation, R&D spending, and startups. The party is promising tax breaks and easier immigration rules to firms and employees pursuing these objectives. Chart 13Spanish Right-Wing Parties Narrow Gap With Left Another outcome of the election would be a governing deal between PSOE and Podemos, along with case-by-case support from Ciudadanos. After a shift to the right lost Ciudadanos 5% in support since the April election, leader Albert Rivera announced in early October that he would be lifting the “veto” on working with the Socialist Party. If the right-wing parties fall short of a majority, then Rivera would be open to talks with Socialist leader Pedro Sanchez. A governing deal between PSOE, Podemos, and Ciudadanos would have 175 seats, as of the latest projections, which is just one seat short of a majority. As we go to press, this is the only outcome that would end Spain’s current political gridlock, and would therefore be the most market-positive outcome. Bottom Line: Despite having a fourth election in as many years, Spanish political risk is contained. This is reinforced by a relatively politically stable backdrop in continental Europe, and marginally positive developments in the U.K. and on the trade front. We remain long European versus U.S. technology, and long EU versus Chinese equities. We will also be looking to go long EUR/USD when and if the global hard data turn. Following our European Investment Strategy, we recommend going long 10-year Italian BTPs / short 10-year Spanish bonos for a trade. Turkey, Brazil, And Russia Chart 14Turkish Risk Will Rise Despite 'Ceasefire' Turkey’s political risk skyrocketed upward after we issued our warning in September (Chart 14). We maintain that the Trump-Erdogan personal relationship is not a basis for optimism regarding Turkey’s evading U.S. sanctions. Both chambers of the U.S. Congress are preparing a more stringent set of sanctions, focusing on the Turkish military, in the wake of Trump’s decision to withdraw U.S. forces from northeast Syria. At a time when Trump needs allies in the senate to defend him against eventual impeachment articles, he is not likely to veto and risk an override. Moreover, Turkey’s military incursion into Syria, which may wax and wane, stems from economic and political weakness at home and will eventually exacerbate that weakness by fueling the growing opposition to Erdogan’s administration and requiring more unorthodox monetary and fiscal accommodation. It reinforces our bearish outlook on Turkish lira and assets. Chart 15Brazilian Risk Will Not Re-Test 2018 Highs Brazil’s political risk has rebounded (Chart 15). The Senate has virtually passed the pension reform bill, as expected, which raises the official retirement age for men and women to 65 and 63 respectively. This will generate upwards of 800 billion Brazilian real in savings to improve the public debt profile. Of course, the country will still run primary deficits and thus the public debt-to-GDP ratio will still rise. Now the question shifts to President Jair Bolsonaro and his governing coalition. Bolsonaro’s approval rating has ticked up as we expected (Chart 16). If this continues then it is bullish for Brazil because it suggests that he will be able to keep his coalition together. But investors should not get ahead of themselves. Bolsonaro is not an inherently pro-market leader, there is no guarantee that he will remain disciplined in pursuing pro-productivity reforms, and there is a substantial risk that his coalition will fray without pension reform as a shared goal (at least until markets riot and push the coalition back together). Therefore we expect political risk to abate only temporarily, if at all, before new trouble emerges. Furthermore, if reform momentum wanes next year, then Brazil’s reform story as a whole will falter, since electoral considerations emerge in 2021-22. Hence it will be important to verify that policymakers make progress on reforms to tax and trade policy early next year. Our Russian geopolitical risk indicator is also lifting off of its bottom (see Appendix). This makes sense given Russia’s expanding strategic role (particularly in the Middle East), its domestic political troubles, and the risks of the U.S. election. The latter is especially significant given the risk (not our base case, however) that a Democratic administration could take a significantly more aggressive posture toward Russia. Political risk in Turkey and Russia will continue to rise. Bottom Line: Political risk in Turkey and Russia will continue to rise. Russia is a candidate for a “black swan” event, given the eerie quiet that has prevailed as Putin devotes his fourth term to reducing domestic political instability. Brazil, on the other hand, has a 12-month window in which reform momentum can be reinforced, reducing whatever spike in risk occurs in the aftermath of the ruling coalition’s completion of pension reform. Canada: Election Post-Mortem Prime Minister Justin Trudeau returned to power at the head of a minority government in Canada’s federal election (Chart 17). The New Democratic Party (NDP) lost 15 seats from the last election, but will have a greater role in parliament as the Liberals will need its support to pass key agenda items (and a formal governing coalition is possible). The NDP’s result would have been even worse if not for its last-minute surge in the polls after the election debates and Trudeau’s “blackface” scandal. Chart 17Liberals Need The New Democrats Now The Conservative Party won the popular vote but only 121 seats in parliament, leaving the western provinces of Alberta and Saskatchewan aggrieved. The Bloc Québécois, the Quebec nationalist party, gained 22 seats to become the third-largest party in the House. Energy investment faces headwinds in the near-term. The Liberal Party will face resistance from the Left over the Trans Mountain pipeline. Trudeau will not necessarily have to sacrifice the pipeline to appease the NDP. He may be able to work with Conservatives to advance the pipeline while working with the NDP on the rest of his agenda. But on the whole the election result is the worst-case scenario for the oil sector and political questions will have to be resolved before Canada can take advantage of its position as a heavy crude producer near the U.S. Gulf refineries in an era in which Venezuela is collapsing and Saudi Arabia is exposed to geopolitical risk and attacks. More broadly, the Liberals will continue to endorse a more expansive fiscal policy than expected, given Canada’s low budget deficits and the need to prevent minor parties from eating away at the Liberal Party’s seat count in future. Bottom Line: The Liberal Party failed to maintain its single-party majority. Trudeau’s reliance on left-wing parties in parliament may prove market-negative for the Canadian energy sector, though that is not a forgone conclusion. Over the longer term the sector has a brighter future. Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Appendix GeoRisk Indicator U.K.: GeoRisk Indicator France: GeoRisk Indicator Germany: GeoRisk Indicator Spain: GeoRisk Indicator Italy: GeoRisk Indicator Canada: GeoRisk Indicator Russia: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator What's On The Geopolitical Radar? Section III: Geopolitical Calendar
Highlights Shifting Trends: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Duration & Country Allocation Strategy: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Credit Allocation Strategy: Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Feature Chart of the WeekBond Yields Sniffing A Turn In Global Growth? It has been fifty days (and counting) since the 2019 low for the benchmark 10-year U.S. Treasury yield was reached on September 3. The year-to-date low for the benchmark 10-year German bund yield was seen six days before that on August 28. Yields have risen by a healthy amount since those dates, up +34bps and +37bps for the 10yr Treasury and Bund, respectively. This has occurred despite the significant degree of bond-bullish pessimism on global growth and inflation that can be found in financial media reporting and investor surveys. The fact that yields are now steadily moving away from the lows suggests that the 2019 narrative for financial markets – slowing global growth, triggered by political uncertainty and the lagged impact of previous Fed monetary tightening and China credit tightening, forcing central banks to turn increasingly more dovish – is no longer correct. If that is true, yields have more near-term upside as overbought government bond markets begin to “sniff out” a bottoming out of global growth momentum (Chart of the Week). In this Weekly Report, we take a look at the changing state of the factors that fueled the sharp decline in bond yields in 2019. We follow that up with a review of all our current recommended investment positions on duration, country allocation and spread product allocations in light of recent developments. We conclude that maintaining a below-benchmark duration exposure, while favoring lower-beta countries in sovereign debt and overweighting corporate debt in the U.S. and Europe, is the most appropriate fixed income strategy for the next 6-12 months. The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. Yields Are Rising At The Right Time, For The Right Reasons Chart 2Bond-Bullish Growth & Inflation Factors Are Turning The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. The diffusion index of our global leading economic indicator (LEI), which leads the real (ex-inflation expectations) component of DM bond yields by twelve months, is at an elevated level (Chart 2). At the same time, the slowing of the annual rate of growth in the trade-weighted U.S. dollar, which leads 10-year DM CPI swap rates by around six months, is signaling that bond yields have room to increase from the inflation expectations side. Finally, the rising trend of positive data surprises for the major DM countries is also pointing to higher yields. Breaking it down at the country level, the pickup in DM 10-year bond yields since the 2019 lows has been widespread (Charts 3 & 4). The range of yield increases is as low as +16bps in Japan, where the Bank of Japan (BoJ) is pursuing a yield target, to +46bps in Canada where the economy and inflation are both accelerating. Chart 3Pricing Out Some Expected Rate Cuts … Chart 4… Across All Developed Markets The increase in yields has also occurred alongside reduced expectations for easier monetary policy. Our 12-month discounters, which measure the expected change in short-term interest rates priced into Overnight Index Swap (OIS) curves, show that markets have partially priced out some (but not all) expected rate cuts in all major DM countries. The Three Things That Have Changed For Global Bond Markets So what has changed to