Asset Allocation
Highlights Excess dollar liquidity is still deteriorating. The U.S. economy’s robustness suggests this trend will continue. Elevated EM-dollar debt and declining dollar liquidity point to lower global growth and a stronger dollar. Despite these cyclical forces, a tactical dollar correction is unfolding. Slowdowns do not evolve in straight lines, and deep investor pessimism is setting the stage for a temporary bout of positive surprises. DXY could correct to 93, EUR/USD could rebound to 1.17-1.18, and USD/CAD could fall to 1.27. Buy NOK/SEK. Feature Investment legend Stanley Druckenmiller often refers to the primacy of liquidity trends when making investment decisions. BCA is highly sympathetic to this view, as our DNA is rooted in the analysis of global liquidity trends. Under this lens, a peculiar trend has caught our attention: U.S. commercial and industrial (C&I) loans are currently accelerating, and easing lending standards point to further gains (Chart I-1). This is in sharp contrast with the 2015-2016 market riots and subsequent slowdown – an episode where banks tightened lending standards and loan growth decelerated sharply. While this represents a good omen for the U.S. economy, it is a dangerous evolution for the rest of the world. Chart I-1Resilient Corporate Sector Credit Growth Growing credit is good for the U.S. because it points to robust domestic demand. However, it is problematic for the rest of the world for two reasons. First, if U.S. credit growth is more robust today than in 2016, it also implies that the Federal Reserve is unlikely to pause its rate-hike campaign as much as it did back then. Thus, U.S. rates, the key determinant of the global cost of capital, may have additional upside as interest rate markets anticipate a year-long pause. This is not yet a problem for the U.S. economy, but it is one for rest of the world, which is exhibiting poorer growth trends. Second, U.S. credit growth is already outpacing the expansion of U.S. money supply by 7%, pointing towards a decline in dollar liquidity available for international financial markets. The reduction in the Fed’s balance sheet will contribute to a continuation of this trend. The fall in the amount of dollars available for the international financial system creates a brake on growth. Over the past 10 years, each time money supply growth fell below the loan uptake of the U.S. corporate sector, our Global Industrial Activity Nowcast, BCA’s Global Leading Economic Indicator, Korean exports, and global export prices all deteriorated considerably (Chart I-2). Chart I-2Deteriorating Excess Liquidity Hurts Global Growth The large dollar debt of emerging markets lies behind this relationship. If less dollars are available outside the U.S. financial system, EM borrowers have to bid more for these greenbacks, raising their cost of capital. Additionally, borrowers are likely to hoard any dollars they access in order to repay their liabilities instead of using these greenbacks to finance economic transactions. As Chart I-3 shows this problem is particularly acute today: relative to EM GDP and various measures of U.S. money supply, EM dollar debt stands at record highs, highlighting deep vulnerabilities if liquidity conditions deteriorate. Chart I-3The Sensitivity To Dollar Liquidity Stems From The Large Stock Of Dollar Debt The problem extends beyond the capacity of the U.S. economy to generate deposits in excess of non-bank liabilities. Despite a meaningful slowdown in non-U.S. industrial production, official reserves are contracting relative to global industrial activity (Chart I-4). This further suggests that the global economy is experiencing some form of liquidity crunch, where the growth of monetary aggregates is insufficient to support economic activity. This is a deflationary environment. Chart I-4High-Powered Money Lagging Sagging Activity Another factor is at play: We have often argued in these pages that carry trades are a key component of global liquidity, as they allocate funds from economies where savings are excessive (i.e. borrowing in funding currencies) to economies that need those savings to generate growth (i.e. carry currencies).1 This is why the performance of high-octane carry trades is often a very reliable leading indicator of global economic activity. However, as Chart I-5 demonstrates, EM carry trades funded in yen continue to perform execrably, a poor signal for global liquidity and growth. Chart I-5Underperforming Carry Trades Add To The Global Liquidity Woes The impact of the deterioration in dollar liquidity, in FX reserves growth and in carry trade liquidity is evident in EM monetary aggregates. EM M1 growth has sharply decelerated. Since decelerating EM money supply presages weaker growth, it also points to stronger counter cyclical currencies like the dollar and the yen, especially against the very growth-sensitive commodity currencies (Chart I-6). The dollar bull market is unlikely to be over this year. Chart I-6Ominious Signal From EM Money Supply This risk is reinforced by the tight inverse correlation between the dollar and U.S. commercial banks’ liquidity. When U.S. banks curtail their holdings of securities, a key source of dollar liquidity in international markets, a dollar rally follows (Chart I-7). Not only does last year’s fall in securities in bank assets point to a firming greenback, but if banks also expand their loan books they will also further curtail their securities holdings. Chart I-7Contracting Liquidity On U.S. Commercial Banks Balance Sheets Support The Dollar The much-higher real rates offered by U.S. Treasurys relative to other DM bonds magnifies these dollar positive trends (Chart I-8). Hence, not only will global growth and money quantity considerations prove tailwinds for the greenback, but so will more well-known drivers of exchange rates. Chart I-8Real Rates Differentials Still Favor The Dollar Bottom Line: The deterioration in global liquidity conditions continues to argue in favor of the dollar. Since U.S. credit growth is still managing to accelerate, the Fed is unlikely to pause on the rate-hike front for too long, implying that excess dollars will further vanish from the international financial system. Consequently, global monetary conditions will tighten again, and global growth has not hit its nadir this cycle. On a 9 to 12 month basis, the dollar will benefit in this environment, especially against cyclical commodity currencies. How Fast Can Investors Price In Bad News? Due to the tightening in global liquidity conditions, global growth has suffered. However, the global and U.S. stock-to-bond ratios, two financial market metrics finely tuned to global economic gyrations, have already fallen in line with our Global Economic and Financial Diffusion Index that tallies the improvement and deterioration among more than 100 key global variables (Chart I-9). This implies that asset prices already reflect much of the deterioration in the economic outlook. Chart I-9The Global Economy Is Soft, But Financial Markets Already Reflect This Reality The problem for bears is that economic cycles rarely play out in a straight line. Now that asset prices are incorporating poor expectations, any positive surprises, even if modest, could lift asset prices. And there is room for improvement in global economic surprises (Chart I-10), particularly as Sino-U.S. trade relations are improving, global financial conditions are easing and China is trying to manage its slowdown. In fact, China’s fiscal and monetary stimulus already points to a rebound in growth-sensitive currencies, and to a correction in the dollar (Chart I-11). Chart I-10Scope For A Rebound In Economic Surprises Chart I-11Chinese Reflation Points To A Dollar Correction, Even If Only A Small One EM breadth confirms this message. Chart I-12 shows that the breadth of EM equities has not been this poor since early 2009. However, it has begun to rebound. Rebounds in EM breadth from such levels are historically associated with a weaker dollar, stronger commodity currencies and a weaker yen. Chart I-12Deep Oversold Conditions In EM Stocks Further Support The Case For A Dollar Correction Flows paint a similar picture. Global investors tend to buy Japanese bonds when global growth conditions deteriorate. Foreigners buying of Japanese fixed-income products now stands near record levels – something normally witnessed when credit spreads widen. However, positive economic surprises and the recent easing in global financial conditions suggest that these flows will reverse. When they do, the dollar will suffer (Chart I-13) and very pro-cyclical pairs like AUD/JPY will appreciate, even if only temporarily. Chart I-13Elevated Flows Into Japanese Bonds Suggest Overdone Pessimism, And Scope For A Dollar Correction It’s not just the commodity currencies that have upside: so does the euro. German bunds’ hedged yields have been rising relative to the U.S., which in recent years has often led to a rally in EUR/USD (Chart I-14). Chart I-14European Hedged Yields Imply A Euro Rebound How deep will this dollar down leg be? Our Intermediate-Term Timing Model suggests that the greenback’s weakness is likely to be limited. The dollar already trades below our fair-value estimate, but during corrective episodes it tends to trough at a 5% discount, implying that the DXY at 93 is a buy (Chart I-15). The euro, the dollar’s mirror image, could rebound to a roughly 5% overvaluation, implying that a countertrend move to 1.17-1.18 is also likely. Finally, the CAD may be able to rebound to USD/CAD 1.27. Chart I-15Gauging The Extent Of The Countertrend Moves At these levels, we would expect the countertrend moves to end. Ultimately, the aforementioned deterioration in global liquidity conditions means that positive surprises are likely to be transitory phenomena. Moreover, we doubt that Chinese stimulus, a key catalyst for a weaker dollar, will be very deep. Ultimately, our view remains that China is only trying to prevent a collapse of its economy and Beijing is extremely reluctant to stimulate enough to generate yet another boom – something needed to genuinely boost global growth if the Fed resumes its tightening campaign. Finally, while a trade deal between China and the U.S. is likely, investors should not get overly exuberant on its ramifications. Disagreements over intellectual property transfers will not be resolved anytime soon, and China remains the U.S.’s largest geopolitical challenger. Bottom Line: Global liquidity conditions may have deteriorated, suggesting a trough in global growth is not yet in the cards, but slowdowns do not evolve in straight lines. This means that oversold risk assets are likely to respond well to positive economic surprises. As a result, the countercyclical dollar will correct, probably to 93. The commodity currency complex should be the main beneficiary of this move, with downside in USD/CAD to 1.27. The euro could rebound toward 1.17-1.18. Buy NOK/SEK In June 29th, we closed our long NOK/SEK trade, expecting corrective action in this cross. A serious selloff ensued, and we are now buying this pair again.2 First, NOK/SEK is very sensitive to oil prices (Chart I-16), and BCA’s Commodity and Energy service anticipates a rebound in oil prices this year on the back of tightening supply conditions. Chart I-16BCA's Oil View Points To A NOK/SEK Rebound Second, the Norwegian economy is outperforming Sweden’s. As Chart I-17 shows, the Norwegian LEI continues to rise relative to Sweden’s, which historically implies a much stronger NOK/SEK. Beyond the LEIs, Norway’s PMIs and economic surprises have not only rebounded, but are also outpacing Sweden’s equivalent metrics. The Norwegian consumer is also participating in the good times. The three-month moving average of employment growth, retail sales and consumer confidence are stronger in Norway than in Sweden. Chart I-17Norwegian Growth Is Superior To Sweden's Third, after a long period of underperformance, Norwegian core inflation stands above that of Sweden, pointing to a potentially more hawkish Norges Bank than Riksbank. Fourth, NOK/SEK trades at a 5% discount to its fair value implied by our Intermediate-Term Timing model. Historically, a rebound in this cross follows such discounts Chart I-18). Chart I-18The ITTM Highlights An Attractive Entry Point To Buy NOK/SEK Finally, NOK/SEK is at a technically attractive spot. Our momentum oscillator shows deeply oversold conditions in the pair (Chart I-19). However, momentum has begun to roll over, suggesting that a reversal of those oversold conditions is starting. Moreover, the uptrend that began in the first quarter of 2016 has been confirmed. Had NOK/SEK not rebounded from where it did, that uptrend would have been seriously challenged, with potential greater downside ahead. Chart I-19Favorable Technical Setup To Buy NOK/SEK Bottom Line: We are re-opening our long NOK/SEK trade. We avoided the serious correction in this pair at the end of last year, but rebounding oil prices, an outperforming Norwegian economy, a potentially more-hawkish Norges Bank, a favorable valuation backdrop and positive technical developments argue in favor of buying this cross. Set a stop at 1.037 and a target at 1.120. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In the Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth", dated December 15, 2017. Both are available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "What Is Good For China Doesn’t Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Capacity utilization outperformed expectations, coming in at 78.7%. However, the Michigan Consumer Sentiment Index surprised to the downside, coming in at 90.7. Finally, existing home sales month-on-month grow also surprised negatively, coming in at 4.99 million. DXY has risen 0.2% this week. While we believe that DXY could experience some weakness in the next couple of months, we remain bullish on the DXY on a cyclical basis, as the strength in the U.S. economy will prompt the Fed to deliver more rate hikes than expected by market participants. Moreover, the sharp focus of Chinese policymakers on limiting indebtedness should continue to put downward pressure on global growth, helping the dollar in the process. Report Links: So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 2019 Key Views: The Xs And The Currency Market - December 7, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro has been negative: Both headline and core inflation came in line with expectations, coming in at 1.6% and 1% respectively. However, Markit Services PMI underperformed expectations, coming in at 50.8. Moreover, the Markit Manufacturing PMI also surprised negatively, coming in at 50.7. EUR/USD fell 0.4% this week. Thursday, ECB President Mario Draghi highlighted that downside risks to the European economy are building up. Overall, we agree with his assessment, and thus remain bearish on the euro on a cyclical basis. We believe that the Fed will eventually raise rates more than the market expects, widening the rate differentials between Europe and the U.S, which will hurt EUR/USD. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Import growth underperformed expectations, coming in at 1.9%. Moreover, driven by weak shipments to China, export growth also surprised to the downside, coming in at a 3.8% contraction. USD/JPY fell 0.1% this week. We remain bearish on the yen on a short-term basis, as the recent easing in global financial conditions and the improvement in sentiment towards risk assets will likely weigh on safe havens like the yen. Moreover, we believe that bond yields will start rising again. In light of the positive relationship between yields and USD/JPY, we remain bullish on this cross. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Retail sales yearly growth and retail sales excluding fuel yearly growth underperformed expectations, coming in at 3% and 2.6%, respectively. Moreover, the claimant count change also surprised to the downside, coming in at 20.8 thousand. However, average hourly earnings growth also outperformed, coming in at 3.4%. GBP/USD has rose 1.5% this week, lifted by motion by MPs to delay the implementation of Article 50, and news that Jeremy Corbyn may be moving more clearly in favor of a new referendum if Labour takes hold of Westminster. We are closing our short EUR/GBP trade today, after reaching our target of 0.87. At this point, we think that plenty of good news have been discounted by the pound. While it is true that GBP could go up on the back of positive political developments, we believe that the risk reward ratio of selling EUR/GBP is not as attractive anymore, especially if EUR/USD can rebound. That being said, we remain bullish on cable on a long-term basis due to its cheap valuation. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in the Australia has been mixed: The participation rate surprised to the downside, coming in at 65.6%. However, the unemployment rate surprised positively, coming in at 5%. Moreover, the change in employment also outperformed expectations, coming in at 21.6 thousand, however, this improvement was driven by part-time positions, not full-time ones. AUD/USD has fallen by 1% this week. We remain bearish on the AUD versus the USD on a cyclical basis given that we expect that Chinese authorities will remain reluctant to over-stimulate their economy while global dollar liquidity deteriorates. Thus, in light of the tight economic links between Australia and Chinese industrial activity, the Australian economy is likely to suffer, dragging the AUD down in the process. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The Q4 New Zealand inflation on a year–over-year basis remains at 1.9%, slightly surprised to the upside. December business NZ PMI has increased to 55.1. December credit card spending year over year growth dropped to 4.5%. NZD/USD appreciated by 0.3% this week. On a structural basis, we are negative on the kiwi. The new government is looking to lower immigration, and implement an unemployment mandate. Both of these developments would likely lower the neutral rate of interest for the RBNZ, which would imply a lower NZD/USD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Consumer price index year over year growth in December surprised to the upside, coming in at 2.0%. Core inflation year over year measure also increased to 1.7%, from the previous 1.5%. Retail sales in November month on month growth is lower than expected, dropping to -0.9% from the previous 0.2% in October. Year-on-year growth hit levels not seen since 2012. USD/CAD is now trading above 1.3354, after a small rebound by 0.5% this week following weak data releases. We are bearish on Canadian dollar in the long run, but are bullish on a tactical basis. Financial condition will stay easy, as suggested by Stephen S. Poloz’s interview with Bloomberg this Wednesday. Given the recent trade tensions, housing market and oil price plunge, there is less urgency for BoC to push for higher rate at this moment. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen 0.3% this week. We are bullish on this cross, given that the surge of the franc against the euro has caused a significant slowdown in Swiss inflation. The strong relationship between inflation and the currency means that any additional currency strength could severely impair the central bank’s objective of achieving 2% inflation. The SNB is very well aware of this developments, which means that it will likely intervene in the currency market in order to put a floor on EUR/CHF. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Norges Bank kept the key interest rate unchanged at 0.75%. Overall, we remain bullish on USD/NOK on a cyclical basis, given that this cross is very sensitive to real rate differentials. We expect the Fed to continue hiking rates this year at a faster pace than the Norges Bank, a development which will widen rate differentials and provide a tailwind for USD/NOK. That being said, we are positive on NOK/SEK. Not only is this cross attractive from a technical perspective, but also the expected rise in oil prices should help the Norwegian economy outperform the Swedish one. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has risen by 0.6% this week. We are bullish on the krona on a long-term basis, as we believe that the Riksbank’s monetary policy is too accommodative considering the strong inflationary pressures brewing in the Scandinavian country. The cyclical outlook for the SEK remains poor, as the krona displays the highest sensitivity to the dollar’s strength of any G10 currencies. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Feature Conditions are falling into place in Brazil that will facilitate a recovery in physical property prices as well as the outperformance of real estate stocks. With the overall Brazilian equity index having rallied considerably, investors are now wondering which sectors of the market presently offer the most upside with the least risk. Our bias is that the risk-reward of property stocks is currently attractive both relative to the overall equity index as well as in absolute terms (Chart I-1). Chart I-1Good Risk-Or-Reward In Property Sector As such, we recommend investors begin accumulating Brazilian real estate stocks on weakness and other proxies that stand to benefit from a revival in both residential and commercial property markets. The Macro Case For Real Estate Following years of severe depression, fertile ground for strong growth in Brazilian real estate and related assets is finally developing: Interest rates are falling, employment and incomes are rising, and credit availability is improving amid substantial pent-up demand for properties. Barring an outright failure by the government to adopt pension reforms, which would cause major financial market turbulence, the economy will continue on a recovery path (Chart I-2). Please see page 7 for more details. Chart I-2Domestic Demand Bottoming... We upgraded our recommended allocation in Brazil from underweight to overweight across equity, fixed-income, currency and credit markets right after the October elections.1 We argued that the presidential election victory by pro-business candidate Jair Bolsonaro was set to revive sentiment and “animal spirits” among businesses, unleashing pent-up demand for capital expenditures and hiring. On the whole, the Brazilian economy is recovering from the most severe economic depression of the past several decades (Chart I-3). Consequently, there is a lot of pent-up demand for discretionary spending in general and properties in particular. Chart I-3...After The Worst Recession In Decades Our view remains negative on Chinese growth and commodities. Historically, Brazilian financial markets have never sustainably diverged from commodities prices, as illustrated in Chart I-4. Nevertheless, going forward the odds that Brazilian domestic plays could decouple from commodities prices are non-trivial. Chart I-4Can Brazilian Financial Markets Decouple From Commodities? Importantly, aggregate exports make up only 13% of Brazilian GDP (Chart I-5). This indicates that Brazil’s exposure to global demand in general and commodities in particular is not substantial. Besides, Brazil’s commodities exports are very diversified – overseas shipments of each commodity accounts for only a small portion of Brazilian exports and GDP (Table I-1). Chart I-5Brazil Is A Closed Economy! In Brazil, the property market is one of the few sectors that is least exposed to global growth and most leveraged to local interest rates and household income growth. Hence, this sector stands to outperform in a scenario where global cyclicals and commodities fare poorly while domestic income and spending recover. Notably, real estate is the most leveraged play on falling real interest rates. The rationale for why real estate is more sensitive to real rather than nominal rates is as follows: Property prices benefit from higher inflation – higher inflation lifts nominal household income, which improves affordability for buyers and renters. In addition, investors often buy properties as an inflation hedge. Provided property prices positively correlate with inflation but negatively correlate with nominal interest rates, it follows that they are very strongly inversely correlated with real (inflation-adjusted) interest rates. Confirming this, relative performance of property stocks to the overall market tracks real interest rate trends very closely (Chart I-6) Chart I-6Lower Real Rates Warrant Real Estate Stocks Outperformance Yields on inflation-indexed bonds – real rates – have recently broken down (Chart I-7). If Congress adopts social security reforms in the coming months, real interest rates could drop further. Chart I-7Real Rates Have Fallen To All-Time Lows In short, falling real rates will greatly benefit real estate prices and volumes. Some commentators might argue that Brazil’s low national savings rate will preclude real rates from falling. We discussed why a low national savings rate is not an impediment to a decline in real interest rates in our March 22, 2018 Special Report (please click on the link to access the report). Property Market: Post Depression… The majority of excesses have been wrung out of the physical property markets in Brazil over the past 5-6 years, and real estate prices and volumes are finally showing signs of recovery. Residential property prices have been flat in nominal terms over the past 5 years. Yet in real (inflation-adjusted) terms they have declined by 20%, and in U.S. dollar terms they are down 40% from their 2014 peak (Chart I-8). Chart I-8Apartment Prices Have Been Beaten Down Nationwide Property sales and prices in São Paulo have already begun rising, but not in Rio de Janeiro (Chart I-9). Typically, bull markets begin in financial and business centers and then spread to other cities and regions. Chart I-9Brazil: Apartment Prices Over the past two days, during our visit to clients in São Paulo, we witnessed very few cranes. Even in this financial and business center, property construction/supply remains extremely subdued. Vacancy rates in office spaces, residential property inventories, and the average sales time are all starting to fall (Chart I-10). These are all early signposts of revival. Chart I-10Signs Of Life Notably, the consumer debt-servicing ratio has fallen due to lower interest rates (Chart I-11). Mortgage rates remain high relative to the (SELIC) policy rate. However, odds are that this spread will narrow as confidence and appetite for mortgage lending among banks improves. Chart I-11Diminishing Household Debt Stress Bottom Line: Overall residential property prices across Brazil’s 11 largest metropolitan areas are slowly starting to rise in nominal but not in real terms yet (Chart I-12). The recovery is only beginning to take shape. Chart I-12Property Price Deflation Is Ending Pension Reforms Hold The Key At the moment, we believe pension reforms – not commodities prices – are the key to sustaining the positive momentum behind Brazil’s financial markets and economy. If Bolsonaro introduces pension legislation immediately, while his political capital is still high, then it will be a market-positive development. However, it is difficult to determine the odds of the passage of the social security reform bill, and the form in which it will be adopted. On one hand, the Brazilian Congress is as fragmented as ever. Bolsonaro’s PSL party holds only 52 seats, or 10% of the total. This means that the president has to convince 256 congressmen outside his party to vote for pension reforms in order to get the 308 votes required to pass this constitutional amendment (Chart I-13). His attempt to find a new way to form a coalition may backfire, at least initially, and he will also face obstructionist voting behavior from minor parties. On the other hand, Brazilian presidents eventually tend to succeed in forming coalitions that comprise a majority of seats. On paper, right-leaning parties have slightly more seats than the three-fifths majority needed for constitutional changes in the Chamber of Deputies. Moreover, many congressmen are new faces in politics and represent small parties. They have little political experience and may not go against a popular president at the very early stages of their congressional terms. It is reasonable to assume that they could side with the president and vote for the pension reforms, for several reasons: (1) distancing themselves from Bolsonaro may not help their own popularity; and (2) voters may well be focused on issues other than unpalatable pension reforms four years from now if the economy is doing well. Hence, voting for the pension reforms early in their term may be a reasonable political strategy for them. Importantly, it seems these reforms have the initial backing of both the military and the police establishments, even though their pensions will be negatively impacted by the changes. Specifically, Vice President and retired general Hamilton Mourão has hinted at the army’s and police’s support of the upcoming social security reforms proposal. In brief, the adoption of pension reforms will create positive tailwinds for investor and business sentiment and in turn support the economic recovery. Investment Recommendation Brazilian stocks have lately exhibited a low correlation with the EM overall equity index. This gives us comfort in arguing that even if our negative view on EM risk assets plays out, Brazilian domestic equity plays will likely have only moderate downside in absolute terms, and certainly outperform the EM equity benchmark on a relative basis. Therefore, we recommend investors begin accumulating Brazilian real estate stocks on weakness. Even though their valuations are not cheap, rising revenue and cash flow will improve their valuation metrics and boost their share prices. With respect to sector composition, the Brazilian real estate sector is comprised of 27 listed firms: 15 listed homebuilders, 7 mall operators, 3 commercial properties and 2 brokers.2 Their total market cap relative to the Bovespa is now around 1.2% – down from 2.4% in 2012 (Chart I-14). We recommend buying a mix of these companies to gain exposure to various parts of the Brazilian property market. Chart I-14More Upside In Real Estate Stocks Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Special Alert "Brazil: A Regime Shift?" dated October 9, 2018, available on page 12. 2 We used the BM&FBOVESPA Real Estate Index (IMOB) in Chart 14. The Real Estate Index (IMOB) is compiled as a weighted average of 13 stocks. For more detail, please refer to: http://www.b3.com.br/en_us/market-data-and-indices/indices/indices-de-segmentos-e-setoriais/real-estate-index-imob.htm Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Portfolio Strategy Vibrant and broad-based bank credit growth, pristine credit quality, pent up bank buyback demand and a V-shaped recovery in bank ROE more than offset the risk of 10/2 yield curve inversion, and suggest that the path of least resistance is higher for the S&P banks index. Rising residential construction versus stalling residential investment, easing interest rates, cheapened lumber prices, and alluring valuations and technicals all signal that more gains are in store for homebuilders at the expense of home improvement retailers. Recent Changes Initiate a long S&P homebuilding/short S&P home improvement retail pair trade today. Table 1 Feature Equities have retraced 50% of the peak-to-trough losses, and are still consolidating the post December Fed meeting tremor. Chart 1 shows that the VIX has been cut in half and the high-yield corporate bond option-adjusted spread has dropped 105bps. Retrenching volatility and deflating junk spreads suggest that the equity risk premium (ERP) remains uncharacteristically high. The path of least resistance is for the ERP to narrow in the coming months as we do not foresee recession in 2019. As a reminder, the ERP and the economy are inversely correlated. Chart 1Risk Premia Renormalization Nevertheless, in order for the reflex rebound since the late-December lows to morph into a durable rally, the macro/policy backdrop has to turn from a headwind to a tailwind. We are closely monitoring three potential positive catalysts: A definitively more dovish Fed, which would help restrain the greenback A positive U.S./China trade resolution A continuation of the earnings juggernaut With regard to the macro related catalysts, an update to our reflation gauge (RG) is in order. The trade-weighted U.S. dollar has been depreciating since early November, the 10-year U.S. Treasury yield has come undone since the early November peak and oil prices are 33% lower than the early-October peak. These three variables comprise our RG and the signal is unambiguously bullish. In other words, a reflationary impulse looms in the months ahead which should pave the way for a rebound in both plunging investor sentiment and the gloomy economic surprise index (RG shown advanced, Chart 2). Chart 2Reflating Away On the earnings front, last week we trimmed our end-2020 SPX EPS forecast to $181 while we sustained the multiple at 16.5 times which resulted in a 3,000 SPX target.1 Drilling beneath the surface and analyzing the composition of SPX profits is revealing. Table 2 highlights sell side analysts’ profit levels and growth projections on a per GICS1 sector basis and also their contribution to overall earnings along with each sector’s projected earnings weight and most recent market capitalization weight. Table 2S&P 500 Earnings Analysis Chart 3 shows that financials, health care and industrials are responsible for 61% of the SPX’s profit growth in 2019. Interestingly, technology’s contribution has fallen to a mere 7.2% and even if we add the new communication services sector’s 9.6% contribution it still falls well shy of the tech sector’s market cap and earnings weight. Another worthwhile observation is that energy profits are no longer off the charts, as base effects since the early-2016 $25/bbl oil trough have filtered out of the dataset. While the risk of disappointment surrounds financials, health care and industrials, there are high odds that tech surprises to the upside as it has borne the brunt of recent negative earnings revisions (Charts 4 & 5). In addition, if our Commodity & Energy Strategy service’s bullish oil forecast pans out this year, the negative energy sector contribution to SPX profit growth will get a sizable upward revision (please look forward to our GICS1 sector EPS growth models updates and profit margin analysis in next week’s report). Chart 4Earnings Revisions... Chart 5...Really Weigh On Tech In sum, if the Fed pauses its hiking cycle through at least the first half of the year, we see a positive U.S./China trade resolution and SPX profits sustain their upward trajectory, then the SPX budding recovery will morph into a durable rally. This week we are updating an interest rate sensitive index that is highly levered to the surging U.S. credit impulse (Chart 6) and are initiating an early cyclical intra-sector and intra-industry pair trade. Chart 6Heed The U.S. Credit Impulse Signal Stick With Banks While our overweight call in the S&P banks index suffered a setback last month, since inception it has moved laterally, and we continue to recommend an above benchmark allocation to this key financials sub group. Not only are the odds of recession low for this year, but narrowing credit spreads and a reversal in financial conditions are also waving the green flag (junk spread shown inverted & advanced, bottom panel, Chart 7). Chart 7Bank On Banks Unlike the previous three reporting seasons when banks revealed blowout numbers and stocks subsequently fell, this season some profit and top line growth misses have been greeted with rising bank stocks prices. Such a reaction suggests that the worst is behind this sector and a sustainable recovery looms. Importantly, on the loan growth front, our credit impulse diffusion index is reaccelerating (Chart 6) and the overall credit impulse is expanding (middle panel, Chart 7). Our total loans & leases growth model and BCA’s C&I loan growth model both corroborate this encouraging credit backdrop (second & bottom panels, Chart 8). The latter is significant given that C&I loans are the single biggest credit category in bank loan books (Chart 9). Importantly, C&I loans have gone vertical recently topping the 10.5% growth mark despite softening capex intentions and CEO confidence. Chart 8Credit Models Flashing Green Chart 9Credit Models Flashing Green Multi-decade highs in consumer confidence are offsetting the Fed’s tightening cycle and suggest that consumer loans, another key lending category, will also gain traction (third panel, Chart 8). The outlook for the second largest credit category, residential real estate, remains upbeat in spite of last quarter’s soft housing related data releases. The recent easing in monetary conditions has breathed life back into the mortgage purchase applications index and also house prices continue to expand at a healthy pace (Chart 10). The upshot is that first-time home buyers will show up this spring selling season. Chart 10Residential Loans Also On Solid Footing Beyond positive credit growth prospects, credit quality remains pristine. BCA’s no recession in 2019 view remains intact, thus NPLs and chargeoffs should stay muted. As a reminder, U.S. banks are the best capitalized banks in the world,2 and their reserve coverage ratio has returned to 124%, a level last seen in 2007 (Chart 11). Chart 11Pristine Credit Quality Another important source of support is equity retirement. Banks have been late to the buyback game as the GFC along with the new strict bank regulatory body, the Fed, really tied their hands with regard to shareholder friendly activities. In fact, according to flow of funds data, the financial sector is still a net equity issuer, albeit at a steeply decelerating pace especially relative to the non-financial corporate sector (Chart 12). Pent up financial sector buyback demand is a boon for bank EPS growth. Chart 12Pent Up Buyback Demand Getting Unleashed This is significant at a time when analysts have been swiftly downgrading EPS growth figures for the SPX. Encouragingly, our bank EPS growth model captures all these positive forces and while it is decelerating it still suggests that profit growth will be stellar in 2019 and easily outpace the overall market (Chart 13). Chart 13Banks EPS Growth Will Outpace The Market Despite all this enticing news, bank valuations remain anchored near rock bottom levels and a resurgent ROE is signaling that a re-rating phase looms (Chart 14). Chart 14Rerating In Still In The Early Innings Nevertheless, there is one headwind banks face as the business cycle is long in the tooth and on track to become the longest expansion on record: the price of credit. One reason for the deflating relative stock price ratio since the January 2018 peak has been the yield curve slope flattening (Chart 15), as it suppresses bank net interest margins. Banks have been fighting this off partly by keeping their source of funding ultra-low judging by still anemic CD rates, according to Bankrate’s national average (bottom panel, Chart 15). Chart 15One Minor Headwind While yield curve inversions have widened all the way out to the 7/1 slope, the key 10/2 slope has yet to invert. Were the 10-year U.S. treasury to resume its selloff, even a mild yield curve steepening will go a long way, as BCA’s bond strategists expect. Clearly a flattening curve is a risk to our sanguine bank view, but the rest of the positives we outlined above more than offset the yield curve blues. Adding it all up, vibrant and broad-based bank credit growth, pristine credit quality, pent up bank buyback demand and a V-shaped recovery in bank ROE more than offset the risk of the 10/2 yield curve inversion, and suggest that the path of least resistance is higher for the S&P banks index. Bottom Line: Maintain the overweight stance in the S&P banks index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC, . Buy Homebuilders/Sell Home Improvement Retailers While we reiterate our recent overweight call on the S&P homebuilding index3 and the high-conviction underweight call on the S&P home improvement retail (HIR) group,4 it also makes sense to initiate a market neutral trade: long homebuilders/short HIR. This pair trade is levered on the swings of residential construction compared with residential investment. Currently the former is significantly outpacing the latter and suggests that relative share prices have ample room to run (top panel, Chart 16). Chart 16A Play On Residential Construction Vs. Investment Put differently, this share price ratio moves in tandem with homebuilders breaking new ground versus home owners renovating their existing house. Chart 17 shows the NAHB’s homebuilder sales expectations survey compared with the remodeling expectations survey. This relative sentiment gauge has ticked up recently, confirming the message from national accounts that residential construction has the upper hand over residential investment. The upshot is that the bull market in relative share prices is in the early innings. Chart 17Relative Survey Expectations... Keep in mind that housing starts and building permits are extremely sensitive to interest rates, depend on first time home buyers and move in lockstep with the homeownership rate. Currently, interest rates are easing, the homeownership rate is coming out of its GFC funk and first time home buyers are slated to make a comeback this spring selling season. This is a boon for homebuilders at the expense of HIR (middle & bottom panels, Chart 16). More specifically on the interest rate front, while both groups move with the oscillation of lending rates, new home sales are more sensitive than HIR sales to the price of credit. Our proxy of mortgage application purchase to refinance index does an excellent job in capturing this relative interest rate sensitivity and the recent jump signals that a catch up phase looms in the relative share price ratio (top panel, Chart 18). Chart 18...Easing Interest Rates... Relative loan growth activity also corroborates that demand for residential real estate is outpacing demand for home renovation (bottom panel, Chart 18). Beyond these macro tailwinds for this intra-sector trade, the price of lumber is a key determinant of relative profitability: lumber represents an input cost to homebuilders whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it. In other words, rising lumber prices are a boon for HIR and a bane to homebuilders and vice versa. The recent drubbing in lumber prices should ease margin pressures on homebuilders but eat into HIR profits (Chart 19). Chart 19...And Cheapened Lumber Prices Favor Homebuilders Over HIR Finally, oversold relative technicals, depressed valuations and extreme sell side analysts’ relative profit pessimism, offer a very compelling entry point in the pair trade for fresh capital (Chart 20). Chart 20Oversold And Unloved Netting it all out, rising residential construction versus stalling residential investment, easing interest rates, cheapened lumber prices, and relative alluring valuations and technicals all signal that more gains are in store for homebuilders at the expense of home improvement retailers. Bottom Line: Initiate a new long S&P homebuilding/short S&P home improvement retail pair trade today. The ticker symbols for the stocks in these indexes are: BLBG: S5HOME – DHI, LEN and PHM, and BLBG: S5HOMI – HD and LOW, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com footnotes 1 Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, “Top 10 Reasons We Still Like Banks” dated March 5, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Report, “Indurated” dated September 24, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, “2019 Key Views: High-Conviction Calls” dated December 3, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights 2018 Performance Breakdown: Our recommended model bond portfolio generated a modest outperformance versus the custom benchmark index of +6bps for all of 2018. Winners & Losers: The outperformance of our model bond portfolio in 2018 mostly came from country selection on our government bond portfolio (underweight U.S. Treasuries, overweight the U.K. and Australia). However, our below-benchmark overall duration stance, as well as our bias favoring U.S. credit over non-U.S. corporates, were drags on performance during the risk-off moves at the end of 2018. Scenario Analysis For 2019: The tactical upgrade to global corporates that we initiated last week is projected to generate outperformance versus the model portfolio benchmark index in the next six months - both from below-benchmark duration positioning and higher exposure to U.S. corporates. Feature 2019 has gotten off to a very busy start, with significant news and market moves forcing us to devote our first two Weekly Reports of the year to analysis and even changes to our views. This week, we belatedly take care of one final piece of housekeeping for 2018 – reporting the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio for the fourth quarter and for the entire calendar year. We also present an updated scenario return analysis for the next six months after the tactical upgrade to global corporate bonds that we initiated last week.1 As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. A Quick Summary Of The Full Year Performance For 2018 The 2018 performance of the model portfolio can really be broken up into two periods: the first ten months of the year and November/December. This is an unsurprising consequence of the severe market moves around year-end that went contrary to our two most significant recommendations – maintaining a below-benchmark stance on overall portfolio duration and overweighting U.S. investment grade corporate debt versus non-U.S. equivalents in Europe and emerging markets (EM). The overall portfolio return in 2018 was +1.10% (hedged into USD), which outperformed our custom benchmark index by +6bps (Chart of the Week).2 That outperformance was considerably higher before the year-end plunge in global bond yields, reaching a peak of +32bps on November 20. In terms of the breakdown of outperformance, our recommended positioning on government bonds (duration and country allocation) contributed +22bps, while our credit tilts (by country and broadly defined credit sectors) were a drag on performance to the tune of -16bps. Chart of the WeekA Small Gain For 2018 After A Q4 Round-Trip The full breakdown of the full-year 2018 performance can be found in the Appendix tables and charts on Pages 14-16. For the government bond portion of the portfolio the full-year outperformers by country were the U.S. (+18bps), Germany (+10bps), Australia (+4bps) and the U.K. (+3bps). These are in line with our long-standing underweight position on the U.S. versus Germany, and our recommended overweights on Australia and the U.K. The laggards were relatively modest, led by our overweight stance on Japan (-4bps) and underweights on France (-3bps) and Italy (-3bps). For the credit portion of the portfolio, the winners were EM USD-denominated corporates (+7bps), U.S. B-rated high-yield (HY) corporates (+3bps) and U.S. Caa-rated high-yield (HY) corporates (+2bps). This was in line with our long-standing bias to favor U.S. junk bonds over EM credit. The losers were our overweights on U.S. investment grade (IG) financials (-15bps), U.S. IG industrials (-8bps), U.S. Ba-rated HY (-4bps), and euro area IG corporates (-2bps). Our overweight tilts on U.S. IG were the issue here. Q4/2018 Model Portfolio Performance Breakdown: A “Risk-Off” Hit To Our Core Recommendations The detailed data on our model bond performance for Q4/2018 only can be found in Table 1. Table 1GFIS Model Bond Portfolio Q4/2018 Overall Return Attribution The total return of the GFIS model bond portfolio was +1.5% (hedged into USD) in Q4, which underperformed the custom benchmark index by a mere -1bp. The main cause for the slight underperformance is from our below-benchmark duration positioning with the Bloomberg Barclays Global Treasury Index yield falling by 20bps over the full quarter. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -2bps of underperformance versus our custom benchmark index while the latter outperformed by just +1bp. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Underweight U.S. government bonds with maturities between 5-7 years (+12bps) Overweight Japanese government bonds (JGBs) with maturities between 7-10 years (+5bps) Underweight Germany government bonds with maturities between 7-10 years (+3bps) Overweight U.K. government bonds with maturities between 5-7 years (+2bps) Biggest underperformers Overweight Japanese government bonds (JGBs) with maturities beyond 10 years (-15bps) Underweight U.S. government bonds with maturities beyond 10 years (-8bps) Underweight Italy government bonds with maturities beyond 10 years (-3bps) Underweight France government bonds with maturities beyond 10 years (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q4/2018. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q4/2018 (red for underweight, blue for overweight, gray for neutral). Government bonds are dominating the left half of the chart, as yields declined in the final months of 2018. This was a drag on our model portfolio performance. However, the best performing sector was U.K. government bonds, generating a total return of 4.7% in Q4/2018 (on a currency-hedged and duration-matched basis). The GFIS model portfolio benefited from this move, given our long-standing overweight bias for U.K. Gilts. The right side of Chart 4 is occupied by global spread product, where currency-hedged returns were flat-to-negative in Q4. This was due to credit spread widening as investors feared both slower global growth and additional Fed tightening. The riskier parts of the corporate bond universe – high-yield, EM corporates – suffered the largest losses. The total return of Bloomberg Barclays U.S. High-Yield Index (currency-hedged into USD) for Q4 was -2.7%, as the option-adjusted spread (OAS) widened by +206bps. Unfortunately for our model portfolio, our preference for U.S. corporate bonds over European and EM credit hurt performance, although not by as much as the below-benchmark duration stance. We are disappointed by the final result for the year, although we are still pleased to generate even a small positive outperformance given the ferocity of the market moves seen at the end of 2018. We can attribute that to lingering gains from good calls made earlier in 2018, but also from our recommended cautious stance on overall portfolio risk (i.e. tracking error) in a more-volatile investment environment. Bottom Line: The outperformance of our model bond portfolio in 2018 mostly came from country selection on our government bond portfolio (underweight U.S. Treasuries, overweight the U.K. and Australia). However, our below-benchmark overall duration stance, as well as our bias favoring U.S. credit over non-U.S. corporates, were drags on performance during the risk-off moves at the end of 2018. Future Drivers Of Portfolio Returns Looking ahead, the performance of the model bond portfolio will benefit from two main factors: our below-benchmark duration bias and our underweight stance on global government bonds versus corporate debt. In terms of specific weighting in the GFIS model bond portfolio, we now have a tactical bias favoring global corporate debt over government debt coming on top of our below-benchmark duration stance (Chart 5). We are sticking with the latter position, about one full year short of the duration of our benchmark index, with global yield curves priced for inflation expectations that are too low and with no rate hikes discounted for 2019 in all major developed markets. Chart 5Portfolio Duration: Staying Below-Benchmark However, we are also keeping our current country allocations on the government bond side of the model portfolio, even after our tactical credit upgrade. That means staying underweight countries where policymakers are only pausing on rate hiking cycles (U.S. and Canada), while overweighting countries that are likely to keep rates on hold for all of 2019 (Japan, U.K., Australia). Our decision to upgrade global credit exposure helps boost the yield of our model portfolio (Chart 6). However, the portfolio is still yielding less than the benchmark thanks to our bear-steepening bias on government yield curves that involves underweights to longer-maturity bonds with higher yields. Chart 6Portfolio Yield: Credit Upgrade Helps Offset Defensive Duration Tilt Importantly, all the changes that were made to our portfolio allocations last week – raising weights on all global corporate bond markets, cutting exposure to government debt in the U.S., Germany and France – did not materially change the tracking error (relative volatility versus the benchmark) of the model portfolio. We do not see the current backdrop as being conducive to taking high levels of overall portfolio risk, even given our tactical view that the U.S. monetary policy will be on hold for the next 3-6 months. We prefer to recommend more relative value positioning via country and credit allocations that help dampen overall portfolio risk and reduce exposure to the kind of volatility spikes that became more frequent in 2018. Thus, we will continue to target a tracking error for the model portfolio of 40-60bps, well below our self-imposed 100bps ceiling (Chart 7). Chart 7Portfolio Risk Budget Usage: Staying Cautious Scenario Analysis & Return Forecasts In April 2018, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.3 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis of projected returns for each asset class in the model bond portfolio by making assumptions on those individual risk factors. In Tables 3A & 3B, we present three differing scenarios, with all the following changes occurring over a six-month horizon. Note that this differs from how we have typically presented these scenario analyses, with projections over the subsequent twelve months. Given that the changes to our recommended allocations introduced last week were tactical in nature (i.e. up to six months), we are shortening our forecast window for this particular scenario analysis to line up with that shorter investment horizon. The scenarios are all driven by what we believe will be the most important driver of market returns in 2019 – the path of U.S. monetary policy. Our Base Case: the Fed stays on hold, the U.S. dollar remain flat, oil prices rise by +10%, the VIX index falls to 15, and there is a bear-steepening of the U.S. Treasury curve. This scenario is the one we laid out in last week’s report, with the Fed taking a pause through at least the March FOMC meeting, allowing market volatility to drift lower as U.S. monetary and financial conditions ease. A Very Hawkish Fed: the Fed does a surprise +25bps rate hike in March, the U.S. dollar rises by +5%, oil prices increase +20%, the VIX index climbs to 25 and there is a sharp bear-flattening of the U.S. Treasury curve. This would be the case if the U.S. economy maintains firm growth, the global growth downturn stabilizes, U.S. inflation expectations increase and market volatility increases from a surprisingly hawkish Fed. A Very Dovish Fed: the Fed cuts the funds rate by -25bps, the U.S. dollar falls by -5%, oil prices decline -20%, the VIX index increases to 35 and there is a sharp bull steepening of the U.S. Treasury curve. This is a scenario where U.S./global growth slows rapidly from the current pace and the Fed has no choice but to ease monetary policy as market volatility surges alongside elevated recession risks. The model bond portfolio is expected to outperform the custom benchmark index by +19bps in our Base Case scenario. This comes from the relative outperformance of credit versus government bonds in an environment of rising bond yields (which also benefits our below-benchmark duration stance), and tighter credit spreads. In the Very Hawkish Fed scenario, our model portfolio is expected to outperform the benchmark by +29bps. This is not only due to our duration tilt and our corporates-versus-governments bias. As in the Base Case, the relative stance favoring U.S. corporates over EM credit would benefit from a backdrop of tightening U.S. monetary conditions and rising market volatility (Chart 8) – both of which are worse for EM credit. Chart 8Risk Factors Assumptions For The Scenario Analysis In the Very Dovish Fed scenario, our portfolio is projected to underperform the benchmark index by -26bps, with falling bond yields (Chart 9) hitting both our defensive duration bias and the overweight on corporates relative to governments. Chart 9UST Yield Assumptions For The Scenario Analysis In all three scenarios, there is a drag on expected performance from the relative carry of the model portfolio versus the benchmark (-17bps). This comes mostly from the below-benchmark overall duration stance that involves reduced exposure to longer-maturity government bonds with higher yields. The drag on carry also comes from the underweight positioning on high-yielding EM debt. We are maintaining that tilt given our concerns that China’s policymakers will be unable to provide enough stimulus to benefit EM economies through greater Chinese demand. Importantly, our recommended allocations win in scenarios that do not involve Fed rate cuts, a very low probability outcome in 2019, in our view. Thus, we expect our current allocations to generate alpha in the first half of the year, even if the Fed returns to a hawkish bias faster than we currently anticipate. Bottom Line: The tactical upgrade to global corporates that we initiated last week is projected to generate outperformance versus the model portfolio benchmark index in the next six months - both from below-benchmark duration positioning and higher exposure to U.S. corporates. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th 2019, available at gfis.bcareseach.com. 2 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start”, dated April 10th 2018, available at gfis.bcareseach.com. Appendix Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The U.S. economy is slowing in a completely predictable manner. With inflationary pressures largely dormant, the Fed can afford to stay on hold for the next few FOMC meetings. Growth in the U.S. and the rest of the world should stabilize by mid-year. This will enable the Fed to resume raising rates in June. A bearish stance towards U.S. Treasurys is warranted over a 12-month horizon. As long as the Fed is hiking rates in response to above-trend GDP growth rather than accelerating inflation, risk assets will fare well. Investors should overweight global equities and spread product for now, but monitor inflation trends closely for signs of when to get out. Brexit fears are overdone. Stay long the pound versus the euro. We were stopped out of our short AUD/JPY trade for a gain of 10%. Feature A Predictable Slowdown Investors are misunderstanding the nature of the current slowdown in the United States and much of the world. Completely predictable slowdowns, such as this one, rarely morph into recessions. Real U.S. GDP rose at a blistering 3.8% average annualized pace in Q2 and Q3 of 2018. There is no way that sort of growth rate could have been sustained. Financial conditions also tightened sharply in Q4, which has inevitably weighed on growth. Given the stock market rout, it is actually surprising that the economy has not weakened more than it has. The New York Fed GDP Nowcast points to growth of 2.5% in Q4 of 2018 and 2.1% in Q1 of 2019. This is still above the Fed’s long-term estimate of potential GDP growth of 1.9%. Most of the slowdown has been concentrated in the manufacturing sector, but even there, the bloodletting may be ending. The latest Philadelphia Fed survey — arguably the most important of the regional Fed manufacturing reports — showed an uptick in activity, with the new orders component hitting the highest level since last July. Despite the tightening in financial conditions, bank lending to the business sector has accelerated over the past three months (Chart 1). The Conference Board’s Leading Credit Index remains in expansionary territory (Chart 2). While business capex intention surveys have come off their highs, they still point to robust spending plans over the next few quarters (Chart 3). Chart 1Credit Is Still Flowing To U.S. Businesses Chart 2Little Sign Of A Looming Credit Crunch Chart 3Capex Plans Still Solid The labor market remains healthy, as evidenced by ongoing strong payroll growth and low initial unemployment claims. Faster wage growth is boosting consumer spending. Holiday sales rose by 5.1% from a year earlier according to the Mastercard SpendingPulse report, the fastest growth in six years. The Redbook same-store index tells a similar story (Chart 4). Chart 4Same-Store Sales Are Robust The housing market struggled for much of 2018, but the recent stabilization in mortgage rates should help matters (Chart 5). Notably, mortgage applications for purchase have surged to their highest levels since 2010 (Chart 6). Homebuilder confidence improved in January, mirroring the rally in homebuilder shares (Chart 7). We are long homebuilders versus the S&P 500, a trade that is up 5.3% since we recommended it on November 1, 2018. Chart 5aThe U.S. Housing Sector Will Stabilize (I) Chart 5BThe U.S. Housing Sector Will Stabilize (II) Chart 6A Positive Signal For U.S. Housing Chart 7U.S. Homebuilder Stocks Have Been Outperforming Recently U.S. Government Shutdown: A Near-Term Hit To Growth The government shutdown poses a near-term risk to the U.S. economy. If it lasts until the end of March, it will shave about 1.7% off Q1 GDP based on White House estimates. While this represents a potentially significant hit to the economy, the effect is likely to be completely reversed once the shutdown ends. Moreover, the drag to growth from the shutdown pales in comparison to the overall stance of fiscal policy. According to the IMF, the cyclically-adjusted budget deficit is set to reach 5.7% of GDP this year, up from 3.2% of GDP in 2015. There is also a reasonable chance that any deal to end the shutdown will involve a commitment to increase spending beyond currently budgeted levels. This would increase the overall amount of fiscal stimulus the economy is receiving. Taking The Pulse Of Global Growth The slowdown in growth has been deeper and more protracted outside the United States. Nevertheless, rays of sunshine are emerging. Our global Leading Economic Indicator diffusion index, which measures the proportion of countries with rising LEIs compared to those with falling LEIs, has bottomed. The diffusion index leads the global LEI by a few months (Chart 8). Chart 8The Uptick In The LEI Diffusion Index Suggests Global Growth Could Stabilize As is increasingly the case, the fate of the Chinese economy will be critical in determining when global growth begins to reaccelerate. The latest Chinese activity data has been disappointing, with this week’s downright awful export figures being the latest example. That said, credit growth may be starting to stabilize, as evidenced by stronger-than-expected loan growth for December. With credit growth now running only slightly above nominal GDP growth, the need for the authorities to maintain their deleveraging campaign has diminished. In an encouraging sign, the Market-Based China Growth Indicator developed by our China Investment Strategy service has been moving higher (Chart 9). Chart 9Encouraging Sign For The Chinese Economy A revival in Chinese growth would aid trade-sensitive economies such as Japan and Germany. The former saw a decline in economic momentum in the second half of 2018, exacerbated by typhoons and an earthquake in Hokkaido. With the consumption tax set to increase from 8% to 10% in October, the Bank of Japan will need to maintain its yield curve control regime at least until 2020. This could weigh on the yen. With that in mind, we tightened the stop on our short AUD/JPY trade two weeks ago and subsequently exited the position with a gain of 10%. The German economy has taken it on the chin recently. Real GDP contracted in the third quarter and barely grew in the fourth quarter. The economy should rebound in 2019 as external demand improves. The drag on growth from the decline in automobile assemblies following the introduction of new emission standards should also turn into a modest tailwind as production resumes. In addition, fiscal policy is set to turn more stimulative, while robust wage growth, lower oil prices, and rising home prices should support consumption. Elsewhere in Europe, the Italian economy should recover as bond yields come down from their highs and confidence improves following the resolution of the impasse with the EU over budget targets. The modest easing in Italy’s fiscal policy of about 0.5% of GDP in 2019 should also benefit growth. It is too early to quantify the effect on the French economy from the “yellow vest” protests. France is no stranger to protests of this sort, so our guess is that the impact on the economy will be minimal. President Macron’s pledge to loosen fiscal policy in hopes of placating the protestors should also support demand. Brexit: A “No Deal” Outcome Looks Less Likely The Brexit saga could end in one of three ways: 1) A “no deal” where the U.K. leaves the EU with no alternative in place; 2) A “soft Brexit” involving an agreement to form a permanent customs union or some sort of “Norway plus” arrangement; 3) A decision to reverse the results of the original referendum and stay in the EU. In thinking about which of these three outcomes is most likely, one should keep the following in mind: Any course of action that the U.K. takes must have the support of the British parliament. A no deal outcome does not have parliament’s support. Not even close. Thus, it will not happen. This leaves options 2 and 3. This publication has argued since the day after the Brexit vote that the European establishment, following the example of the Irish and Danish referendums over various EU treaties, will keep insisting on do-overs until it gets the result it wants. If one referendum is good, two is even better – it’s twice as much democracy! The betting markets seem to be coming around to our view. As we go to press, PredictIt shows a one-in-three chance that a new referendum will be called by March 31 (Chart 10). Polling trends suggest that if another referendum were held, the remain side would probably prevail (Chart 11). Chart 11U.K.: A Change Of Heart? In some sense though, it does not matter for investors whether the original referendum is reversed or a soft-Brexit deal is reached. Either outcome would be welcomed by markets. We continue to advocate buying GBP/EUR. My colleague Dhaval Joshi, BCA’s Chief European strategist, also recommends that equity investors purchase the FTSE 250 index, which comprises from the 101st to the 350th largest companies listed on the London Stock Exchange. Unlike its large-cap counterpart, the FTSE 100, the FTSE 250 index is more geared to what happens in the U.K. than in the rest of the world. Investment Conclusions Global inflation remains subdued, which gives central banks the luxury of taking a wait-and-see approach to tightening monetary policy. Growth in the U.S. and the rest of the world should stabilize by mid-year. This will enable the Fed to resume raising rates in June. Given that the market is no longer pricing in any Fed hikes, a bearish stance towards U.S. Treasurys is warranted over a 12-month horizon (Chart 12). Outside of Japan, bond yields will also rise in the major developed economies. Chart 12Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected We downgraded global equities in June as our leading indicators began to point to slower growth ahead, but upgraded them back to overweight after stocks plunged following the December FOMC meeting. The rally over the past three weeks has reversed deeply oversold conditions and our tactical MacroQuant model is once again flagging some near-term risk to stocks. Nevertheless, if the global economy avoids a recession this year, as we expect, equities should fare well over a 12-month horizon. The MSCI All-Country World index is trading at a modest 13.6-times forward earnings (Chart 13). Profit estimates have been revised down meaningfully, suggesting that the bar for upward earnings surprises is now quite low. Chart 13A Lot Of Bad News Already Discounted? Risk assets can tolerate higher rates as long as tighter monetary policy is the result of stronger growth. What risk assets cannot withstand is a stagflationary environment where growth is slowing but the Fed is hiking rates in order to bring down inflation. That is not the situation today, but could be the situation next year. Bottom line: Investors should overweight global equities and spread product for now, but monitor inflation trends closely for signs of when to get out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Highlights Please note that country sections on Mexico and Colombia published below. The policy stimulus in China could produce a growth revival in the second half of 2019, but there are no signs of an imminent bottom in China’s growth over the next several months. The lack of policy support for real estate is the key difference between the current stimulus program and previous ones. Crucially, the property market holds the key to consumer and business sentiment and hence, their willingness to spend. Continue to overweight Mexico within EM currency, fixed-income and equity portfolios. Colombia warrants a neutral weighting. A new trade: bet on yield curve flattening. Feature China has been undertaking both fiscal and monetary stimulus since last summer. A key question among investors is: At what point will the cumulative effects of these efforts become sufficient to revive the mainland’s business cycle and produce a rally in China-related plays akin to 2016-’17? This report helps investors dissect China’s stimulus, and reviews the indicators that will likely help identify the turning point in the mainland’s business cycle, as well as in China-exposed financial markets. Chart I-1 conveys the main message: Our credit and fiscal spending impulse is still falling, indicating that the slump in the Chinese industrial sector will persist for now with negative ramifications for EM corporate profits and other segments of the global economy that are leveraged to China. Looking forward, odds are reasonably high that the credit and fiscal spending impulse will bottom sometime in the first half of 2019. Yet, a bottom in China-plays in global financial markets is likely be several months away from now and potential downside could still be substantial. Monetary Stimulus On the monetary policy front, there has been multifaceted easing: Several cuts to banks’ reserve requirement ratios (RRRs) have been implemented; Lower interest rates for SME borrowers and a reduction in funding costs for the banks that originate these loans; The use of preferential liquidity provisions to encourage banks to purchase bonds issued by private companies. Monetary easing in of itself is not a sufficient condition to produce an economic revival. There are two variables standing between easing liquidity/lower borrowing costs, on the one hand, and the performance of the economy on the other: The first one is the money multiplier, which is calculated as a ratio of broad money supply (or banks assets) to excess reserves. It measures the willingness of banks to expand their balance sheets at a given level of excess reserves, assuming there is loan demand. Chart I-2 shows that China’s money multiplier has risen substantially since 2008 but has recently rolled over. A further drop in the money multiplier could offset the positive effect of monetary easing. Chart I-2China: Money Multiplier Is Falling In other words, the central bank is injecting more liquidity into the banking system and interbank rates are falling, but commercial banks may be unwilling or unable to originate more loans due to financial regulations, lack of loan demand or for other reasons. Notably, the growth rate of bank assets (including policy banks) remains lackluster, while non-bank (shadow) credit is decelerating (Chart I-3). Chart I-3China: Bank Credit And Non-Bank Credit The second variable is the willingness of companies and households to spend. This is captured by our proxies for marginal propensity to spend by companies and consumers. Chart I-4 denotes that both propensity measures are dropping, signifying a diminishing willingness to spend among these two sectors. Chart I-4China: Diminishing Propensity To Spend By Consumers And Companies If economic sentiment among businesses and households remains downbeat – which has been the case in China over the past six to nine months – their reduced expenditures could offset any positive impulse from increased credit origination. Economists think of nominal GDP (aggregate spending) as money supply times the velocity of money (Nominal GDP = Money Supply x Velocity of Money). New lending activity among banks increases money supply, while economic agents’ spending raises the velocity of money. If the velocity of money drops more than the rise in money supply, aggregate expenditure (nominal GDP growth) will decline. Chart I-5 illustrates that the velocity of money rose in 2017, supporting robust growth during this period, despite very lackluster money growth. The opposite phenomenon – a decline in the velocity of money offsetting faster money expansion – could be a risk to the positive view on Chinese growth in 2019. Chart I-5Velocity Of Money: Will It Resume Its Decline? Bottom Line: There is so far no clear evidence that the credit cycle has bottomed. Besides, a bottom in the credit impulse is not in and of itself sufficient to herald an economic recovery. Fiscal Stimulus Unlike in previous easing episodes, policymakers this time around have prioritized fiscal over monetary stimulus because of the already high leverage. In the past six months or so, the government has announced the following fiscal measures: A reduction in the personal income tax rate; Subtraction of certain household expenses from taxable personal income; A reduction in taxes and fees paid by small businesses; A potential VAT cut. These measures will certainly have a positive impact on small businesses and consumer spending. This is why we do not foresee a deepening slump in consumer spending. Nevertheless, the tax reductions and other policies benefiting small businesses and households are unlikely to boost industrial output and construction in China. The latter two are crucial for global investors because many countries are leveraged to China’s industrial and construction activity. For the industrial part of the economy, the most pertinent stimulus measure announced so far has been the issuance of local government special bonds. These bonds are used for infrastructure/public welfare projects. Chart I-6A shows the growth rates of aggregate fiscal spending and its components, which are expenditures by central and local governments as well as by government managed funds (GMFs). GMF spending – a form of quasi-government (off-balance sheet) spending – has surged in recent years and now accounts for 8.5% of GDP, which is more than twice larger than central government spending (Chart I-6B). Chart I-6AChina: Fiscal Spending Annual Growth... Chart I-6B…And As % Of Nominal GDP Although the 2019 budget has not yet been released – it will be announced in March during the National People's Congress – there have been some announcements that we can use to gauge the potential fiscal spending impulse in 2019. On the positive side, Beijing has recently authorized local governments to begin issuing bonds in early 2019 before the overall budget is released in March. Local governments are sanctioned to issue RMB 810 trillion of special bonds, which is 60% of their 2018 quotas. This contrasts with the previous years' practice, when local governments only started to issue bonds in April after obtaining directives from Beijing. The earlier-than-usual quota authorization will allow local governments to issue bonds from the beginning of the year. There is no timeline as to when these bonds will be issued, but it is safe to assume that their issuance will occur in the first half of 2019. This, in turn, should boost infrastructure investments throughout 2019. On the negative side, government managed funds (GMFs) derive 85% of their revenues from land sales. Land sales are tumbling due to previous credit tightening and scarce access to financing among property developers. Chart I-7 demonstrates that land sales lag the credit cycle by nine months. As developers are no longer acquiring land, GMF revenues and spending are set to shrink over the next 12 months. This will, to a certain degree, offset the augmented special bonds issuance. Chart I-7China: Credit Leads Land Sales And Quasi-Fiscal Spending We performed a simulation on what would be the aggregate fiscal impulse in 2019 using the following assumptions: Central and local government spending growth rates are held constant at 2018 levels. Local government special bond issuance is RMB 1.62 trillion. This is twice the recently authorized quota. Hence, our simulation assumes a 20% increase in local government special bond issuance in 2019 over 2018, respectively. GMF land revenues drop by 25% – a comparable drop in land sales occurred in 2015. Table I-1 reveals that using these assumptions, the fiscal spending impulse in 2019 will be 0.1% of GDP down from 4% in 2018 (Chart I-8, bottom panel). Chart I-8China: Credit And Fiscal Spending Impulse The next step is to combine this with our credit impulse forecast. We assume the 2019 year-end growth rate of credit to companies and households will be 9% in our pessimistic scenario, 10% in our baseline scenario and 11% in our optimistic scenario, compared with the December 2018 recorded rate of 10%. This entails no deleveraging at all. Under these assumptions, our forecasts for aggregate credit and fiscal impulses are 0.2% of GDP (pessimistic), 2.3% (baseline) and 4.4% (optimistic) (Table I-1). Presently, the credit and fiscal impulse is close to zero (Chart I-8). Bottom Line: China’s credit and fiscal spending impulse will bottom in the first half of 2019 (Chart I-8). However, this does not mean that EM/China plays have already bottomed and investors should chase the latest rebound in China-plays worldwide. We discuss the historical correlation between the credit and fiscal impulse and China-related financial markets below. What Is Different From Previous Stimulus Programs? The lack of stimulus targeting the real estate sector is the key difference between the current stimulus programs and those implemented in the past 10 years. The central government has so far abstained from stimulating the property market due to already existing speculative excesses there. This is very different from the policy easing that took place in 2008-‘09, 2012 and 2015-’16, when the authorities boosted property markets along with other sectors of the economy. Chart I-9 reveals that the 2015-‘17 residential property market revival and following boom was facilitated by the Pledged Supplementary Lending (PSL) program conducted by the People’s Bank of China (PBoC) – which was de-facto the outright monetarization of real estate by the central bank.1 The authorities have so far been reluctant to use this PSL program again, and the odds are that housing sales and new construction will continue to decline (Chart I-10). Chart I-9Residential Property Market Is Deteriorating Chart I-10China: Construction Volumes Are Shrinking Importantly, the property market holds the key to consumer and business sentiment and, hence, their willingness to spend. The latter is crucial to the growth outlook. Overall, a deepening slump in real estate demand and prices could dent consumer and small business confidence as well as their spending. Meanwhile, shrinking construction volumes will dampen industrial sectors (Chart I-10). Investment Implications: A Replay Of 2016-‘17? How does the credit and fiscal impulse relate to financial markets globally that are leveraged to the Chinese economy? The top two panels of Chart I-11 show our money impulse as well as credit and fiscal spending impulse (CFI), while the bottom two panels contain EM share prices and industrial metals prices. There are a few observations to be made: Chart I-11China: Money And Credit/Fiscal Impulses, EM Stocks And Metals Prices First, the CFI has not yet bottomed – i.e., it has not confirmed the upturn in the money impulse. Second, as illustrated in this Chart, the bottoms in the money impulse as well as the CFI in July 2015 preceded the bottom in EM and commodities by six months, and their peaks led the top in financial markets - in January 2018 - by about 15 months. Besides, in 2012-‘13, the rise in both the money impulse and CFI did not do much to help EM stocks or industrial commodities prices. Third, the credit and fiscal impulse leads the global manufacturing PMI by several months as illustrated in Chart I-1 on page 1, as well as mainland’s capital goods imports (Chart I-12). Chart I-12China's Impact On Industrial Goods And Commodities On the whole, investors should consider buying China-related plays only after both the money impulse and the CFI bottom together which has not yet occurred. Besides, even if these indicators rise in tandem, the bottom in China-related financial market plays could be a few months later because these impulses have historically led markets. This is why we believe a final down leg in EM and China-related plays still lies ahead. Typically, the last/capitulation phase in bear markets is considerable and being early can be very painful. Bottom Line: We continue to recommend underweighting/playing EM and China-related risk assets on the short side. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com Mexico: Reiterating Our Overweight Stance Mexican financial markets have rebounded, outperforming their EM counterparts since mid-December. This outperformance has further upside because the AMLO administration is proving to be less populist and more pragmatic, especially relative to investors’ expectations. We are reiterating our recommendations to overweight Mexican markets, especially the currency, local fixed-income and sovereign credit, within respective EM portfolios due to the following considerations: The 2019 budget is a prime example of sensible rather than populist policies by the AMLO administration. The budget targets a primary surplus of 1% of GDP versus 0.8% of GDP in 2018 (Chart II-1). Notably, the 2019 budget envisages an absolute decline in nominal expenditures in 29 out of 56 categories. Chart II-1Fiscal Tightening In 2019 Such a restrained budget follows the conservative fiscal policy of the previous administration. In brief, the nation’s fiscal policy and public debt profile remain sound. Public spending will be increased mostly in the areas that are critical to boosting productivity. These include infrastructure spending, vocational training, promoting “financial deepening” and competition, eliminating graft and improving security. These efforts are critical to boosting business confidence, investment and ultimately productivity. On the revenue side, the budget has become much less reliant on oil revenues than before. The share of oil revenues in total government revenues historically hovered around 30%, but in 2018 it declined to 18%. The 2019 budget assumes an average oil price of $55 per barrel, a conservative projection. Investors have also been somewhat alarmed by the 16% hike in minimum wages, but this should be put into historical context. Chart II-2 illustrates that the minimum wage in real terms (deflated by consumer price inflation) dropped by 70% since its peak in 1976, before rising in the recent years. Chart II-2Historical Perspective On Minimum Wage Importantly, Mexico’s competitiveness problem does not stem from high wages but from a lack of productivity gains. Productivity has been stagnant, and wages in real terms have not risen in many years. Hence, the true test for the nation is to raise productivity, not curb wages. Remarkably, the Mexican peso is very cheap, as measured by the real effective exchange rate based on unit labor costs (Chart II-3). Hence, the minimum wage hike can be viewed as payback after decades of dramatic declines in the minimum wage in real terms. Chart II-3The Mexican Peso Is Cheap The central bank has overdone it with hiking interest rates: interest rates are currently among the highest of the mainstream EM economies, both in nominal and real terms (Chart II-4). Hence, local rates offer great value relative to other EMs (Chart II-4, bottom panel). Chart II-4High Real And Nominal Interest Rates Tight fiscal and monetary policies will curb domestic demand and promote disinflation. Money and credit growth remain very sluggish (Chart II-5). This is negative for consumer and business spending, but positive for investors in local currency bonds. Chart II-5Monetary Growth Is Weak The basis is that a retrenchment in domestic demand and thereby imports will help stabilize the trade balance amid low oil prices. Hence, this is on the margin a positive for the peso as well as for local currency bonds relative to their EM counterparts. Finally, Mexico will benefit from its ties to the U.S. economy, unlike many other EMs that are more exposed to China. Investment Recommendation We continue to recommend overweighting the peso and local currency bonds within an EM fixed-income portfolio. Currency traders should maintain our long MXN / short ZAR trade (Chart II-6, top two panels). Chart II-6Remain Overweight Mexican Currency And Fixed-Income Credit market investors should continue to overweight Mexican sovereign credit within an EM credit portfolio (Chart II-6, bottom panel). Finally, we are also reiterating our long Mexico position within an EM equity portfolio. While domestic demand growth and corporate profits will continue to disappoint, the declining risk premium on Mexican assets due to a re-assessment among investors of AMLO’s policies warrants a mild overweight in large caps and a sizable overweight in small caps relative to their EM peers. Colombia: Headed Into Another Downtrend The Colombian economy is set to undergo another phase of growth retrenchment: The government is planning to reduce the overall fiscal deficit from 4.5% to 2.4% of GDP by the end of 2019 (Chart III-1). Oil-related revenues make up under 10% of total government revenues, and they are shrinking as both oil production and prices have plunged. Chart III-1Fiscal Policy Will Tighten In 2019 As a result, the government should undertake major fiscal cutbacks and hike taxes to achieve the overall budget deficit target of 2.4%. Such substantial fiscal tightening will hurt domestic demand. Regarding the exchange rate, the central bank is pursuing a “hands-off” approach, which is likely to continue. Therefore, the currency is set to depreciate due to the large current account deficit and lack of sufficient foreign funding. Notably, the current account deficit excluding oil is -7% of GDP (Chart III-2, top panel), and the plunge in oil prices and weak domestic demand will cause FDI inflows to drop meaningfully (Chart III-2, bottom panel). Together, this points to further currency depreciation. Chart III-2BoP Dynamics Are Deteriorating Meanwhile, the central bank is not in a position to ease policy to offset the impact of fiscal tightening, as a weaker exchange rate historically leads to higher inflation (Chart III-3, top panel). In fact, given core inflation is at the upper end of the central bank’s target range (Chart III-3, bottom panel), a considerable currency depreciation could lead to rate hikes. Raising rates amid weakening growth is a recipe for considerable yield curve flattening. Chart III-3Weaker Currency = Higher Inflation Lending rates remain well above nominal GDP growth, and the banking system is still restructuring following years of a credit boom. Credit growth will remain weak, reinforcing weakness in domestic demand stemming from substantial fiscal tightening. Finally, consumer and business confidence seem to be faltering due to the negative attention surrounding Colombian President Iván Duque Márquez’s policies. The negative terms-of-trade shocks and the imminent fiscal tightening will reinforce worsening sentiment among economic agents. Profound cyclical headwinds to growth indicate that the economy is set to return to a growth recession – a very low but slightly positive growth rate. With respect to investment strategy, we recommend the following: First, we are downgrading this bourse from overweight to neutral within an EM equity portfolio. While overweighting Latin American stocks as a whole within an EM equity portfolio, we believe that Brazilian, Chilean and Mexican share prices offer a better risk-reward profile than Colombian ones (Chart III-4). Chart III-4Colombia Is Unlikely To Outperform LATAM Second, as to sovereign credit investors, we are reiterating an overweight stance because fiscal tightening and monetary policy orthodoxy as well as low government debt levels will help Colombian sovereign credit to outperform. Third, two opposing cross-currents will shape the domestic bond market. On the one hand, weak growth is positive for bonds. On the other hand, currency depreciation is negative. Net-net, investors in local currency government bonds should be slightly overweight or neutral this market within an EM local bond portfolio. For fixed-income investors, we recommend a new trade: position for yield curve flattening (Chart III-5). This is a bet on a considerable growth slowdown amid looming fiscal austerity. Chart III-5Colombia: Bet On Yield Curve Flattening Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Special Report "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, available on ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Global Corporates: The Fed is now clearly signaling a near-term capitulation to tightening financial conditions alongside slowing global growth and inflation. A pause in the U.S. rate hiking cycle, after credit spread valuations have cheapened up, opens up a window of opportunity for global corporate bond market outperformance versus government debt over the next 3-6 months. Country Allocation: Move to overweight (4 of 5) on both U.S. investment grade and high-yield corporates, while downgrading U.S. Treasuries to underweight (2 of 5). Upgrade euro area investment grade and high-yield corporates to neutral (3 of 5), while downgrading euro area governments to underweight (2 of 5). Upgrade emerging market U.S. dollar denominated debt (both sovereign and corporate) from maximum underweight to underweight (2 of 5). Feature We downgraded our overall recommended investment stance on global corporate debt to neutral on June 26 of last year.1 That decision reflected our concern at the time that less accommodative central banks, a rising U.S. dollar, weakening global growth momentum and intensifying U.S.-China trade tensions had all significantly worsened the near-term risk/reward tradeoff for owning corporate bonds. This accompanied a firm-wide call at BCA to pare back our recommended exposure to global equities for the same reasons. We now see an opportunity, driven by better value and diminished market volatility after the Fed has clearly signaled a pause on U.S. rate hikes (Chart of the Week), to go back to an overweight stance on corporate credit on a tactical basis (3-6 months). Chart of the WeekTime For A Pause In Corporate Spread Widening To be clear, we still see medium-term risks for corporate credit once global growth stabilizes and a resilient U.S. economy forces the Fed to restart the rate hikes in the latter half of 2019. A move to a restrictive stance by the Fed toward year-end, signaled by an inversion of the U.S. Treasury yield curve, will raise recession risks and be the eventual death knell for this credit cycle. In the meantime, corporate debt is likely to outperform government bonds, justifying a tactical overweight position. This mirrors the recent change in the BCA House View, returning to a tactical overweight stance on global equities. On a regional basis, we prefer taking more of our upgraded credit risk in U.S. corporates over European and emerging market (EM) equivalents. The outlook for growth remains more favorable on a relative basis to Europe or China, the latter being most critical for the outperformance of EM assets. Why The Spread Widening Will Pause: A Patient Fed Is Taking A Break Global corporate bond spreads have widened since we did our downgrade in June, across all countries and credit tiers (Chart 2). Typically, some underperformance of corporate credit should occur when global growth momentum slows, as was the case throughout 2018. Yet the most violent period of spread widening only began once the Fed began signaling that it would continue with its interest hikes and balance sheet runoff, despite softening global growth. This set off yet another clash between policy and the markets – one of BCA’s key investment themes for 2018 that still applies in 2019 – resulting in a sharp selloff in global risk assets, including corporate debt. The result was a tightening of U.S. financial conditions, first through a stronger U.S. dollar (supported by rate hike expectations) and later through lower equity prices and wider corporate spreads. This echoed the 2014/15 period when the Fed was trying to lift rates off the zero bound after ending its quantitative easing program. The Fed was only able to deliver a single rate hike in December 2015 before pausing because of severely slumping global growth (most notably in China) and a sharp tightening in financial conditions, both of which knocked the wind out of the U.S. economy. Turning to 2019, the downturn in cyclical growth indicators like manufacturing purchasing managers indices (PMI) and the global leading economic indicator (LEI) has reached levels last seen after that 2014/15 episode (Chart 3). Importantly, our global LEI diffusion index, which measures the number of countries with rising LEIs compared to falling LEIs and is itself a reliable leading indicator of the global LEI, is bottoming out at the same level that preceded the 2016 LEI revival (middle panel). This suggests that a stabilization of the global LEI could unfold in the next few months, which would also signal a potential rebound in corporate credit returns (bottom panel). Chart 3Credit Returns Already Reflect Slowing Growth Given the many similarities between today and the 2014/15 backdrop, it is sensible to look for other indicators that accurately heralded the end of that period of spread widening to help time a potential increase in recommended exposure to corporates. Over the past several weeks, our colleagues at our sister BCA service, U.S. Bond Strategy, have been following a checklist of market-based signals to determine the timing of a potential peak in U.S. credit spreads.2 These are grouped into two categories: signals of rebounding global growth and signals of Fed capitulation on rate hikes. For global growth, the indicators monitored are shown in Chart 4: Chart 4Checklist For Peak U.S. Spreads: Global Growth the CRB raw industrials index of commodity prices (a broader measure that excludes highly volatile oil prices) the BCA Market-Based China Growth Indicator (created by our China Investment Strategy team as a proxy of investor expectations of Chinese growth3) the Global Industrial Mining equity price index For Fed capitulation, the indicators monitored are shown in Chart 5: Chart 5Checklist For Peak U.S. Spreads: Fed Capitulation our 12-month fed funds discounter, which measures the amount of expected Fed rate hikes over the next year discounted in the U.S. Overnight Index Swap (OIS) curve the price of gold in dollars (a higher price correlating with perceptions of easier U.S. monetary policy and vice versa) the nominal trade-weighted U.S. dollar index Among the growth-focused elements of the checklist, only the China Growth Indicator is in a clear uptrend. Non-oil commodity prices had been stabilizing at the end of 2018 but appear to be rolling over, while it is not yet clear if the downturn in Mining stocks has ended. With momentum in global PMIs and LEIs still having not yet bottomed out, it may be too early to expect a cyclical rebound in non-oil commodities and related equities. At a minimum, that will require even greater signs that China’s economy is regaining some vigor. However, as we discussed last week, Chinese policymakers’ options to stimulate growth are far more limited now than they were in 2015 and 2016 when a rebounding China boosted commodity demand and EM asset performance.4 Within the Fed-focused components of the “Peak Spreads Checklist”, the near-term bullish signal for credit is much stronger. Our fed funds discounter has rapidly priced out all rate hikes for 2019. Since November, gold is up nearly 8% and the nominal trade-weighted U.S. dollar is down 2%. The shift in recent Fed messaging from signaling a “gradual pace” of tightening to exhibiting “patience” on any future policy moves was a highly dovish signal for investors. This alone has been enough to stabilize equity and credit markets, which had been discounting that Fed tightening in 2019 would drive the U.S. into a possible recession. In the constant battle between financial conditions and the Fed, the former has won this latest round. How long will this Fed pause last? Continuing with the comparison to the 2014/15 episode, a critical difference is that underlying trends in U.S. economic growth and inflation are firmer today. This is evident in the BCA Fed Monitor, which is comprised of economic and financial data that indicate pressure on the Fed to tighten or ease monetary policy. Chart 6 shows a “cycle-on-cycle” comparison of the Fed Monitor (and its subcomponents) today versus 2014/15. The Fed Monitor is still signaling a need for the Fed to continue tightening because the Economic Growth and Inflation Components remain elevated. Yet the Monitor has declined from its recent peak thanks entirely to the plunge in the Financial Conditions Component, which has fallen even faster than it did in 2014/15. Chart 6BCA Fed Monitor: Today Vs 2014/15 The implication from our Fed Monitor is that there needs to be more evidence of slowing U.S. economic growth and reduced inflation pressures for the Fed to stay on hold for longer. If the data stay firm, but financial conditions ease because investors expect a prolonged pause from the Fed, then the Fed could quickly return to a hawkish bias later this year. This is now our base case scenario for how 2019 will play out. This is also why we are only upgrading corporate debt on a tactical basis. We do not expect U.S. growth or inflation to slow enough to prevent more Fed tightening later this year – an outcome that will weigh on credit returns as the Fed moves to a restrictive policy stance. Yet even if we are wrong and the U.S. economy decelerates more sharply, that is also a bad outcome for credit because it means weaker corporate profits and rising downgrades and defaults. For bond investors with longer-time horizons than 3-6 months, the credit rally that we are anticipating can actually provide an opportunity to reduce credit exposure for the final leg of the Fed’s monetary policy cycle and the multi-year corporate credit cycle. In other words, selling into the rally rather than chasing it. For now, we are choosing to play for the shorter-term move by upgrading our recommended global credit allocations. Yet we do not envision this turning into a long-term position. The medium-term outlook for corporates is far more challenging given the advanced age of the monetary, business and credit cycles. Bottom Line: The Fed is now clearly signaling a near-term capitulation to tightening global financial conditions alongside slowing global growth and inflation. A pause in the U.S. rate hiking cycle, after credit spread valuations have cheapened up, opens up a window of opportunity for global corporate bond market outperformance versus government debt over the next 3-6 months. The Specific Changes To Our Recommended Asset Allocation As part of our tactical upgrade of global corporate debt, we are making the following changes to our recommended portfolio allocation tables (see Page 13): Upgrade overall global credit exposure to overweight (4 out of 5) Upgrade both U.S. investment grade and high-yield corporate exposure to overweight (4 out of 5), while downgrading U.S. Treasury exposure to underweight (2 out of 5) Upgrade euro area investment grade and high-yield corporate exposure to neutral (3 out of 5) and downgrade euro area government bond exposure to underweight (2 out of 5) Upgrade EM U.S. dollar denominated debt from maximum underweight to underweight (2 out of 5), both for sovereign and corporate debt. The changes all represent a one-notch upgrade from our previous allocations, based on our more positive tactical view on overall global credit risk, while still maintaining our relative preference for U.S. corporates over non-U.S. equivalents. We prefer U.S. credit not only because we expect better relative economic growth momentum in the U.S., but also because our preferred valuation metrics indicate that U.S. corporate bond spreads now look relatively attractive. Our estimate of the default-adjusted spread on U.S. high-yield corporates, which is simply the current spread minus losses from defaults, has risen to 302bps, well above the long-run average of 268bps (Chart 7). That is a function of the high-yield spread now discounting a 2019 default rate of nearly 6%, well above our forecasted default rate of 2.5%.5 Chart 7Too Much Default Risk Priced Into U.S. Junk Corporate credit spreads in the U.S. also look attractive on a volatility-adjusted basis. Our estimates of Breakeven Spreads – the amount of spread widening required for corporate returns to break-even with duration-matched U.S. Treasuries on a one-year horizon – shows that credit spreads have cheapened to levels that are in the upper end of the historical range for both investment grade and high-yield debt (Charts 8 & 9). Chart 8Vol-Adjusted IG Spreads Have Cheapened Chart 9Vol-Adjusted HY Spreads Are Cheap Credit spreads have also cheapened up in Europe and EM, and a “risk-on” rally from a Fed pause will likely benefit spread product in those regions. However, the performance of U.S. credit versus non-U.S. credit remains largely determined by relative growth trends (Charts 10 & 11). Given our more positive view on U.S. growth on a relative basis, we are maintaining a higher recommended allocation to U.S. corporates versus euro area and EM equivalents, even as we upgrade overall global corporate exposure. This is also a way to provide a partial hedge to the specific risks in the latter regions coming from: Chart 10Global Corporates: Continue Favoring U.S. Over Europe Chart 11Global Corporates: Continue Favoring U.S. Over EM a) an end of the ECB’s corporate bond buying as part of its Asset Purchase Program, which takes a major buyer out of the euro area corporate market b) a more persistent slowing of Chinese growth momentum and softer non-oil commodity prices, both of which would be negatives for EM assets On a final note, we are also changing the specific weighting in our Model Bond Portfolio on Page 12 to reflect all of the above changes. The allocations to all U.S., euro area and EM corporates are increased – with bigger allocation changes in the U.S. – funded out of reduced weightings in U.S., German and French government bonds. Note that we are not making any changes to our relative U.K. exposures this week, given the unique risk for U.K. financial markets from the Brexit uncertainty. Thus, we are maintaining an overweight stance on U.K. Gilts in the government bond portion of the model portfolio, while remaining underweight U.K. corporates on the credit side. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral”, dated June 26th 2018, available at gfis.bcaresearch.com. 2 Please see BCA U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27th 2018, available at usbs.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21st 2018, available at cis.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, “Three Big Questions To Start Off 2019”, dated January 8th 2019, available at gfis.bcaresearch.com. 5 That forecasted default rate is taken from Moody’s, who have a similarly positive outlook on 2019 U.S. growth as BCA. Therefore, we see no reason to use a different default rate assumption in our high-yield valuation estimate. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Corporates: The same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. Investors should tactically increase exposure to corporate bonds at the expense of Treasuries. Duration: Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. TIPS: The 10-year TIPS breakeven inflation rate has fallen too far, and it is now well below the fair value reading from our Adaptive Expectations model. Remain overweight TIPS versus nominal Treasury securities. Feature We continue to view the 2015/16 episode as the appropriate comparable for current market behavior, and the same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. As such, we recommend increasing portfolio allocations to both investment grade and high-yield corporate bonds at the expense of Treasury securities (see the Recommended Portfolio Specification Table on the last page of this report). Importantly, our cyclical view of the credit cycle has not changed. Elevated corporate debt balances and a relatively flat yield curve suggest that we are in the awkward middle phase of the cycle when excess returns from corporate credit tend to be positive, but low.1 However, recent spread widening has been excessive for this middle phase of the cycle, and we expect spreads to tighten from oversold levels during the next few months. Three Reasons To Upgrade Credit (& One Key Risk) Reason 1: Elevated Spreads The first reason to upgrade corporate credit is the attractive entry point (Chart 1). Outside of the Aaa space, 12-month breakeven spreads for every credit tier (encompassing both investment grade and junk) are above their respective historical medians. For example, the 12-month breakeven spread for the Baa credit tier is at 59%. This means that the spread has been tighter than its current level 59% of the time since 1988 and wider than its current level 41% of the time. Historically, spreads tend to hover within the tight-end of their historical range during this middle phase of the credit cycle, and only cheapen significantly when the yield curve inverts and the default rate moves higher. Chart 1Corporate Bonds: Attractive Entry Point Reason 2: Fed Capitulation The 2015/16 roadmap is applicable to the current market because in both cases credit spread widening was driven by the combination of weaker global growth and relatively hawkish Fed policy.2 With that in mind, an important pre-condition for spread tightening is a shift in the market’s expectations for Fed policy. Investor psyche must change from viewing monetary policy as restrictive to viewing it as accommodative. Chart 2 shows the three indicators we’ve been monitoring to signal when this shift occurs. All three called the early-2016 peak in credit spreads, and all are sending a strong buy signal at the moment. Chart 2Fed Capitulation Indicators Send A Strong Signal... Our 12-month Fed Funds Discounter, the change in the fed funds rate that is priced into the overnight index swap curve for the next 12 months, has collapsed from an early-November peak of 66 bps all the way to -4 bps (Chart 2, top panel). The gold price has also rebounded smartly (Chart 2, panel 2). Gold tends to rally when the market perceives that monetary policy is becoming more accommodative because the increased risk of future inflation makes gold’s “store of value” characteristics more appealing.3 Finally, the trade-weighted dollar has started to depreciate (Chart 2, bottom panel). This signals that U.S. monetary policy is easing relative to the rest of the world, and is historically correlated with stronger global growth. Reason 3: Imminent Global Growth Rebound The high-frequency global growth indicators that called the early-2016 peak in credit spreads are not sending as strong a signal as the monetary policy indicators, but there has been some positive movement (Chart 3). Chart 3...While There Is Positive Movement In Global Growth Indicators The CRB Raw Industrials index has only flattened-off in recent weeks (Chart 3, top panel), but the Market-Based China Growth Indicator created by our China Investment Strategy team has been rising quickly (Chart 3, panel 2).4 Finally, the price of global industrial mining stocks is no longer in free-fall. Rather, it is showing some signs of stabilization (Chart 3, bottom panel). Of the six indicators shown in Charts 2 and 3, four are sending strong buy signals and the other two are more or less neutral. In sum, we think this is enough of a signal to upgrade exposure to corporate bonds. One Key Risk The key risk to our tactical upgrade is that there is no follow-through from Fed easing to stronger global growth. In 2016, Fed capitulation coincided with a ramp-up in Chinese stimulus efforts. Chart 4 shows that our China Investment Strategy team’s Li Keqiang Leading Indicator moved sharply higher in early 2016.5 Moreover, all six components of the indicator participated in the uptrend. At present, only some components of the Leading Index have rebounded and the overall index has merely leveled-off. Chart 4Chinese Growth Is The One Key Risk When it comes to Chinese growth, a trade deal with the U.S. would certainly help matters. However, the risk remains that Chinese policymakers continue to curb credit growth so much that the pass through from easier Fed policy to global growth is weaker than in 2016. Bottom Line: With Fed rate hikes priced out of the market and signs of stabilization in high-frequency global growth indicators, the toxic combination of tight Fed policy and weak global growth is disappearing. This should allow credit spreads to tighten from current oversold levels. The rapid shift in monetary policy expectations makes us think that spread tightening could occur over a relatively short timeframe. As such, we would recommend this upgrade only to tactical (3-6 month) investors. Those with longer investment horizons may be better served by waiting for spreads to tighten and then using that opportunity to reduce cyclical corporate bond exposure. A Note On Portfolio Duration As mentioned above, the market has completely priced out Fed rate hikes. At present, the overnight index swap curve discounts 4 bps of rate cuts over the next 12 months and 17 bps of rate cuts over the next 24 months. This shift in market rate expectations is the main reason for our rosier outlook on corporate spreads, but it’s important to remember that the causation between credit spreads and policy expectations runs both ways (Chart 5). It is the recent spread widening and sharp tightening in financial conditions that caused the Fed to adopt a more accommodative policy stance in the first place (Chart 6). In the background, the U.S. economic data remain robust. The New York Fed’s GDP Nowcast model projects above-trend real GDP growth of 2.5% in 2018 Q4 and 2.1% in 2019 Q1. The corollary is that once credit spreads tighten and financial conditions ease, the Fed will have no further reason to stay on hold. Chart 6Financial Conditions Likely Going To Ease Going Forward If financial conditions ease during the next few months, as we expect, then it is very likely that the Fed will be ready to lift rates again at the June FOMC meeting. The fed funds futures curve currently discounts less than a 20% chance of that happening. Bottom Line: The U.S. economic data are solid. The sharp fall in rate hike expectations and Treasury yields is purely a reaction to tighter financial conditions. Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. Inflation & TIPS The main reason why the Fed feels comfortable responding to tighter financial conditions by adopting a more dovish policy stance is that inflation remains well contained. Last week’s CPI report showed that core CPI grew by 2.2% in 2018, somewhat below levels that are consistent with the Fed’s target (Chart 7).6 Chart 7Inflation Remains Well Contained Looking at the monthly changes, we also see that core CPI has increased by roughly 0.2% in each of the past three months. This translates to an annualized rate of approximately 2.4%, in line with the Fed’s target (Chart 8). The monthly changes shown in Chart 8 also reveal that the year-over-year growth rate in core CPI will almost certainly decline next month when the strong 0.35% print from last January falls out of the trailing 12-month sample. Chart 8Muted Inflationary Pressures For Now However, after next month base effects start to turn supportive. Our Base Effects Indicator, an indicator that compares rates of change in core CPI ranging from 1 to 11 months, predicts that year-over-year core CPI inflation will be higher six months from now (Chart 9). Chart 9Expect Higher Inflation Six Months From Now The conclusion is that inflationary pressures appear muted right now, and will continue to appear muted through the end of February. However, we expect them to ramp up again as we head into March. Come June, it is quite likely that the Fed will be feeling the pressure to lift rates as inflation approaches target. Coincident with a renewed uptick in inflation, TIPS breakeven inflation rates are also biased higher during the next six months. Slowing global growth and falling oil prices drove long-maturity breakevens lower during the past few months, with the result that the 10-year TIPS breakeven inflation rate is now 1.83%, 14 bps below the fair value reading from our Adaptive Expectations model (Chart 10).7 Chart 10Message From Our Adaptive Expectations Model Our Adaptive Expectations model contains three independent variables: The 10-year trailing rate of change in core CPI (Chart 10, panel 3) The 12-month trailing rate of change in headline CPI (Chart 10, panel 4) The New York Fed’s Underlying Inflation Gauge (Chart 10, bottom panel) Of those three variables, the 10-year trailing rate of change in core CPI carries the largest weight. This long-run measure of core inflation is currently running at an annualized pace of 1.83%. This translates roughly to an average monthly increase of 0.15%. In other words, as long as monthly core inflation prints above the 0.15% level, the fair value from our Adaptive Expectations model will continue to rise. Bottom Line: Core inflation has been steady during the past few months, but base effects will turn positive after next month’s report. This means that we will probably see higher year-over-year core CPI inflation in six months. With the 10-year TIPS breakeven inflation rate already well below the fair value reading from our Adaptive Expectations model, we expect TIPS will outperform nominal Treasuries during the next six months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Signal From Gold?”, dated May 1, 2018, available at usbs.bcaresearch.com 4 For further details on how this indicator is constructed please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 5 The Li Keqiang Leading Indicator is a composite indicator of money and credit growth measures designed to predict changes in the Li Keqiang Index (a coincident indicator of Chinese economic activity). For further details on how the Leading Index is constructed please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 6 The Fed targets 2% PCE inflation. CPI inflation tends to run about 0.4%-0.5% higher than PCE, which means the Fed’s target is roughly 2.4%-2.5% for CPI. 7 For further details on the model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy The budding recovery in Chinese infrastructure outlays and easing in monetary conditions, a pause in the U.S. dollar’s rally on the back of a more dovish Fed and improving domestic steel final-demand dynamics along with compelling valuations and technicals, all suggest it no longer pays to be bearish the S&P 1500 steel index. Boost to overweight. A marginally improving China monetary backdrop, a de-escalation in the U.S./China trade tussle, recovering EM market internals and a brightening profit backdrop, all signal that a re-rating phase looms in the S&P materials sector. Upgrade to a modest overweight. Recent Changes Boost the niche S&P 1500 Steel Index to overweight today. This move also lifts the S&P Materials Index to a modest overweight. Table 1 Feature The S&P 500 convulsed following the December 19th Fed meeting and suffered a cathartic 450 point peak-to-trough fall last month. The Fed likely made a policy error, and Fed Chair Powell’s resolve is getting tested as has happened with every Chair since Volcker (Chart 1).1 Chart 1Powell's Resolve Getting Tested The top panel of Chart 2 shows that the 2018 peak in the SPX occurred one week prior to the September Fed meeting. That meeting, when the Fed raised rates for the third time that year, was the straw that broke the camel's back. Indeed, the bond market has been signaling that the U.S. economy has reached the neutral rate last year, as the 10-year UST yield stalled near the 3.10% mark on several occasions (middle panel, Chart 2). Chart 2Fed Policy Mistake Our recent research also suggests that the Fed’s tightening cycle (from trough-to-peak) is now above the historical median and at least a pause is warranted.2 To put last year’s discount rate increases into further perspective, bottom panel of Chart 2 shows that a 100bps increase in the fed funds rate caused a roughly 30% collapse in the forward P/E. Not only is this multiple compression overdone, but prices also corrected 19% from peak-to-trough, likely paving the way for a smart recovery. Our running assumption remains that the U.S. economy will avoid recession this year and EPS will continue to expand. True, the yield curve inversions have widened beyond the 5/3 and 5/2 slopes to the 7/1, and we heed the bond market’s message (Chart 3). However, as we highlighted last month, yield curve inversions occur before stock market peaks. Keep in mind that the most important yield curve slope, the 10/2, has not yet inverted. The upshot is that the SPX has yet to peter out for the cycle.3 Chart 3Yield Curve Inversion Is Spreading With regard to our end-2019 SPX target we are revising our base case scenario to 3,000 (from 3,150 previously),4 based on a 2020 EPS revision to $181 (from $191 previously),5 but we are sustaining the multiple at 16.5 times (Table 2). Assuming 2018 EPS end near $162, this represents a 6% EPS CAGR, in line with the still mid-single digit expansion signal from our EPS growth model (Chart 4). Table 2SPX EPS & Multiple SensitivityChart 4EPS Growth Model Still Expects Mid-Single Digit Expansion Adding it up, stocks hit rock bottom late-last year and a pause in the Fed tightening cycle, at least for the first half of the year, will likely serve as a welcome catalyst; any positive news on the trade tussle front with China will also act as a tonic for stocks, especially beaten down deep cyclicals. This week we are upgrading a U.S./China trade war GICS1 sector victim to a modest overweight position, via boosting a niche deep cyclical sub-index to an above benchmark allocation. Made Of Steel We are booking gains of 2.3% in the niche S&P 1500 steel index and boosting it from underweight all the way to an overweight stance. Beyond the contrary buy signal that bombed out technicals and depressed valuations are sending (Chart 5), there are high odds that relative profit outperformance is in the early innings. Chart 5Steel Is A Steal While U.S. steel stocks should have benefitted enormously from the U.S./China trade war and steel import tariffs, China macro dictates the fate of the S&P 1500 steel index. China’s waning fiscal and credit impulses have weighed heavily on U.S. steel stocks (top panel, Chart 6). Chinese authorities have been trying to engineer a soft landing, but the Chinese manufacturing PMI has now dipped below the boom/bust line (middle panel, Chart 6). Chart 6Mixed China Signals... Nevertheless, the recovering Li KEQIANG index is sending a positive signal (bottom panel, Chart 6). In addition, recent news of a mini fiscal package centered on high speed rail infrastructure spending is a step in the right direction. Historically, Chinese infrastructure outlays and relative share prices have been joined at the hip (middle panel, Chart 7). Chart 7...But Monetary And Fiscal Taps Are Opening On the monetary front, the easing in the banks’ reserve-requirement-ratio (RRR), albeit with a delayed effect, should also aid infrastructure spending uptake (RRR shown inverted, bottom panel, Chart 7). Similarly, the steepening in the Chinese yield curve underscores that easing financial conditions are conducive to a pickup in capital outlays (top panel, Chart 7). The U.S. dollar is another important macro variable driving U.S. steel stocks performance. The greenback’s steep appreciation since April 2018 has dealt a dual blow to domestic steel producers: not only is the underlying commodity quoted globally in U.S. dollars, but also FX translation losses have dented sector profitability. Despite the grim U.S. dollar news, there is light at the end of the tunnel. Were the Fed to pause its hiking cycle, at least in the front half of the year, the greenback’s advance may go on hiatus. Importantly, J.P. Morgan’s EM FX index is staging a comeback and steel prices are holding their own (top and bottom panels, Chart 8). Chart 8Bright Profit Drivers On the domestic front, news is also encouraging. Ever since President Trump came into power, blast furnaces have been running around the clock. Industry resource utilization rates are in a V-shaped recovery since 2016 and only recently returned to levels last seen prior to the Great Recession (middle panel, Chart 8). Steel new order growth is running at a healthy clip and is even surpassing inventory accumulation. This bright demand backdrop is a boon for steelmaking earnings (Chart 9). Chart 9Domestic Operating Backdrop... With regard to the domestic demand front, while automobile sales have been flirting with the zero growth line for the better part of the past three years, non-residential construction has been a primary beneficiary from the easing in fiscal policy (bottom panel, Chart 10). Fiscal thrust will continue to goose the U.S. economy in 2019, according to the IMF’s October 2018 World Economic Outlook update, and a new infrastructure spending bill, however modest, will, at the margin, buoy steel profits. Finally, according to the Fed’s latest Senior Loan Officer Survey, bankers are far from constricting the flow of credit toward the key end-demand segments, autos and commercial real estate. Chart 10...And Domestic Demand Will Buoy Steel Profits In sum, compelling valuations and technicals, the budding recovery in Chinese infrastructure outlays and easing in monetary conditions, a pause in the U.S. dollar’s rally on the back of a more dovish Fed and improving domestic steel final-demand dynamics, all suggest that it no longer pays to be bearish the S&P 1500 steel index. Bottom Line: Lift the S&P 1500 steel index from underweight to overweight and lock in gains of 2.3%. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL – NUE, STLD, RS, X, ATI, CMC, CRS, WOR, AKS, SXC, TMST, HAYN and ZEUS. Time To Dip Into Materials Raising the S&P 1500 steel index to an above benchmark allocation shifts the S&P materials sector into the overweight column. China macro dominates the direction of U.S. materials stocks. On the monetary front, the easing cycle continues unabated and the near 150bps year-over-year drop in the 10-year Chinese Treasury yield will soon start to bear fruit (yield change shown inverted and advanced, bottom panel, Chart 11). Chart 11Buy Materials As China's Monetary Spigots Are Loosening The renminbi also moves in lockstep with relative share prices. The apparent de-escalation in the U.S./China trade tensions has boosted the CNYUSD and is signaling that a playable reflation trade is in the offing in the S&P materials sector (top panel, Chart 11). Beyond the budding recovery in some key Chinese data (bottom panel, Chart 12), the troughing in emerging markets (EM) currencies versus the greenback also suggests that U.S. materials stocks have put in a bottom (top panel, Chart 12). Chart 12Shifting EM Internals Are A Boon For Materials The EM stock outperformance compared with the global benchmark (second panel, Chart 12) along with EM market internals corroborate the EM FX message. In more detail, EM Latin American equities have been significantly outperforming EM Asian bourses. This real time proxy of commodity producers versus consumers has been an excellent indicator of relative share prices and the current message is to expect more relative gains in the S&P materials sector (third panel, Chart 12). On the earnings front, while last year’s trade dispute related collapse in relative share prices is signaling profit trouble in the coming months, our EPS growth model (comprising the U.S. dollar, interest rates and commodity prices) has ticked up. Similar to the 2012 and 2016 lows, there are good odds that our model is picking up a soft landing in profits (second panel, Chart 13). Chart 13Profit Growth Model Has Troughed S&P materials sub-sector EPS breadth has slingshot higher compared with the overall market and relative long-term EPS growth forecasts are trying to bottom near the 2016 nadir (third & bottom panels, Chart 13). With regard to the sector’s financial health, materials’ indebtedness profile remains in recovery mode, still in the aftermath of the late-2015/early-2016 manufacturing recession with net debt-to-EBITDA in a free fall and a steeply accelerating interest coverage ratio. Capital outlays are also expanding smartly and are now on an even keel with sales growth (Chart 14). Given this improvement in corporate health, there are low odds of debt-related materials sector deflation. Chart 14Clean Bill Of Corporate Health Taking the pulse of investor sentiment toward this niche deep cyclical sector reveals that technical conditions are as oversold as can be; in fact our Technical Indicator sits at one standard deviation below the historical mean, a level that has preceded previous recovery rallies (Chart 15). Chart 15Contrary Buy Alert: Under-owned... Finally, according to our Valuation Indicator, relative valuations have crumbled to the lowest level since the GFC, and even relative EV/EBITDA has also corrected to the historical mean (Chart 16). Chart 16...And Unloved Netting it out, a marginally improving China monetary backdrop along with a de-escalation in the U.S./China trade tussle, recovering EM market internals and a brightening profit backdrop, all signal that a re-rating phase looms in the S&P materials sector. Bottom Line: Lift the S&P materials sector to a modest overweight position. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Will The Market Test Powell?” dated November 13, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Manic Market” dated November 19, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, “Lifting SPX Target” dated April 30, 2018, available at uses.bcaresearch.com. 5 Ibid. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps