Asset Allocation
Highlights We conservatively estimate lost output from shutdowns and social distancing will equal $10 trillion, and we expect the jobs market to be permanently scarred. Inflation, even at 2 percent, is a pipe dream, which leads to three investment conclusions on a 1-year horizon: Overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs. Any high-quality bond yield that can decline will decline. Overweight CHF/USD. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities (technology and healthcare) versus cyclical equities (banks and energy). This implies underweight European equities versus other markets. Fractal trade: Short Germany versus the UK. The recent outperformance of German equities is technically extended. Feature Chart of the WeekCredit Impulses Are Large, But The Hole In Output Is Much Larger Big numbers befuddle us. Hardly a day passes without someone listing the unprecedented global stimulus unleashed to counter the coronavirus forced shutdowns – the trillions in government spending promises, tax relief, loan guarantees, money supply growth, and central bank asset-purchases. The most optimistic estimates quantify the total stimulus at $15 trillion. This includes $7 trillion of loan guarantees plus increases in central bank balance sheets which do not directly boost demand. So the direct stimulus is closer to $7 trillion.1 Yet the size of the stimulus is meaningless until we quantify the massive hole in economic output that needs to be filled. Assuming no further large-scale shutdowns, we conservatively estimate that the hole will amount to 12 percent of world output, or $10 trillion. A $10 Trillion Hole In Output Last week, the UK’s Office for National Statistics (ONS) helped us to estimate the hole in output, because unusually the ONS calculates UK GDP on a monthly basis. Between February and April, when the UK economy went from fully open to full shutdown, UK GDP collapsed by 25 percent. This despite the UK having an outsized number of jobs suitable for ‘working from home.’ For a more typical economy, we estimate that a full shutdown collapses output by 30 percent (Chart I-2). Chart I-2A Full Shutdown Collapses Output By 30 Percent The next question is: how long does the full shutdown last? Assuming it lasts for three months, output would suffer a hole amounting to 7.5 percent of annual GDP.2 But in practice, the economy will not fully re-open after three months. Social distancing will persist until people feel confident that the pandemic is under control. An effective vaccine against Covid-19 is unlikely to be available for a year. So, even without government policy to enforce social distancing, many people will choose to avoid crowds and congregations for fear of catching the virus. The size of the stimulus is meaningless until we quantify the massive hole in economic output. This means that the sectors that rely on crowds and congregations – leisure and hospitality and retail trade – will be operating at half-capacity, at best. Given that these sectors generate 9 percent of GDP, operating at half-capacity will create an additional hole amounting to 4.5 percent of output. More worryingly, these two sectors employ 21 percent of all workers, so operating at sub-par will leave the jobs market permanently scarred.3 Combining the 7.5 percent existing hole with the 4.5 percent future hole, the full hole in economic output will amount to around 12 percent of annual GDP. As global GDP is worth around $85 trillion, this equates to $10 trillion. Crucially though, our estimate assumes that a second wave of the pandemic will not force a new cycle of shutdowns. If it does, the hole will become even bigger. Don’t Be Fooled By Money Supply Growth The recent growth in broad money supply seems a big number. Since the start of the year, the outstanding stock of bank loans has increased by around $0.7 trillion in the euro area, and by $1 trillion in both the US and China (Chart I-3 and Chart I-4). This has boosted the 6-month credit impulses in all three economies. Indeed, the US 6-month credit impulse recently hit its highest value of all time, and the combined 6-month impulse across all three blocs equals around $2 trillion (Chart of the Week). Chart I-3Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Chart I-4...And In ##br##China This 6-month credit impulse quantifies the additional borrowing in the most recent six-month period compared to the previous period. Ordinarily, a $2 trillion impulse would create a huge boost to demand. After all, the private sector does not usually borrow just to hold the cash in a bank. Yet in the coronavirus crisis this is precisely what has happened. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers. Therefore, much of the money growth will not generate new demand. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers. To the extent that this cash is sitting idly in a firm’s bank account, the monetary velocity will decline. Meaning there will be a much-reduced transmission from credit impulses to spending growth. Furthermore, when the economy re-opens, many firms will relinquish the precautionary credit lines. There is no point holding cash in the bank when there are few investment opportunities. Hence, credit impulses will fall back – as seems to be the case right now in the US. QE: The Great Misunderstanding To repeat, big numbers befuddle us. They must always be put into context. No truer is this than when it comes to central bank asset-purchases. The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Central banks act as lenders of last resort to solvent but illiquid banks and sovereigns. If there is ample liquidity in these markets – as is the case now – then the primary function of central bank asset-purchases is to set the term-structure of interest rates. In turn, the term-structure of global interest rates establishes the prices of $500 trillion of global assets. The prices of these assets are inextricably inter-connected and inter-dependent4 (Chart I-5). Chart I-5The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Yet central banks set no price target for their asset-purchases. They leave that to the market. Moreover, in the context of the $500 trillion of inter-dependent asset prices, the $10-15 trillion or so of central bank asset-purchases to date constitutes chicken feed (Chart I-6). Hence, the mechanism by which asset-purchases work is through the signal they give to the $500 trillion market on the likely course of interest rate policy. This sets the term-structure of interest rates, which in turn sets the required return on all the $500 trillion of assets (Chart I-7). Chart I-6$10-15 Trillion Of QE Is Chicken Feed... Chart I-7...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates As the ECB’s former Chief Economist, Peter Praet, explains: “There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. This credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these asset purchases are a concrete demonstration of our desire (to keep policy rates at the lower bound.)” The credible commitment to keep policy rates near the lower bound for an extended period depresses bond yields towards the lower bound too. But once bond yields have reached their lower bound the effectiveness of central bank asset-purchases becomes exhausted. Three Investment Conclusions The main purpose of this report was to put the $7 trillion of direct stimulus dollars unleashed into the economy into a proper context. With lost output estimated at $10 trillion and the jobs market permanently scarred, inflation – even at 2 percent – is a pipe dream. Moreover, a second wave of the pandemic and a new cycle of shutdowns would inject a further disinflationary impulse. This leads to three investment conclusions on a 1-year horizon: Any high-quality bond yield that can decline – because it is not already near the -1 percent lower bound to yields – will decline. An excellent relative value trade is to overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs (Chart I-8). Long CHF/USD is a win-win. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities versus cyclical equities, with technology correctly defined as defensive, not cyclical. The performance of cyclicals (banks and energy) versus defensives (technology and healthcare) is now joined at the hip to the bond yield (Chart I-9). This implies underweight European equities versus other markets. Chart I-8Bond Yields That Can Decline Will Decline Chart I-9The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield Fractal Trading System* The recent outperformance of German equities is technically extended. Accordingly, this week’s recommended trade is to go short Germany versus the UK, expressed through the MSCI dollar indexes. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long euro area personal products versus healthcare achieved its 7 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 65 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Footnotes 1 Source: Reuters estimate. 2 A 30 percent loss in output for a quarter of a year (3 months) amounts to a 30*0.25 = 7.5 percent loss in annual output. 3 Using the weights of leisure and hospitality and retail trade in the US economy as a proxy for the global weights. 4 The $500 trillion of assets comprises: real estate $300 trillion, public and private equity $100 trillion, corporate bonds and EM debt $50 trillion, and high-quality government bonds $50 trillion. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations
Dear client, It was my pleasure to join Dhaval Joshi, BCA’s Chief European Investment Strategist, this past Friday June 12, 2020 on a webcast he hosted titled: “Sectors To Own, And Sectors To Avoid In The Post-Covid World”. You can access the replay of the lively webcast here, where Dhaval and I debate how investors should be positioned in different time horizons. I hope you will find it both insightful and informative. Kind Regards, Anastasios Highlights Portfolio Strategy While we cannot time the exact equity market top, our sense is that we are more than fairly valued at the current juncture and the equity market has entered a speculative phase; thus the risk/reward tradeoff is poor in the near-term. We are compelled to put the S&P home improvement retailers index (HIR) on our downgrade watch list and institute a stop at the 10% return mark in order to reflect softness in our HIR macro model, a hook down in existing home sales and a high profit growth bar that sell-side analysts have set for the coming year. Recent Changes Our rolling 10% stop got hit last Tuesday and we monetized 32% gains since the reinstatement of the long S&P oil & gas exploration & production / short global gold miners pair trade.1 Feature Equities briefly erased all losses for the year early last week, but the Fed’s June meeting lacked any additional easing measures and served as a catalyst for a much needed breather – the fifth 5.3-7.3% pullback since the March 23 bottom – as the week drew to a close. While extremely easy monetary and fiscal policies remain the key macro drivers for the SPX, any hiccups in passing a new fiscal spending bill once the money runs out on July 31, carry enough risk to short circuit the equity market’s momentum and result in a shakeout phase. Importantly, given the recent speculative overshoot in equities, the cyclical return potential has diminished, and that is cause for concern. The ongoing COVID-19 catalyzed recession that the NBER last week confirmed commenced in February, the “second wave” risk, a flare up in the US/Sino trade war and more recently, civil unrest have dominated the news flow. However in all this chaos, the November election has slowly moved into the background, especially the SPX return implications during the 4th year of a Presidency. Chart 1 shows the profile of the S&P 500 during Presidential Election calendar years, going back to the 1950s. The solid green line shows the historical mean, and shaded areas denote the 10th and 90th percentiles of SPX performance. If history rhymes, the average profile of these 17 iterations suggests that more cyclical gains are in store for the S&P 500. Chart 1Do Not Ignore… Nevertheless, before getting carried away, a word of caution is in order. As we highlighted last week, a Biden win represents a risk to the SPX’s euphoric rise from the March lows, and could serve as a catalyst for a much needed pullback (Chart 2).2 Thus, according to our analysis if the 90th percentile proves accurate, then the SPX could trace this lower bound and fall 640 points or 20% (Chart 1). This is a key tail risk to our cyclically sanguine equity market view. Chart 2…(Geo)Political Risks Turning over to the reopening of the economy, while the SPX has now discounted a near fully functioning economy for the rest of the year and beyond (bottom panel, Chart 3), fixed income investors are not in total agreement. In fact, the missing ingredient in giving the green light for equities is a selloff in the bond market, which financials/banks are currently sniffing out on the back of the reopening of the economy. Until fixed income investors get on the same page as equity investors, the SPX will remain on shaky ground (top panel, Chart 3). We first turned positive on the cyclical prospects of the equity market in mid-March3 and cemented our conviction in our March 23 report presenting 20 reasons to buy stocks.4 Since then, the SPX has rocketed higher by 1000 points and overshot our 3,000 SPX target that we recently derived from three methods.5 While we cannot time the exact top and equities may have a bit more upside, our sense is that today, stocks are more than fairly valued and they have entered a speculative phase (Chart 4). Thus the risk/reward tradeoff in the near-term has shifted to the downside. Once these (geo)political risks get appropriately repriced via a higher risk premium, then the broad equity market will resume its cyclical upside march. Chart 3Bond Market Is Not Buying Stock Market’s Euphoria Chart 4Lots Of Good News Is Priced In This week we update one consumer discretionary subgroup and put it on our downgrade watch list. Put Home Improvement Retailers On Downgrade Alert We are putting the S&P home improvement retailers index (HIR) on downgrade alert and setting a stop at the 10% return mark in order to protect handsome gains for our portfolio since the mid-April overweight inception. HIR have catapulted to all-time highs both in absolute terms and relative to the broad market. Granted, this has been an earnings-led propulsion (top panel, Chart 5), however, we are uneasy that HD is a top ten holding in the S&P growth index (middle panel, Chart 5).6 Importantly, the first print in the real GDP release for Q1/2020 in late-April made for grim reading, with one notable exception: real residential investment. Business capex took it to the chin, but housing related outlays spiked over 20% on a quarter-over-quarter annualized basis, and signal that DIY same-store retail sales will likely prove resilient this summer (bottom panel, Chart 6). Chart 5An Earnings-Led Advance… Chart 6…Buttressed By Resilient Residential Investment… As a reminder, these Big Box retailers are highly levered to the ebbs and flows of residential investment and the latest GDP print should sustain the recent bid under S&P HIR prices (top & middle panels, Chart 6). Tack on the roughly $75/tbf jump in lumber prices since the early-April trough (not shown), and profits benefit from a dual lift: rising volumes and firming selling prices. The DIY avalanche is real and not likely to dissipate any time soon as a consequence of the coronavirus-induced working from home pervasiveness. Yet, HIR has run too far too fast and is due for a consolidation phase. One yellow flag is the recent fall in existing home sales, despite the all-time lows in mortgage rates brought back by the Fed’s ZIRP. The middle panel of Chart 7 shows that if the home sales decline continues in the summer months, then HIR sales will face stiff headwinds as remodeling activity suffers a setback. In addition, in previous recessions the inventory of homes for sale has surged, but at the current juncture only a small jump in inventories is visible (inventories shown inverted, top panel, Chart 7). Were that trend to gain steam, it could put downward pressure to high-flying HIR equities. Chart 7…But Soft Home Sales Are An Issue… Chart 8…And The Tick Down In Our HIR Model Is A Yellow Flag The industry’s net earnings revision ratio has climbed to multi-year highs and warns that analyst optimism is excessive, which is contrarily negative (bottom panel, Chart 7). Our macro driven HIR model does an excellent job in encapsulating all the moving parts and its recent tick down is worrisome (Chart 8). Nevertheless, given that this has been a profit-led advance, HIR have a large valuation cushion. The relative forward P/E is trading near a market multiple and below the historical mean (bottom panel, Chart 5). Netting it all out, we are compelled to put the S&P HIR index on our downgrade watch list and institute a stop at the 10% return mark in order to reflect softness in our HIR macro model, a hook down in existing home sales and a high profit growth bar that sell-side analysts have set for the coming year (middle panel, Chart 5). Bottom Line: While we remain overweight the S&P HIR index it is now on downgrade alert. We also set a stop at the 10% return mark in order to protect profits for our portfolio. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Insight Report, “Pocketing Gains In Oil/Gold Pair Trade” dated June 10, 2020, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Weekly Report, “Don’t Turn A Blind Eye To Geopolitical Risks” dated June 8, 2020, available at uses.bcaresearch.com. 3 Please see BCA US Equity Strategy Weekly Report, “Inflection Point” dated March 16, 2020, available at uses.bcaresearch.com. 4 Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 5 Please see BCA US Equity Strategy Weekly Report, “New SPX Target” dated April 20, 2020, and “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com. 6 https://us.spindices.com/indices/equity/sp-500-growth#data-constituents Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018 Favor value over growth April 28, 2020 Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Highlights Historically, when global growth picks up, the yen weakens. But this is less likely in an environment where global yields remain anchored at low levels. Meanwhile, there is rising risk that consumption in Japan will remain muted. This will limit any pickup in domestic inflation. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. That said, cheap yen valuations will buffet Japanese exports. Go short USD/JPY with an initial target of 100. Feature Chart I-1Higher Volatility, Higher Yen The powerful bounce in global markets since the March lows is at risk of a bigger technical correction. As we enter the volatile summer months, it may only require a small shift in market sentiment to trigger this reversal. The yen has tended to strengthen when market volatility rises (Chart I-1). Should this happen, it will provide the necessary catalyst for established long yen positions. On the other hand, if risk sentiment stays ebullient, the yen will surely weaken on its crosses but can still strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Growth And Monetary Policy Like most other economies, Japan entered a recession in the first quarter of this year, with GDP contracting at a 2.2% annualized pace. For the private sector, this is the worst growth rate since the Fukushima crisis in 2011. This is particularly significant, since the structural growth rate of the economy has fallen below interest rates. Going back to Japan’s lost decades, where private sector GDP growth averaged well below nominal rates (due to the zero bound), it is particularly imperative that Japan exits this liquidity trap in fast order (Chart I-2). A strong yen back then, on the back of deficient domestic demand, led to a self-fulfilling deflationary spiral. Chart I-2The Story Of Japan In One Chart The Bank of Japan began to acknowledge this problem with the end of the Heisei era1 last year. For example, with the BoJ owning almost 50% of outstanding JGBs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. The yen has become extremely sensitive to shifts in the relative balance sheets between the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at the current pace, then the rate of expansion in its balance sheet will severely lag behind the Fed, and could trigger a knee-jerk rally in the yen (Chart I-3). Chart I-3The Yen And QE Inflation And The 2% Target The US is a much more closed economy than Japan, and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream for any timeline in the near future. There are three key variables the authorities pay attention to for inflation: Core CPI, the GDP deflator and the output gap. All three indicators point towards deflationary pressures, with the recent slowdown in the global economy exacerbating the trend. In fact, since the financial crisis, prices in Japan have only been able to really rise during a tax hike (Chart I-4). Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. The overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. More importantly, almost 50% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for domestically-driven prices, an ageing demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years, a strong voting lobby has been able to advocate for lower telecom prices, which makes it difficult for the BoJ to re-anchor inflation expectations upward (Chart I-5). Chart I-4Japan CPI At A Glance Chart I-5Strong Deflationary Pressures In Japan Meanwhile, the BoJ understands that it needs domestic banks to expand the credit intermediation process if any inflation is to take hold. Unfortunately, the yield curve control strategy and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart I-6). This puts the BoJ in a precarious balance between trying to stimulate the economy further and biting the hand that will feed a pickup in inflation. Chart I-6Point Of No Return For Japanese Banks? Japanese Consumption And Fiscal Policy The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. COVID-19 has dealt a fatal blow. In prior episodes of the tax hikes, it took around three to four quarters for growth to eventually bottom. This suggests that a protracted slowdown in Japanese consumption is a fait accompli (Chart I-7). Foreign and domestic machinery orders are slowing, employment growth has gone from over 2% to free fall and the availability of jobs relative to applicants has reversed a decade-long rising trend. The Abe government has passed an additional 117 trillion yen of fiscal stimulus. With overall fiscal announcements near 40% of GDP, could this fully plug the spending gap? Not quite. The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. First, as is usually the case with Japanese stimulus announcements, the timeframe is uncertain for when the funds will be deployed. It could be one year or ten years. Chart I-7A V-Shaped Recovery Might Stall Chart I-8More Jobs, More Savings Second, Japanese consumption has been quite weak for some time. Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has trended downward. The reason is that government spending triggered a rise in private savings, because of expectations of higher taxes. In other words, the savings ratio for workers has surged. If consumers were not willing to spend prior to COVID-19 due to Ricardian equivalence,2 they are unlikely to do so with much higher fiscal deficits (Chart I-8). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. In particular, the postponement of the Olympics will continue to be a drag on Japanese construction activity, and the labor (and income) dividend from immigration has practically vanished. The important tourism industry that faced sudden death will only recover slowly. This suggests a much more protracted recovery in many nuggets of Japanese activity. The Yen As A Safe Haven Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-9). Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. With global growth bottoming, a continued rise in global equity markets is a key risk to our scenario. However, if inflows into Japan accelerate on cheap equity valuations, the propensity of investors to hedge these purchases will be much less today, given how cheap the yen has become. This is especially important since in an era of rising budget deficits, balance of payments dynamics can resurface as the key driver of currencies. This suggests the negative yen/Nikkei correlation will continue to weaken, as has been the case in recent quarters. Chart I-9Real Rates And The Yen Chart I-10USD/JPY And DXY Are Positively Correlated As a low-beta currency, our contention is that the yen will surely weaken on its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-10). This places short USD/JPY trades in an envious “heads I win, tails I do not lose too much” position. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito from 8 January 8th, 1989 until his abdication on April 30th, 2019. 2 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: Nonfarm payrolls increased by 2.5 million in May after declining by a record 20.7 million in April. This was better than expectations of an 8 million job loss. The unemployment rate fell from 14.7% to 13.3%. The NFIB business optimism index increased from 90.9 to 94.4 in May. Headline consumer price inflation fell from 0.3% to 0.1% year-on-year in May. Core inflation fell from 1.4% to 1.2%. Initial jobless claims increased by 1542K for the week ended June 5th. The DXY index fell by 1.3% this week. On Wednesday, the Fed left interest rates unchanged, with a signal that rates might not be increased before the end of 2022. The Fed also stated that it will maintain the current pace of Treasuries and mortgage-backed securities purchases, at minimum. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been improving: The Sentix investor confidence index improved from -41.8 to -24.8 in June. Employment increased by 0.4% year-on-year in Q1. GDP contracted by 3.1% year-on-year in Q1. The euro appreciated by 1.2% against the US dollar this week. At an online seminar held this week, Isabel Schnabel, member of the executive board of the ECB, noted that "evidence is increasingly pointing towards a protracted impact of the crisis on both demand and supply conditions in the euro area and beyond" and that the current PEPP remains appropriate in de aling with the global recession. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The coincident index fell from 88.8 to 81.5 in April. The leading economic index also decreased from 85.1 to 76.2. The current account surplus shrank from ¥1971 billion to ¥262.7 billion in April. Annualized GDP fell by 2.2% year-on-year in Q1. Machine tool orders plunged by 52.8% year-on-year in May, following a 48.3% decrease the previous month. The Japanese yen appreciated by 2.6% against the US dollar this week. According to a Bloomberg survey, the majority of economists believe that the BoJ has done enough to cushion the economy, and expect the BoJ to leave current monetary policy unchanged next week. We continue to recommend the yen as a safe-haven hedge, especially given a possible second wave of COVID-19. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: Halifax house prices increased by 2.6% year-on-year in May. Retail sales surged by 7.9% year-on-year in May, up from 5.7% the previous month. GfK consumer confidence was little changed at -36 in May. The British pound rose by 1% against the US dollar this week. On Wednesday, BoE governor Andrew Bailey noted that easing lockdown restrictions has been fueling a recovery in the UK, which could be faster than previously anticipated. Our long GBP/USD and short EUR/GBP positions are 4% and 0.2% in the money, respectively. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The NAB business confidence index increased from -45 to -20 in May. The business conditions index also ticked up from -34 to -24. The Westpac consumer confidence index increased from 88.1 to 93.7 in June. Home loans declined by 4.8% month-on-month in April, down from a 0.3% increase the previous month. That said, expectations were for a fall of 10%. AUD/USD was flat this week. While the RBA has other options in its policy toolkit to combat the global recession, negative interest rates is still on the table and hasn't been totally ruled out. We remain positive on the Australian dollar both against the US dollar and the New Zealand dollar due to cheap valuations and increasing Chinese stimulus. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Manufacturing sales declined by 1.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. ANZ business confidence increased from -41.8 to -33 in June. The activity outlook index also ticked up from -38.7 to -29.1. The New Zealand dollar appreciated by 0.8% against the US dollar this week. RBNZ's Deputy Governor Geoff Bascand said that house prices in New Zealand could fall by 9-10% or even worse. Besides disrupting exports and imports for a trade-reliant country like New Zealand, the global health crisis is also likely to further reduce immigration to New Zealand, curbing housing demand. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: The unemployment rate ticked up from 13% to 13.7% in May, versus expectations of a rise to 15%, but this was due to a rise in the participation rate from 59.8% to 61.4%. Average hourly wages increased by 10% year-on-year in May. Net employment increased by 289.6K, up from a 1994K job loss the previous month. Housing starts increased by 193.5K in May, up from 166.5K the previous month. The Canadian dollar fell by 0.2% against the US dollar this week. The labor market has seen some recovery in May with the gradual easing of COVID-19 restrictions and re-opening of the economy. Employment rebounded and absences from work dropped. Notably, Quebec accounts for nearly 80% of overall employment gains in May. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: FX reserves increased from CHF 801 billion to CHF 816 billion in May. The unemployment rate increased from 3.1% to 3.4% in May, lower than the expected 3.7%. The Swiss franc appreciated by 2.3% against the US dollar this week, reflecting a flight back to safety amid concerns over political risks and a second wave of COVID-19. While the euro has been strong recently and EUR/CHF touched 1.09, the franc has lost most of those gains. We are lifting our limit buy on EUR/CHF to 1.055 on expectations we are in a run-of-the-mill correction. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Manufacturing output shrank by 1.6% month-on-month in April. PPI fell by 17.5% year-on-year in May. Headline consumer prices increased by 1.3% year-on-year in May, up from 0.8% the previous month. Core inflation also increased from 2.8% to 3% in May. The Norwegian krone fell by 1.5% against the US dollar this week. The recent OPEC meeting over the weekend concluded that all members agreed to the extension to curb oil production. We believe that oil prices will continue to recover, and recommend to stay long the Norwegian krone. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Household consumption plunged by 10% year-on-year in April. The current account surplus increased from SEK 43.2 billion to SEK 80.6 billion in Q1. Headline consumer prices recovered from a 0.4% year-on-year decline to flat in May. The Swedish krona increased by 0.6% against the US dollar this week. Sweden is benefitting economically from a less stringent Covid-19 agenda. With very cheap valuations, we remain short EUR/SEK and USD/SEK. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Please note that yesterday we published Special Report on Egypt recommending buying domestic bonds while hedging currency risk. Today we are enclosing analysis on Hungary, Poland and Colombia. I will present our latest thoughts on the global macro outlook and implications for EM during today’s webcast at 10 am EST. You can access the webcast by clicking here. Yours sincerely, Arthur Budaghyan Hungary Versus Poland: Mind The Reversal Conditions are set for the Hungarian forint to outperform the Polish zloty over the coming months. We recommend going long the HUF against the PLN. Hungarian opposition parties criticized the government about the considerable depreciation in the forint. As a result, we suspect that political pressure from Prime Minister Viktor Orban led monetary authorities to alter their stance since April. Critically, the main architect of super-dovish monetary policy Marton Nagy resigned from the board of the central bank on May 28. In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. The Hungarian central bank (NBH) tweaked its monetary policy in April after the currency had plunged to new lows against the euro, underperforming its Central European counterparts. The NBH widened its policy rate corridor by hiking the upper interest band to 1.85% and keeping the policy rate at 0.90%. The wider interest rate corridor makes it more costly for commercial banks to borrow reserves from the central bank. Hence, such liquidity tightening is positive for the forint. For years, Hungary was pursuing a super-easy monetary policy and consumer price inflation rose to 4% (Chart I-1). With the NBH keeping interest rates close to zero, real rates have plunged well into negative territory (Chart I-2, top panel). Chart I-1Hungary: Inflation Could Pause For Now Chart I-2Hungary Vs. Poland: Real Rates Reversal Is Coming In brief, the central bank has been behind the inflation curve. As a result, the forint has been depreciating against both the euro and its central European peers. In such a situation, the key to reversal in the exchange rate trend would be the monetary authority’s readiness to raise real interest rates. The NBH has made a small step in this direction. Going forward, the central bank will be restrained in its quantitative easing (QE) program and will not augment it any further. So far, QE uptake has been slow: around half out of the available HUF 1,500 billion has been tapped by commercial banks and corporates. Importantly, the NBH announced its intention to sterilize its government and corporate bond purchases. Already, the commercial banks excess reserves at the central bank have fallen to zero, which suggests that liquidity is no longer abundant in the banking system (Chart I-3). In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. Hungarian authorities have become more cognizant of the economic and financial risks associated with their ultra-accommodative policies. For instance, they initiated a clampdown on real estate speculation, which is leading to dwindling real estate prices. This will lead to a decline in overall inflation expectations and, thereby, lift expected real interest rates. The open nature of Hungary’s economy – whereby exports of goods and services constitute 85% of GDP - makes it much more sensitive to pan-European tourism and manufacturing cycles. With the collapse in its manufacturing and tourism revenues, wage growth in Hungary is bound to decelerate rapidly (Chart I-4). Chart I-3Hungary: Central Bank Has Drained Liquidity Chart I-4Economic Growth: Hungary Is More Vulnerable Than Poland Rapidly deteriorating wage and employment dynamics reduces the odds of an inflation breakout anytime soon. This will cool down inflation and, thereby, increase real rates on the margin. The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. Bottom Line: Although this monetary policy adjustment does not entail the end of easy policy in Hungary, generally, it does signal restraint on the part of monetary authorities resulting from a much reduced tolerance for currency depreciation. This creates conditions for the forint to outperform. Poland In the meantime, Polish monetary authorities have switched into an ultra-accommodative mode. Recent policy announcements by the National Bank of Poland (NBP) represent the most dramatic example of policy easing in Central Europe. Such a policy stance in Poland will produce lower real rates than in Hungary, which is negative for the Polish zloty against the forint. The NBP is set to finance the majority of a new 11% of GDP fiscal spending program enacted by the government amid the COVID-19 lockdowns. This amounts to de-facto public debt and fiscal deficit monetization. The latter will not be sterilized unlike in Hungary and will therefore lead to an excess liquidity overflow in the banking system. The Polish central bank has cut interest rates by 140 bps to 10 bps since March. Pushing nominal rates down close to zero has produced more negative real policy rates than in Hungary (Chart I-2, top panel on page 2). Also, Polish prime lending rates in real terms have fallen below those in Hungary (Chart I-2, bottom panel). Chances are that inflation in Poland will also prove to be stickier than in Hungary due to the minimum wage raise at the beginning of the year and very aggressive fiscal and monetary stimulus since the pandemics has erupted (Chart I-5). Critically, the Polish economy is much less open than Hungary’s, and it is therefore less vulnerable to the collapse of pan-European manufacturing and tourism. This will ensure better employment and wage conditions in Poland. All in all, Poland’s final demand outperformance, versus Hungary, will contribute to a higher rate of inflation there. Bottom Line: The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. This is producing a U-turn in both countries’ nominal and relative real interest rates, which heralds a reversal in the HUF / PLN cross rate (Chart I-6). Chart I-5Polish Inflation Will Be Sticker Than In Hungary Chart I-6Go Long HUF / Short PLN Investment Strategy For Central Europe A new trade: go long the HUF versus the PLN. Take a 3% profit on the short HUF and PLN / long CZK trade. Close the short IDR / long PLN trade with a 20% loss. Downgrade central European bourses (Polish, Czech and Hungarian) from an overweight to a neutral allocation within the EM equity benchmark. Lower for longer European interest rates disfavor bank stocks that dominate central European bourses. Andrija Vesic Associate Editor andrijav@bcaresearch.com Colombia: Continue Betting On Lower Rates Colombia has been badly hit by two shocks: the precipitous fall in oil prices and the strict quarantine measures to constrain the spread of the COVID-19 outbreak. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. We have been recommending receiving 10-year swap rates in Colombia since April 23rd and this strategy remains unchanged: While oil prices seem to have rebounded sharply, they will remain structurally low (Chart II-1). The Emerging Markets Strategy team's view is that oil prices will average $40 per barrel this year and next.1 After the recent rally, chances of further upside in crude prices are limited. Chart II-1A Long-Term Perspective On Oil Prices Table II-1Colombia’s Fiscal Package Is The Lowest In The Region Colombia's high sensitivity to oil prices is particularly visible via its current account balance. Indeed, Colombia’s net crude exports cover as much as 50% of the current account deficit, such that low oil prices severely affect the currency and produce a negative income shock for the economy. Fiscal policy remains unreasonably tight, especially in the face of the global pandemic. The government’s fiscal response plan amounts to only a meagre 1.5% of GDP. This is low not only compared to advanced economies but also to the rest of Latin America (Table II-1). Moreover, President Duque’s administration has been running the tightest fiscal budget in almost a decade, with the primary fiscal balance reaching 1% of GDP before the pandemic. The country’s COVID-19 response has been fast and effective. Colombia has managed to achieve the lowest amount of infections and deaths among major economies in Latin America (Chart II-2). Chart II-2COVID-19 Casualties Across Latin America Duque’s administration has taken a pragmatic approach to handling the pandemic by enforcing strict lockdowns and banning international and inter-municipal travel since late March, only three days after the country’s first casualty. Further, the nationwide confinement measures have been extended until July 1st, with particularly stringent rules applying to major cities. These have helped the country avoid a nation-wide health crisis, but they will engender prolonged economic pain. Regarding monetary stimulus, the central bank (Banrep) has cut interest rates by 150 basis points since March of this year. It also embarked on the first and largest QE program in the region. Banrep has committed to purchase 12 trillion pesos worth of government and corporate securities (amounting to a whopping 8% of GDP). Consumer price inflation is falling across various core measures and will drop below the low end of Banrep’s target range (Chart II-3). This will push the central bank to continue cutting rates. Despite the monetary easing, nominal lending rates are still restrictive. Real lending rates (deflated by core CPI) remain elevated at 7% (Chart II-4). Chart II-3Colombia: Inflation Will Fall Below Target Chart II-4Colombia: Real Lending Rates Are Still High Chart II-5The Colombian Economy Was Already Under Pressure Importantly, there has not been an appropriate amount of credit support and debt waving programs for SMEs, as there has been in many other countries. Given that SMEs employ a large share of the workforce, and that household spending accounts for about 70% of GDP, consumer spending and overall economic growth will contract substantially and be slow to recover. Employment rates had already been contracting, and wage growth downshifting, before the pandemic started (Chart II-5). Household income is now certainly in decline as major cities are in full lockdown and economic activity is frozen. Investment Recommendations Even though we are structurally positive on the country due to its orthodox macroeconomic policies, positive structural reforms, and low levels of debt among both households and companies, we maintain a neutral allocation on Colombian stocks within an EM equity portfolio. This bourse is dominated by banks and energy stocks. The lack of both fiscal support and bank loan guarantees amid the recession means that banks will carry the burden of ultimate losses. They will suffer materially due to loan restructuring and defaults. For fixed income investors, we reiterate our call to receive 10-year swap rates and recommend overweighting local currency government bonds versus the EM domestic bond benchmark. The yield curve is steep and real bond yields are elevated (Chart II-6). Hence, long-term interest rates offer great value. Additional monetary easing, including quantitative easing, will suppress yields much further. Chart II-6A Great Opportunity In Colombian Rates Chart II-7The COP Has Depreciated Considerably We are upgrading Colombia sovereign credit from neutral to overweight within an EM credit portfolio. General public debt (including the central and state governments) stands at 59% of GDP. Conservative fiscal policy and the central bank’s large purchases of local bonds will allow the government to finance itself locally. Presently, 40% of public debt is foreign currency and 60% local currency denominated. As a result, sovereign credit will outperform the EM credit benchmark. In terms of the currency, we recommend investors to be cautious for now. Even though the peso is cheap (Chart II-7), another relapse in oil prices or a potential flare up in social protests could cause further downfall in the currency. Juan Egaña Research Associate juane@bcaresearch.com 1 This differs from the view of BCA’s Commodities and Energy Strategy service. We believe structural forces such as the lasting decline in air travel and commuting will impede a recovery in oil demand while, at the same time, US shale production will rise again considerably if crude prices rise and remain well above $40 Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
In a webcast this Friday I will be joined by our Chief US Equity Strategist, Anastasios Avgeriou to debate ‘Sectors To Own, And Sectors To Avoid In The Post-Covid World’. Today’s report preludes five of the points that we will debate. Please join us for the full discussion and conclusions on Friday, June 12, at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8.00 PM HKT). Highlights Technology is behaving like a Defensive. Defensive versus Cyclical = Growth versus Value. Growth stocks are not a bubble if bond yields stay ultra-low. The post-Covid world will reinforce existing sector mega-trends. Sectors are driving regional and country relative performance. Fractal trade: Long ZAR/CLP. Chart of the WeekSector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price 1. Technology Is Behaving Like A Defensive How do we judge an equity sector’s sensitivity to the post-Covid economy, so that we can define it as cyclical or defensive? One approach is to compare the sector’s relative performance with the bond price. According to this approach, the more negatively sensitive to the bond price, the more cyclical is the sector. And the more positively sensitive to the bond price, the more defensive is the sector (Chart I-1). On this basis the most cyclical sectors in the post-Covid economy are, unsurprisingly: energy, banks, and materials. Healthcare is unsurprisingly defensive. Meanwhile, the industrials sector sits closest to neutral between cyclical and defensive, showing the least sensitivity to the bond price. The tech sector’s vulnerability to economic cyclicality appears to have greatly reduced. The big surprise is technology, whose high positive sensitivity to the bond price during the 2020 crisis qualifies it as even more defensive than healthcare. This contrasts sharply with its behaviour during the 2008 crisis. Back then, tech’s relative performance was negatively correlated with the bond price, defining it as classically cyclical. But over the past year, tech’s relative performance has been positively correlated with the bond price, defining it as classically defensive (Chart I-2 and Chart I-3). Chart I-2In 2008, Tech Behaved Like ##br##A Cyclical... Chart I-3...But In 2020, Tech Is Behaving Like A Defensive This is not to say that the big tech companies cannot suffer shocks. They can. For example, from new superior technologies, or from anti-oligopoly legislation. However, the tech sector’s vulnerability to economic cyclicality appears to have greatly reduced over the past decade. 2. Defensive Versus Cyclical = Growth Versus Value If we reclassify the tech sector as defensive in the 2020s economy, then the post mid-March rebound in stocks was first led by defensives. Cyclicals took over leadership of the rally only in May. Moreover, with the reclassification of tech as defensive, the two dominant defensive sectors become tech and healthcare. But tech and healthcare are also the dominant ‘growth’ sectors. The upshot is that growth versus value has now become precisely the same decision as defensive versus cyclical (Chart I-4). Chart I-4Defensive Versus Cyclical = Growth Versus Value 3. Growth Stocks Are Not A Bubble If Bond Yields Stay Ultra-Low Some people fear that growth stocks have become dangerously overvalued. There is even mention of the B-word. Let’s address these fears. Yes, valuations have become richer. For example, the forward earnings yield for healthcare is down to 5 percent; and for big tech it is down to just over 4 percent. This valuation starting point has proved to be an excellent guide to prospective 10-year returns, and now implies an expected annualised return from big tech in the mid-single digits. Yet this modest positive return is well above the extremes of the negative 10-year returns implied and delivered from the dot com bubble (Chart I-5). Chart I-5Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Moreover, we must judge the implied returns from growth stocks against those available from competing long-duration assets – specifically, against the benchmark of high-quality government bond yields. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. Meaning higher absolute valuations (Chart I-6 and Chart I-7). Chart I-6Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Chart I-7Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 In the real bubble of 2000, big tech was priced to return 12 percent (per annum) less than the 10-year T-bond. Whereas today, the implied return from big tech – though low in absolute terms – is above the ultra-low yield on the 10-year T-bond. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. The upshot is that high absolute valuations of growth stocks are contingent on bond yields remaining at ultra-low levels. And that the biggest threat to growth stock valuations would be a sustained rise in bond yields. 4. The Post-Covid World Will Reinforce Existing Sector Mega-Trends If a sector maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. This is because the lower share price stretches the elastic between the price and the up-trending profits, resulting in an eventual catch-up. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the price may be forced ultimately to catch-down. This leads to a somewhat counterintuitive conclusion. After a big drop in the stock market, long-term investors should not buy everything that has dropped. And they should not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. In this regard, the post-Covid world is likely to reinforce the existing mega-trends. The profits of oil and gas, and of European banks will remain in major structural downtrends (Chart I-8 and Chart I-9). Conversely, the profits of healthcare, and of European personal products will remain in major structural uptrends (Chart I-10 and Chart I-11). Chart I-8Oil And Gas Profits In A Major ##br##Downtrend Chart I-9Bank Profits In A Major ##br##Downtrend Chart I-10Healthcare Profits In A Major Uptrend Chart I-11Personal Products Profits In A Major Uptrend 5. Sectors Are Driving Regional And Country Relative Performance Finally, sector winners and losers determine regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy and healthcare-heavy US stock market must outperform, while healthcare-lite emerging markets (EM) must underperform. It also follows that the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. Sector mega-trends will shape the mega-trends in regional and country relative performance. Equally, when energy and banks underperform, the energy-heavy Norway and bank-heavy Spain stock markets must underperform. (Chart I-12 and Chart I-13). These are just a few examples. Every stock market is defined by a sector fingerprint which drives its relative performance. Chart I-12Sector Relative Performance Drives... Chart I-13...Regional And Country Relative Performance If sector mega-trends continue, they will also shape the mega-trends in regional and country relative performance – favouring those stock markets that are heavy in growth stocks and light in old-fashioned cyclicals. Please join the webcast to hear the full debate and conclusions. Fractal Trading System* This week’s recommended trade is to go long the South African rand versus the Chilean peso. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long Spanish 10-year bonds versus New Zealand 10-year bonds achieved its 3.5 percent profit target at which it was closed. And long Australia versus New Zealand equities is approaching its 12 percent profit target. The rolling 1-year win ratio now stands at 63 percent. Chart I-14ZAR/CLP When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Social distancing must persist to prevent dangerous super-spreading of COVID-19. The jobs recovery will be much weaker than the output recovery, because the sectors most hurt by social distancing have a very high labour intensity. This will force a prolonged period of ultra-accommodative monetary policy… …structurally favour T-bonds and Bonos over Bunds and OATs… …growth defensives such as tech and healthcare… …and the S&P 500 over the Euro Stoxx 50. Stay overweight Animal Care (PAWZ). Working from home has generated a puppy boom. Fractal trade: short gold, long lead. Feature As economies reopen, economists and strategists are quibbling about the shape of the output recovery: U, V, W, square root, or even ‘swoosh’. But for the furloughed or displaced worker, the more urgent question is, what will be the shape of the jobs recovery? Unfortunately, the jobs recovery will be much weaker than the output recovery – because the sectors most hurt by social distancing have a very high labour intensity (Chart Of The Week). Chart Of The Week 1ALeisure And Hospitality Makes A Large Contribution To Jobs Relative To Output Chart Of The Week 1BFinance Makes A Small Contribution To Jobs Relative To Output Output Might Snap Back, But Jobs Will Not The sectors most hurt by social distancing make a huge contribution to employment but a much smaller contribution to economic output. This is true for Europe and all advanced economies, though the following uses US data given its superior granularity and timeliness. The leisure and hospitality sector generates 11 percent of jobs, but just 4 percent of output. Retail trade generates 10 percent of jobs, but just 5 percent of output. It follows that if both sectors are operating at half their pre-coronavirus capacity, output will be down by 4.5 percent, but employment will collapse by 10.5 percent. Conversely, sectors which are relatively unaffected by social distancing make a small contribution to employment but a much bigger contribution to economic output. Financial activities generate just 6 percent of jobs, but 19 percent of economic output. Information technology generates just 2 percent of jobs, but 5 percent of output (Table I-1). Table I-1Sectors Hurt By Social Distancing Have A Very High Labour Intensity If economies are reopened but social distancing persists – either via government policy or personal choice – then output can rebound in a V-shape, but employment cannot (Chart I-2). Forcing a prolonged period of ultra-accommodative monetary policy, with all its ramifications for financial markets. Chart I-2UK Unemployment Is Set To Surge If The US Is Any Guide This raises a key question. Must social distancing persist? To answer, we need to pull together our latest understanding of COVID-19. COVID-19: What We Know So Far Many people argue that coronavirus fears are disproportionate. The mortality rate seems comfortingly low, at well below 0.5 percent (Chart 3). Yet this argument misses the point. Chart I-3The COVID-19 Mortality Rate Is Not High COVID-19 is dangerous not because it kills, but because it makes a lot of people seriously ill. It has a low mortality rate, but a high morbidity rate. According to the World Health Organisation, around one in six that gets infected “develops difficulty in breathing”. Moreover, The Lancet points out that many recovered COVID-19 patients suffer pulmonary fibrosis, a permanent scarring of the lungs that impairs their breathing for the rest of their lives. Hence, while COVID-19 is highly unlikely to kill you, it could damage your health forever1 (Figure I-1). Figure 1COVID-19 Is Unlikely To Kill You, But It Could Permanently Damage Your Lungs The most famous COVID-19 victim to date is British Prime Minister Boris Johnson who spent several days recovering in intensive care. By his own admission, Johnson’s only pre-existing conditions are that he is overweight and “drinks an awful lot”. But those pre-existing conditions could apply to a large swathe of the population. COVID-19 is virulent. But we now know that most infections are the result of so-called ‘super-spreaders’ – a small minority of virus carriers who infect tens or hundreds of other people. We also know that talking loudly, singing, or chanting tends to eject higher doses of the virus, and in an aerosol form that can linger in enclosed spaces. This creates the perfect conditions for one infected person to infect scores of others very quickly. Based on this latest knowledge, the good news is that economies can reopen. The bad news is that, until an effective vaccine is developed, social distancing must persist. Specifically, people must avoid forming the crowds, congregations, and loud gatherings that can generate very dangerous super-spreading events. Hence, the sectors that are most hurt by social distancing – leisure and hospitality and retail trade – will continue to operate well below capacity for many months, at a minimum. And as these sectors have a very high labour intensity, there will be no V-shape recovery in jobs. Without Higher Bond Yields, European Equities Struggle To Outperform Social distancing is set to persist, which will create heaps of slack in advanced economy labour markets. This will force central banks to push the monetary easing ‘pedal to the metal’ – though in many cases, the pedal is already at the metal. In turn, this will force bond yields to stay ultra-low and, where they can, go even lower. One immediate takeaway is to stay overweight positively yielding US T-bonds and Spanish Bonos versus negatively yielding German Bunds and French OATs. Depressed bond yields must also compress the discount rate on competing long-duration investments that generate safely growing cashflows. Meaning, growth defensive equities such as technology and healthcare. Now comes the part that is conceptually difficult to grasp because it is novel to this unprecedented era of ultra-low bond yields. Take some time to absorb the following few paragraphs. For growth defensives, both components of the discount rate – the bond yield and the equity risk premium (ERP) – compress together. This is because the ERP is a tight function of the difference in equity and bond price ‘negative asymmetries’, defined as the potential price downside versus upside. When bond yields converge to their lower limit, bond prices converge to their upper limit, which increases the potential price downside versus upside. The result is that the difference in equity and bond negative asymmetries converges to zero, forcing the ERP to converge to zero. As the discount rate on growth defensives such as tech and healthcare collapses towards zero, the net present value must increase exponentially. This exponentially higher valuation of tech and healthcare is a mathematical consequence of the novel risk relationship between growth defensive equities and bonds at ultra-low bond yields. The unprecedented phenomenon has a major implication for European equity relative performance. The Euro Stoxx 50 is heavily underweight technology and healthcare, and this defining sector fingerprint is the key structural driver of European equity market relative performance (Chart I-4). Meanwhile, the relative performance of technology and healthcare is just an inverse exponential function of the bond yield (Chart I-5). The upshot is that European equities tend to outperform other regions only when bond yields are heading higher and the growth defensives are underperforming (Chart I-6). Chart I-4The Euro Stoxx 50's Underweight In Tech Drives Its Relative Performance Chart I-5Tech Outperforms When The Bond Yield Declines... Chart I-6...Hence, Without Higher Bond Yields The Euro Stoxx 50 Struggles To Outperform Some commentators are calling the higher valuations in tech and healthcare a new bubble. But it is a bubble only to the extent that bond yields are in a ‘negative bubble’, meaning that ultra-low yields are unsustainable. However, with social distancing set to leave heaps of slack in the advanced economy labour markets, ultra-low bond yields are here to stay and could go even lower. Moreover, as shown earlier, tech and healthcare demand and output are immune to social distancing. They may even benefit from social distancing. Hence, on a one-year horizon and beyond, stay overweight the growth defensive tech and healthcare sectors. And stay overweight the tech and healthcare heavy S&P 500 versus Euro Stoxx 50. A Puppy Boom We finish on a very positive note for animal lovers. The shift to working from home has generated a puppy boom. The Association of German Dogs claims that “the demand for puppies is endless” and the UK Kennel Club says that “there is unprecedented demand.” In the era of social distancing, the waiting list for puppies has quadrupled, and prices of easy to look after crossbreeds such as cockapoos have more than doubled. The demand for pet food and equipment is also very strong. Dogs make excellent companions for the socially isolated, which describes how many people are now feeling. Furthermore, with millions of people now working from home or on extended furlough, a growing number of households can fulfil the dream of owning a dog. We have recommended a structural overweight to the Animal Care sector based on the ‘humanisation’ of pets and the structural uptrend in spend per pet, especially on veterinary costs (Chart I-7). Animal Care has outperformed by 50 percent in the past two and a half years, but the shift to working from home will add impetus to the structural uptrend (Chart I-8). Chart I-7Animal Care Prices Are Rising... Chart I-8...And The Animal Care Sector Is Strongly Outperforming Stay overweight Animal Care. The ETF ticker, appropriately enough, is called PAWZ. Fractal Trading System This week’s recommended trade is to short gold versus lead, given that the relative performance recently reached a fractal resistance point that has successfully identified four previous turning points. Set the profit target and symmetrical stop-loss at 13 percent. In our other open trades, five are in profit and one is in loss. The rolling 1-year win ratio now stands at 64 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 https://www.thelancet.com/journals/lanres/article/PIIS2213-2600(20)30222-8/fulltext Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Chart 1More Stimulus Forthcoming? Last week we posited that bond yields could move modestly higher during the next couple of months as the US economy re-opens and economic growth recovers. However, any economic recovery is contingent on the US consumer maintaining an adequate amount of income, whether that income comes from employment or government assistance. So far, real personal income is holding up nicely. It is actually up 9% since February as the CARES act’s one-time stimulus checks and enlarged unemployment insurance benefits have more than offset the 9% drop in income from non-government sources (Chart 1). Contrast this with 2008, when government assistance only tempered the peak-to-trough decline in income from 8% to 4%. However, the stimulus checks are not recurring and the extra unemployment benefits lapse at the end of July. Before then, either employment income will have to rise or the government will have to pass additional stimulus measures. Otherwise, real personal income will fall and any nascent economic recovery will be stopped in its tracks. Stay tuned. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 181 basis points in May, bringing year-to-date excess returns up to -705 bps. The average index spread tightened 28 bps on the month and has tightened 199 bps since the Fed unveiled its corporate bond purchase programs on March 23. However, the index’s 12-month breakeven spread remains above its historical median (Chart 2). Spreads are high relative to history and the investment grade corporate bond market benefits strongly from Fed support.1 The sector therefore meets both our criteria for an overweight allocation. One caveat to our overweight stance is that while Fed lending can forestall bankruptcy, it can’t clean up highly-levered corporate balance sheets. With firms taking on more debt, either from the Fed or the public market, ratings downgrades remain a risk. Indeed, Moody’s already downgraded 18 investment grade issuers in March and another 7 in April, while recording no upgrades in either month (panel 4). With downgrade risk still in play, sector and firm selection is particularly important. Investors should seek out pockets of the market that are unlikely to be downgraded, subordinate bank bonds being one example (bottom panel).2 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3AHigh-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 427 basis points in May, bringing year-to-date excess returns up to -937 bps. The average index spread tightened 107 bps on the month and has tightened 463 bps since the Fed unveiled its corporate bond purchase programs on March 23. Encouragingly, lower-rated (B & below) credits performed well in May, but they still lag the Ba credit tier since the March 23 peak in spreads (Chart 3A). Appendix A on page 14 shows returns for all fixed income sectors since March 23. Chart 3BB-Rated Excess Return Scenarios Better performance from the lower credit tiers that don’t benefit from the Fed’s emergency facilities signals that investors are becoming more optimistic about an economic turnaround. But for our part, we remain skeptical about valuations in the B-rated and lower space. Chart 3B shows that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds.3 The same holds true for lower-rated credits. We appear to be on track for that sort of outcome. Moody’s recorded 15 defaults in April, the highest monthly figure since the 2015/16 commodity bust, bringing the trailing 12-month default rate up to 5.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 21%. MBS: Underweight Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in May, bringing year-to-date excess returns up to -31 bps. Chart 4MBS Market Overview The average yield of the conventional 30-year MBS index rose from 1.18% to 1.74% on the month, and the index duration extended from 1.5 to 2.9. The result is that value – as measured by the index option-adjusted spread (OAS) – has improved considerably, especially relative to other spread products. The 30-year conventional MBS index OAS is now 100 bps. This is greater than the 91 bps and 93 bps offered by Aaa-rated consumer ABS and Agency CMBS, respectively. It’s also greater than the 91 bps offered by Aa-rated corporate bonds (Chart 4). There’s no doubt that MBS are starting to look more attractive, and if current trends continue, we will likely upgrade our recommendation in the coming months. However, we are reluctant to do so just yet because we worry that the prepayment assumptions embedded in the current index OAS will turn out to be too low. Our concern stems from the extremely high primary/secondary mortgage spread (bottom 2 panels). That wide spread shows that capacity constraints have so far prevented mortgage originators from competing on price and dropping rates, even as Treasury and MBS yields plummeted. The risk remains that bond yields will stay low and that primary mortgage rates will eventually play catch-up. That could lead to a surge of refinancing activity and wider MBS spreads. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 162 basis points in May, bringing year-to-date excess returns up to -474 bps. Sovereign debt outperformed duration-equivalent Treasuries by 589 bps on the month, bringing year-to-date excess returns up to -930 bps. Foreign Agencies outperformed the Treasury benchmark by 99 bps in May, bringing year-to-date excess returns up to -798 bps. Local Authority debt outperformed Treasuries by 187 bps in May, bringing year-to-date excess returns up to -688 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -72 bps. Supranationals outperformed by 8 bps, bringing year-to-date excess returns up to -31 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.4 In that report we posited that valuation and the performance of EM currencies are the primary drivers of sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Saudi Arabia, UAE, Colombia, Qatar, South Africa and Malaysia all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 290 basis points in May, bringing year-to-date excess returns up to -646 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries tightened considerably in May, but valuations remain very attractive. The 2-year Aaa Muni / Treasury spread stands at -2 bps, implying a breakeven effective tax rate of 12%.5 Meanwhile, the 10-year Aaa Muni / Treasury spread is above zero (Chart 6). As we showed in last week’s report, municipal bonds are also attractively priced relative to corporates across the entire investment grade credit spectrum.6 In last week’s report we also flagged our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments is likely on its way, and the Fed could feel pressure to lower MLF pricing if that stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve steepened in May, as long-maturity yields rose and short-dated yields declined slightly. The 2-year/10-year Treasury slope steepened 5 bps to end the month at 49 bps. The 5-year/30-year Treasury slope steepened 19 bps to end the month at 111 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.7 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or if, like us, you do not want to make a large duration bet but suspect that Treasury yields will move modestly higher as the US economy re-opens during the next couple of months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.8 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 62 basis points in May, bringing year-to-date excess returns up to -494 bps. The 10-year TIPS breakeven inflation rate rose 8 bps to 1.16%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps to 1.48%. March’s market crash created an extraordinary amount of long-run value in TIPS. For example, headline CPI has to average below 1.16% for the next decade for a buy & hold investor to lose money long the 10-year TIPS and short the equivalent-maturity nominal Treasury. In last week’s report we argued that such a position should also work on a 12-month horizon.9 We calculate that headline CPI will have to be below -0.6% for the next 12 months for a long TIPS/short nominals position to lose money. With the recent drop in core inflation not mimicked by the trimmed mean and oil prices already on the mend (Chart 8), we’d bet against headline CPI getting that low. We also advise investors to enter real yield curve steepeners.10 In a repeat of the 2008/09 zero-lower-bound episode, front-end real yields jumped this year when oil prices collapsed (bottom 2 panels). In 2008/09, the real yield curve steepened sharply once oil prices troughed. We think now is a good time to position for a similar outcome. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 101 basis points in May, bringing year-to-date excess returns up to -104 bps. The index option-adjusted spread for Aaa-rated ABS tightened 49 bps on the month to 91 bps. It remains 51 bps above where it was at the beginning of the year. Aaa-rated ABS meet both our criteria to own. Index spreads are elevated and the securities benefit from Fed support through the TALF program. Specifically, TALF allows eligible counterparties to borrow against Aaa ABS collateral at a rate of OIS + 125 bps (Chart 9). TALF benefits don’t extend to non-Aaa ABS and we recommend avoiding those securities even though valuation is more attractive. Since the March 23 peak in spreads, non-Aaa ABS have outperformed Aaa-rated ABS by 197 bps, but have only re-traced a fraction of their prior losses (panel 2). As with municipal bonds, Aaa ABS yields are now below the cost of TALF loans. This certainly makes the bullish case for ABS spreads less robust. However, unlike munis, yields are only slightly below the cost of Fed support (bottom panel). Also, as shown on page 1, government spending has so far prevented a collapse in personal income. As long as this continues, it should prevent a wave of consumer bankruptcies and ABS defaults. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 99 basis points in May, bringing year-to-date excess returns up to -697 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 22 bps on the month to 169 bps. As was the case in April, non-Aaa CMBS underperformed Aaa securities (Chart 10). This is not surprising given that only Aaa-rated CMBS benefit from the Fed’s TALF program and the underlying credit outlook for commercial real estate is very poor with most people now working from home. We continue to recommend avoiding non-Aaa CMBS, but think that Aaa spreads can tighten further. The cost of borrowing against Aaa CMBS through TALF remains well below the current Aaa non-agency CMBS yield (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 62 basis points in May, bringing year-to-date excess returns up to -161 bps. The average index spread tightened 9 bps on the month to 93 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 29, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 29, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 51 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 51 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of May 29, 2020) Footnotes 1 For a detailed description of the Fed’s different emergency facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 For more details on our recommendation to favor subordinate bank bonds please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 3 For an explanation of how we calculate default-adjusted spreads by credit tier please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 5 Investors will see a greater after-tax yield in the municipal bond compared to the Treasury bond if their effective tax rate is above the breakeven effective tax rate. 6 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 8 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 For more details on this recommendation please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
The GAA DM Equity Country Allocation model is updated as of May 29, 2020. The model has not made any significant change this month. It has kept the same order for the top four overweight countries (Spain, Australia, Sweden, and the US) as well as the four large underweight countries (Japan, the UK, France, and Switzerland), as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark in May by 29 bps. The Level 1 model outperformed 2 bps because of the overweight in the US. The Level 2 model outperformed by 85 bps thanks to the overweight of Sweden, Germany and the Netherlands, as well as the underweight in the UK and Switzerland. Since going live, the overall model has outperformed its MSCI World benchmark by 180 bps, with 246 bps of outperformance from the Level 2 model, and 33 bps of outperformance from the Level 1 model. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US Model (Level 1) Chart 3GAA Non US Model (Level 2) For more on historical performance, please refer to our website https://www.bcaresearch.com/site/trades/allocation_performance/latest/G…. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. GAA Equity Sector Selection Model Chart 4Overall Model Performance The GAA Equity Sector Model (Chart 4) is updated as of May 29, 2020. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The model reversed its defensive stance implemented throughout March and April and is now tilted towards cyclical sectors. However, the semi-defensive tilt led the model to outperform its benchmark by 21 basis points during May. Year-to-date, the model has outperformed its benchmark by 88 basis points, and 86 basis points since inception. The model’s global growth proxy improved – mostly driven by EM currencies and commodity prices, and therefore turned positive on various cyclical sectors and reversed its defensive stance implemented in March. Global monetary easing and low rates should keep the liquidity component favouring a mixed bag of cyclical and defensive sectors. The valuation component remains muted across all sectors except Energy. However, multiple sectors are approaching expensive and cheap territories – mainly Info Tech (expensive), and Real Estate (cheap). The model awaits confirming momentum signals to change recommendations for that component. The model is now overweight five sectors in total, four cyclical sectors versus one defensive sectors. These are Information Technology, Consumer Discretionary, Communication Services, Materials and Health Care. Table 3Overall Model Performance For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 4Current Model Allocations Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy Senior Analyst amrh@bcaresearch.com