trigger a reduction in rate cut expectations and an increase in global yields? The bond-bullish narrative that we refer to in the title of this report can be broken down into the following three elements, which have all turned recently: Slowing global growth (now potentially bottoming) Chart 5Global Growth Bottoming Out Current global growth is still trending lower, when looking at measures like manufacturing PMIs or sentiment surveys like the global ZEW index. Forward-looking measures like our global LEI, however, have been moving higher in recent months, suggesting that a bottom in the PMIs may soon unfold (Chart 5). We investigated that improvement in our global LEI in a recent report and concluded that the move higher was focused almost exclusively within the emerging market (EM) sub-components that are most sensitive to improving global growth.1 This fits with the improvement shown in the OECD LEI for China, a bottoming of the annual growth rate of world exports, and the general acceleration of global equity markets – the classic leading economic indicator. Rising political uncertainty (now potentially fading) The U.S.-China trade war (including the implications for the upcoming 2020 U.S. presidential election) and the U.K. Brexit saga have been the main sources of bond-bullish political uncertainty over the past several months. Yet recent developments have helped reduce the odds of the most negative tail risk outcomes, providing a bit of a boost to global bond yields. The U.S. and China have agreed (in principle) to a “phase one” trade deal that, at a minimum, lowers the chances of a further escalation of the trade dispute through higher tariffs. Meanwhile, the momentum has shifted towards a potential final Brexit agreement between the U.K. and European Union that can avoid an ugly no-deal outcome. Our colleagues at BCA Research Geopolitical Strategy believe that developments are likely to continue moving away from the worst-case scenarios, given the constraints faced by policymakers.2 U.S. President Donald Trump is now in full campaign mode for the 2020 elections and needs a deal (of any kind) to deflect criticism that his trade battle with China is dragging the U.S. economy into recession. Already, there has been a sharp decline in income growth for workers in swing states that could vote for either party’s candidate in next year’s election (Chart 6). Trump cannot afford to lose voters in those states, many of which are in the U.S. industrial heartland (i.e. Ohio, Michigan) that helped put him in the White House. In other words, he is highly incentivized to turn down the heat on the trade war or else face a potential loss next November. While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Meanwhile, China is facing a slowing economy and rising unemployment, but with reduced means to fight the downtrend given high private sector debt that has impaired the typical response between easier monetary conditions and economic activity (Chart 7). While the Chinese government does not want to be seen as caving in to U.S. pressure on trade policy, its desire to maintain social stability by preventing a further rise in unemployment from the trade war provides a powerful incentive to try and ratchet down tensions with the U.S. Chart 6Political Reasons For Trump To Retreat On Trade In the U.K., a no-deal Brexit is an economically painful and politically unpopular outcome that would severely damage the re-election chances of Prime Minister Boris Johnson and his Conservative party. Thus, even a hard-line Brexiteer like Johnson must respond to the political constraints forcing him to try and get a Brexit deal done (Chart 8). Chart 7Economic Reasons For China To Retreat On Trade Chart 8Political Reasons To Retreat On A No-Deal Brexit While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Bull-flattening pressure on yield curves (now turning into moderate bear-steepening) The final leg down in bond yields in August had a technical aspect to it, fueled by the demand for duration and convexity from asset-liability managers like European pension funds and insurance companies. Falling yields act to raise the value of liabilities for that group of investors, forcing them to rapidly increase the duration of their assets to match the duration of their liabilities (the technique used to limit the gap between the value of assets and liabilities). That duration increase is carried out by buying government bonds with longer maturities (and higher convexity), but also through the use of interest rate derivatives like long maturity swaps and swaptions. The end result is a bull flattening of yield curves (both for government bonds and swaps) and a rise in swaption volatility (i.e. the price of swaptions). Those dynamics were clearly in play in August after the shocking imposition of fresh U.S. tariffs on Chinese imports early in the month. Bond and swaption volatilities spiked, and bond/swap yield curves bull-flattened, in both Europe and the U.S. (Chart 9). That effect only lasted a few weeks, however, and volatilities have since declined and curves have steepened. This suggests that the “convexity-buying” effect has run its course and is now starting to work in the opposite direction, with asset-liability managers looking to reduce the duration of their assets as higher yields lower the value of their liabilities. This is putting some upward pressure on longer-maturity global bond yields. Chart 9Signs Of Reduced Convexity-Related Bond Buying Chart 10Bull-Flattening Yield Curve Pressures Easing Up A Bit Chart 11Fed & ECB Actions Should Help Steepen Up Curves The steepening seen so far must be put in context, however, as yield curves remain very flat across the DM world (Chart 10). Term premia on longer-term bonds remain very depressed, although those should start to increase as global growth stabilizes and the massive safe-haven demand for global government debt begins to dissipate. Some pickup in inflation expectations would also help impart additional bear-steepening momentum to yield curves – a more likely result now that the Fed and ECB have both cut interest rates and, more importantly, will start provide additional monetary easing by expanding their balance sheets (Chart 11). Bottom Line: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Reviewing Our Recommended Bond Allocations In light of these shifting global trends described above, the fixed income investment implications are fairly straightforward: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. Duration: A moderate below-benchmark overall duration stance is warranted for global fixed income portfolios, with yields likely to continue drifting higher over at least the next six months. A big surge in yields is unlikely, as central banks will need to see decisive evidence that global growth is not only bottoming, but accelerating, before shifting away from the current dovish bias. Given the reporting lags in the economic data, such evidence is unlikely to appear until the first quarter of 2020 at the earliest. Yet given how flat yield curves are across the DM government bond markets, the trajectory of forward rates is quite stable relative to spot yield levels, making it much easier to beat the forwards by positioning for even a modest yield increase. Country Allocation: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. In that case, using yield betas to the “global” bond yield is a good way to consider country allocation decisions within a fixed income portfolio. We looked at those yield betas in an August report, using Bloomberg Barclays government bond index data for the 7-10 year maturity buckets of individual countries and the Global Treasury aggregate (Chart 12).3 The rolling 3-year betas were highest in the U.S. and Canada, making them good countries to underweight within a global government bond portfolio in a rising yield environment. The yield betas were lowest in Japan, Germany and Australia, making them good overweight candidates. The U.K. was a unique case of having a relatively high historical yield beta prior to the 2016 Brexit referendum and a lower yield beta since then - making the U.K. allocation highly conditional on the resolution of the Brexit uncertainty. Spread Product Allocation: The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. Thus, an overweight stance on overall global spread product versus governments is warranted. The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. With regards to our current strategic fixed income recommendations and model bond portfolio allocations, we already have much of the positioning described above in place. We are below-benchmark on overall duration, underweight higher-beta U.S. Treasuries; overweight government bonds in lower-beta Germany, France, Japan and Australia (Chart 13); overweight investment grade corporate bonds in the U.S., euro area and U.K.; and overweight high-yield corporate bonds in the U.S. and euro area. Chart 12Favor Lower-Beta Government Bond Markets There are areas where our positioning could change, however. Chart 13Lower-Beta Laggards Should Start To Outperform In terms of government bonds, we are currently overweight the U.K. and neutral Canada. A final Brexit deal would justify a downgrade of Gilts to at least neutral, if not underweight, as the Bank of England has signaled that rate hikes would be justified if the Brexit uncertainty was resolved. A downgrade of higher-beta Canadian government debt to underweight could also be justified, although the Bank of Canada is not signaling that a change in monetary policy (in either direction) is warranted. For now, we will hold off on any change to our U.K. stance, as it is now likely that there will be another extension of the Brexit deadline beyond October 31. As for Canada, we remain neutral for now but will revisit that stance in an upcoming Weekly Report. With regards to spread product, we are only neutral EM USD-denominated sovereign and corporate debt, as well as Spanish sovereign bonds; and underweight Italian government debt. An EM upgrade to overweight would require two things that are not yet in place: a weaker U.S. dollar and accelerating Chinese economic growth. Chart 14Stay Overweight Corporates In The U.S. & Europe As for Peripheral governments, we have preferred to be overweight European corporate debt relative to sovereign bonds in Italy and Spain. The recent powerful rally in the Periphery, however, has driven the spreads over German bunds in those countries down to levels in line with corporate credit spreads (Chart 14). We will maintain these allocations for now, but will investigate the relative value proposition between euro area Peripheral sovereigns and corporates in an upcoming report. Bottom Line: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “What Is Driving The Improvement In The BCA Global Leading Economic Indicator?”, dated October 2, 2019, available at gfis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy Weekly Report, “Five Constraints For The Fourth Quarter”, dated October 11, 2019, available at gps.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy/Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?", dated August 20, 2019, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. Fed: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. Negative Convexity: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Feature Chart 1Positive Surprises Driven By The Hard Data The next two months are crucial for the U.S economy. Measures of sentiment, on both the business and consumer side, are sending recessionary signals. However, measures of actual economic activity paint a more benign picture (Chart 1). This divergence between the “hard” and “soft” data will likely resolve itself within the next couple of months, and the outcome of U.S./China trade negotiations will play a major part in determining whether that resolution is positive or negative. On the “Hard” And “Soft” Data There is a ton of economic data available to investors these days, but all of it can generally be classified as either “soft” or “hard”. We call measures of actual economic activity, such as housing starts or retail sales, “hard” data. These are the sorts of measures used to calculate a nation’s GDP. Alternatively, we use the term “soft” data to describe survey measures where firms or consumers are asked to describe whether activity is improving or deteriorating, or whether they are becoming more or less optimistic about the future. Some examples of soft data are PMI surveys and measures of consumer confidence. Both sorts of measures have value. Soft data are usually timelier and often lead the hard data. However, they are also more prone to whipsaws. The hard data tend to be more reliable, but don’t always provide enough lead time to be actionable. The soft and hard data are sending very different signals. At present, the soft and hard data are sending very different signals. On the consumer side, core retail sales are growing at the robust year-over-year pace of 4.8%, even though consumer confidence has declined during the past year (Chart 2). On the business side, the ISM manufacturing PMI survey came in at 47.8 in September, the lowest print since 2009. However, industrial production has fallen by only 0.1% during the past year. Industrial production growth got as low as -4% during the 2015/16 period, when the ISM was at a higher level (Chart 3). Similarly, actual orders for core durable goods have barely contracted, even though CEO confidence is at recessionary levels (Chart 3, panel 2). Capacity utilization also remains fairly strong, well above its 2016 low (Chart 3, bottom panel) Chart 2Hard Vs. Soft Data: On The Consumer Side Chart 3Hard Vs. Soft Data: On The Business Side Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. All measures of housing activity are growing strongly, a rapid snapback following last year’s weakness (Chart 4). Chart 4Housing Activity Summary Trade Negotiations Are Pivotal The soft data started to lag the hard data at around the same time as the Global Economic Policy Uncertainty index shot higher last year (Chart 5). This leads us to conclude that worries about the trade war’s negative consequences have caused sharp declines in measures of sentiment and confidence, even though the trade war’s actual impact on the hard data has been minor. This is what makes the outcome of November’s U.S./China trade talks so important. If an agreement is reached that makes it clear that no new tariffs will be implemented, we expect that would remove enough uncertainty for the soft data to improve, converging with the hard data. However, if things fall apart, then we would expect the negative survey data to eventually drag the hard data lower. Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. Our sense at the moment is that the looming 2020 U.S. election provides enough incentive for both sides to strike a deal, but the outcome could still go either way. Last Friday’s report from our Global Investment Strategy service discussed the outlook for trade negotiations in more detail.1 For bond investors, we are confident that a removal of trade uncertainty would lead to a rebound in important soft data measures such as the ISM manufacturing PMI and the CRB Raw Industrials index. Any increase in those measures would also send bond yields sharply higher. The ratio between the CRB Raw Industrials index and Gold continues to track the 10-year Treasury yield closely (Chart 6). Chart 5Trade War Worries Affecting ##br##Sentiment Chart 6Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bottom Line: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. The Fed Next Week The dichotomy between hard and soft data fits nicely with how the Fed has been describing the economic outlook for most of the year. That is, an economy who’s baseline outlook is favorable but that faces some downside risks. While that outlook doesn’t immediately suggest a policy response, low inflation expectations make it pretty clear what the Fed’s course of action will be during the next few months. The 5-year/5-year forward TIPS breakeven inflation rate is currently 1.68%, well below the 2.3%-2.5% range that is consistent with the Fed’s inflation target (Chart 7). What’s more, the median 3-year inflation forecast from the New York Fed’s Survey of Consumer Expectations just hit an all-time low (Chart 7, bottom panel). The Fed must take appropriate action to drive inflation expectations higher. At present, this means that it must ensure that financial conditions stay accommodative so that the economic recovery can continue. Eventually, continued economic recovery will lead to higher realized inflation (Chart 7, panel 2), and inflation expectations will follow realized inflation higher. Chart 7Low Inflation Expectations Equals Accommodative Fed In order to keep financial conditions accommodative, the Fed must at least match the market’s current rate cut expectations. An October rate cut is more or less fully priced, and it is therefore highly likely that the Fed will cut rates next week. After that, the market is pricing in roughly 50/50 odds of a fourth rate cut in December. But those expectations will certainly change as we learn the outcome of November’s trade talks and as the economic data roll in. Ultimately, we expect that enough good news will hit the wire between now and December that a fourth rate cut will be unnecessary. But the more important message is that, as long as inflation expectations are low, the Fed will not risk upsetting market expectations. Balance Sheet Update The Fed decided not to wait until next week to unveil its revamped balance sheet policy. It didn’t really have the luxury of time, given the turmoil in money markets that we discussed in a recent report.2 The main conclusion from our report is that the Fed must inject more bank reserves into the economy if it wants to maintain control of interest rates. This is exactly what the Fed will do going forward. It announced that it will purchase Treasury bills at least until the second quarter of 2020, starting at an initial pace of $60 billion per month. It will also continue to reinvest the proceeds from maturing Treasury notes/bonds and MBS into newly issued Treasury notes/bonds. Continued economic recovery will lead to higher realized inflation. Assuming the pace of $60 billion per month stays constant, and making some other assumptions about the growth rates of non-reserve liabilities, we project that the Fed’s actions will cause the supply of reserves to rise from $1.53 to $1.63 trillion by next June, and that its securities holdings will rise from $3.59 to $4.05 trillion (see Chart 8 and Table 1). Chart 8The Fed's Balance Sheet Over Time Table 1Fed's Balance Sheet: Projections As we have argued in the past, now that the link between the Fed’s balance sheet and its interest rate policy has been severed, we see no investment implications from the Fed’s new balance sheet strategy. As per our Golden Rule of Bond Investing, changes in the fed funds rate relative to expectations will continue to drive bond yields.3 Since the Fed’s balance sheet strategy tells us nothing about its future interest rate plans, it should mostly be ignored. Bottom Line: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. A Good Time To Buy Negative Convexity We have repeatedly mentioned the attractiveness of high-yield bonds and Agency MBS during the past few weeks. The one thing those sectors have in common is that they are negatively convex. That is, unlike most fixed income instruments, their durations are positively correlated with yields. As a result, this year’s big drop in yields has led to large declines in duration for both high-yield and agency MBS (Chart 9). But despite this lower duration, junk spreads have remained relatively flat while MBS spreads have actually widened. In other words, expected return has not fallen even as the risk embedded in negatively convex securities has declined markedly. Chart 9Negatively Convex Products Are Attractive Last week we unveiled a new way of measuring risk for U.S. spread products.4 The Risk Of Losing 100 bps can be thought of as the number of standard deviations of annual spread change necessary for a sector to underperform duration-matched Treasuries by more than 100 basis points. A higher value means the sector is at a lower risk of losing 100 bps, and vice-versa. Chart 10 shows our new risk measure plotted against expected return for the investment grade and high-yield credit tiers, as well as for conventional 30-year Agency MBS. The y-axis shows each sector’s 12-month expected excess return, which we calculate as OAS less an adjustment for expected default losses. The x-axis shows the Risk Of Losing 100 bps. To put recent market moves in context, we show how each sector has moved within Chart 10 since spreads last troughed, about one year ago. Notice that last October, Ba and B rated junk bonds offered more expected return than Baa-rated corporates, with similar risk. Now, Ba and B offer a similar return advantage, but with much less risk. Caa-rated junk now strictly dominates the Baa sector in terms of risk and reward. Chart 10Risk-Reward Tradeoff Favors Negatively Convex Securities Turning to Agency MBS, we see again that the large fall in duration has led to a substantial risk reduction since last October. This is why we recently recommended upgrading Agency MBS at the expense of Aaa, Aa, and A corporates.5 Bottom Line: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Kumbaya”, dated October 18, 2019, available at gis.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification