Market Returns
Highlights Global growth will rebound in 2020, led by the US and China, putting upward pressure on global bond yields. Maintain below-benchmark overall duration exposure. Central banks will stay dovish until policy reflation has clearly turned into inflation, limiting how high bond yields can climb in 2020 but sowing the seeds for a far more bond-bearish backdrop in 2021. Expect mild bear-steepening pressure on global yield curves, led by rising inflation expectations. Accommodative monetary policy and faster growth will delay the peak in the aging global credit cycle. Stay overweight global corporate debt versus sovereign bonds. Returns on global fixed income will be far lower in 2020 than in 2019, given rich valuation starting points. Country and sector selection will be more important in driving fixed income outperformance. For sovereign bonds, favor countries where yields are less sensitive to change in overall global yields; for credit, favor sectors with lower interest rate durations and lower spread volatility. Feature BCA Research’s Outlook 2020 report, outlining the main investment themes for next year from the collective mind of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2020. In a follow-up report to be published in the first week of the new year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2020 Outlook Chart 1Expect A Cyclical Rise In Global Yields In 2020 The main conclusions from the Outlook 2020 report were cyclically bullish looking out over the next twelve months, but more cautious beyond that. The downturn in global growth seen in 2019 is projected to end in response to several headwinds that have become tailwinds: a small wave of Chinese stimulus and reflation; more stimulative global monetary policies; the substantial easing of global financial conditions as risk assets have rallied worldwide; a fading drag on global manufacturing from inventory destocking; both China (weak growth) and the US (the 2020 US election) have good reasons to de-escalate the trade war in 2020. This backdrop should push global bond yields moderately higher in 2020, while maintaining a backdrop that is once again favorable for risk assets on a relative basis versus government debt (Chart 1). A critical element to this story is the supportive monetary policy backdrop. Central banks worldwide, led by interest rate cuts from the US Federal Reserve and a resumption of asset purchases from the European Central Bank (ECB), are now running more stimulative policies in response to this year’s global manufacturing slump and elevated level of political uncertainty. Policymakers will maintain accommodative monetary policy through 2020 to try and bring depressed inflation expectations back up to central bank targets. This will create a “sweet spot” for global risk assets, with improving economic growth and accommodative monetary policy. A repeat of the spectacular total return numbers seen across the majority of asset classes in 2019 is unlikely, but global equity and credit markets should solidly outperform government bonds. Yet all that monetary stimulus does not come without a price. Policymakers will maintain accommodative monetary policy through 2020 to try and bring depressed inflation expectations back up to central bank targets. This will create a “sweet spot” for global risk assets, with improving economic growth and accommodative monetary policy. A revival of inflationary pressures in 2021 will force central banks to raise rates much more aggressively. Combined with a China that remains wary of promoting excess leverage, this will drive the current prolonged global business cycle expansion to its recessionary endgame, taking equity and credit markets down with it. This will eventually trigger a new decline in global bond yields as policymakers shift back to easing mode, but from much higher levels than today. Our Four Main Key Views For Global Fixed Income Markets In 2020 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall duration exposure. The pickup in global growth that we expect in 2020 has its roots in two locations: China and the US. For China, policymakers are keenly aware that the current growth slowdown cannot continue, as it has already pushed nominal GDP growth below 8% (Chart 2). For an economy as highly leveraged as China, slowing nominal growth is lethal and must be avoided to prevent a surge in private sector defaults and rising unemployment. Already, China has delivered significant policy stimulus in 2019: the reserve requirement ratio has been cut by 400bps; taxes have been cut by 2.8% of GDP; capital spending at state-owned enterprises has increased; the currency has depreciated; and, more recently, monetary policy has been eased via traditional interest rate cuts. These measures have eased our index of Chinese monetary conditions and triggered a surge in the China credit impulse, which leads Chinese import growth (i.e. China’s most direct impact on the global economy) by nine months. There are signs that Chinese growth is already bottoming out, as evidenced by the recent pickup in the China manufacturing PMI. Expect more signs of improvement in the first half of 2020. The BCA global leading economic indicator (LEI) has been rising since January of this year, and the global LEI diffusion index is signaling that the upturn will continue in 2020 (Chart 3). With global financial conditions at highly stimulative levels thanks to the robust performance of risk assets in 2019, the backdrop is already conducive to faster global growth. BCA’s geopolitical strategists are of the view that a “détente” in the US-China trade war is still the most likely base case scenario, which would go a long way in reducing the growth-inhibiting effects of elevated uncertainty (bottom panel). Chart 2A Boost To Global Growth From China In 2020 Chart 3Lower Uncertainty + Easy Financial Conditions = Faster Growth As for the US, the lagged impact of the Fed’s 75bps of rate cuts this year has boosted domestic liquidity conditions in a pro-growth fashion. The BCA US Financial Liquidity Indicator, which leads not only US growth but also leads the BCA global LEI and commodity prices by 18 months, is already signaling that US economic momentum is set to bottom out in early 2020 (Chart 4). This signal is in addition to the leading properties of US financial conditions (middle panel), which suggests a reacceleration of real GDP growth back above trend is about to unfold. Chinese policy reflation has typically been a good leading indicator for US capex and is heralding a rebound in investment spending (bottom panel). The pickup in global growth would also help revive the dormant euro zone economy, which has been hit hard though plunging export demand and overall weakness in the manufacturing sector. The entire slump in euro area real GDP growth since the start of 2018 can be attributed to plunging net exports, while domestic demand has held steady (Chart 5). The increase in the China credit impulse and our global LEI diffusion index – both leading indicators of euro area export growth – are signaling that euro area export demand is already in the process of bottoming out (bottom two panels) and should gain momentum in the first half of 2020. Chart 4US Growth Is Poised To Accelerate Chart 5The Drag On European Growth From Trade Will Soon End This better growth backdrop will put moderate upward pressure on global bond yields in 2020. This better growth backdrop will put moderate upward pressure on global bond yields in 2020. Key View #2: Expect mild bear-steepening pressure on global yield curves, led by rising inflation expectations. While we expect bond yields to drift higher in the next 6-12 months, the upside will be capped with central banks likely to stay dovish until policy reflation has clearly turned into higher inflation. Interest rate markets will not begin to price in expectations of tighter monetary policy without evidence of actual inflation picking up. The Fed, ECB, Bank of Japan and other central banks have all stated publicly that they will maintain current accommodative policy settings until realized inflation has sustainably returned to target levels, typically around 2%. This would be a major change in the modus operandi of these policymakers, who have typically signaled rate hikes based simply on forecasts of higher inflation. The implication is that interest rate markets will not begin to price in expectations of tighter monetary policy without evidence of actual inflation picking up (Chart 6). Chart 6Central Banks Will Stay Dovish Until Inflation Sustainably Accelerates A critical ingredient for global inflation to begin moving higher again is a softer US dollar (USD). The year-over-year growth rate of the trade-weighted USD is correlated to global export price inflation and commodity price inflation, more generally (Chart 7). The typical drivers of the USD are all pointing in a more bearish direction: Chart 7The USD Is Critical For Global Reflation Chart 8Global Real Yields & Inflation Expectations Will Drift Higher In 2020 the Fed has cut interest rates multiple times since the summer and is expanding its balance sheet via repo operations and treasury bill purchases; global (non-US) growth is bottoming out, and capital tends to flow out of the USD into more cyclical currencies in Europe and EM when global growth is accelerating; elevated policy uncertainty, which tends to attract inflows into the safety of the USD, is starting to diminish. The combination of improving global growth and a softer USD would normally be enough to generate a significant increase in global bond yields. Yet we do not expect the sort of move higher in the real component of bond yields signaled by our global LEI diffusion index in 2020 (Chart 8, top panel). While real yields should move higher alongside faster growth, if there is no expected tightening of monetary policy as well, the move in real yields will be more limited. The grind higher in global bond yields that we expect in 2020 will come first through faster inflation expectations and, much later in the year, higher real bond yields when central bankers (starting with the Fed) begin to signal a need to turn more hawkish. The grind higher in global bond yields that we expect in 2020 will come first through faster inflation expectations and, much later in the year, higher real bond yields when central bankers (starting with the Fed) begin to signal a need to turn more hawkish. This suggests that inflation-linked bonds should perform reasonably well in countries where inflation is likely to accelerate the fastest, like the US. Faster inflation expectations will also result in some bear-steepening of global government bond yield curves in the first half of 2020 (Chart 9). There is very little curve steepening discounted in bond forward rates in the developed markets – a consequence of the general flatness of yield curves – which suggests that yield curve steepening trades could prove to be profitable in 2020. Chart 9Expect A Mild Bear-Steepening Of Global Yield Curves Chart 10The Fed Has Dis-Inverted The Treasury Curve In the case of the US, the Fed’s recent easing actions have pushed short-term interest rates below longer-term Treasury yields, removing the yield curve inversion that sparked recession fears among investors during the summer of 2019 (Chart 10). With the Fed likely to sit on its hands for most of next year, even as US growth and inflation are likely to improve, this will put additional bear-steepening pressure on the US Treasury curve. In Europe, bond markets have already discounted a very significant impact from the ECB restarting its Asset Purchase Program, which only began last month. Investment grade corporate bond spreads, as well as Italy-Germany government bond spreads, have narrowed substantially despite a weak euro area economy (Chart 11, bottom panel). Meanwhile, the term premium on 10-year German bunds is back to the deeply negative levels middle panel) seen when the ECB was expanding its balance sheet at a 30-40% pace, rather than the 5% pace implied by the current announced pace of purchases of 20 billion euros per month (top panel). This potentially leaves longer-term European yields exposed to the same bear-steepening pressures seen in other bond markets, even within the context of a renewed ECB bond-buying program. Chart 11European Bonds Already Discount A Very Dovish ECB Chart 12The Wild Card For Bonds Markets In 2020: Fiscal Policy A potentially big wild card for global bond markets next year will be fiscal policy, which can also exacerbate yield curve steepening pressures. Any sign of a push toward more government spending, particularly in Europe where there has been such reluctance to open the fiscal taps, would result in a sharper upward move in global bond yields than we are expecting. This is not because of a supply effect related to more government bond issuance that would require higher yields to attract buyers. It is because fiscal stimulus (Chart 12) would push growth to an even faster pace that would bring forward the date when inflation returns to policymaker targets and tighter monetary policy could commence. This would follow a similar path to the curve steepening dynamics described earlier, with a fiscal boost to growth pushing up longer-term inflation expectations before starting to push up short-term interest rate expectations. Key View #3: Stay overweight global corporate debt versus sovereign bonds. Investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. The combination of faster global growth, somewhat higher inflation and accommodative monetary policies laid out in the BCA Outlook 2020 report will delay the peak in the aging global credit cycle. This means investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. Low borrowing rates are already helping to extend the credit cycle by making it easier for highly indebted borrowers to service their debts. This can be seen in the US, where interest coverage ratios (using top-down data for the non-financial corporate sector) remain above the levels that have preceded previous recessions (Chart 13). Low borrowing rates are also helping indebted borrowers in Europe, particularly in Italy and Spain where the banking system is now far less exposed to non-performing loans than during the peak years of the 2011-12 European Debt Crisis (Chart 14). Chart 13Low Rates Helping Extend The US Credit Cycle Chart 14Low Rates Helping Ease Stress In European Banks Declining Non-Performing Loans Are A Positive For The European Periphery Chart 15A Cyclically Positive Backdrop For Global Corporates According to our checklist of indicators to watch for an end of the corporate credit cycle in the US – tight monetary policy, deteriorating corporate sector financial health, and tightening bank lending standards – only corporate financial health is flashing a warning signal according to our Corporate Health Monitor as we discussed in a recent report.2 In fact, our global Corporate Health Monitor is rolling over – a trend that should continue as growth improves in 2020 – which should support global corporate bond outperformance versus government debt next year (Chart 15). Key View #4: Returns on global fixed income will be far lower in 2020 than in 2019. Country and sector selection will be more important in driving fixed income outperformance in 2020. The start of 2020 looks far different in terms of fixed income valuations compared to the beginning of 2019. For example, the 10yr US Treasury yield started the year at 2.72% and is now 1.83%, while the 10yr German bund yield started this year at 0.24% and is now MINUS-0.31%. These lower yields reflect the slower pace of global economic growth and monetary policy easing delivered by the Fed and ECB. Yet at the same time, corporate credit spreads have narrowed in both the US (the high-yield index OAS is down from 526bps to 360bps) and the euro area (the investment grade index OAS is down from 152bps to 100bps). These massive rallies in global bond markets this year resulted in both lower government bond yields and tighter credit spreads - even with slower global growth that would normally be a trigger for wider spreads/higher risk premiums. Looking at the current valuation of government bond yields in the major developed markets from a long-run perspective, it is difficult to make the case that it is attractive. Medium-term real bond yields remain well below potential GDP growth rates, a consequence of central banks keeping policy rates well below neutral levels suggested by measures like the Taylor Rule (Chart 16). Chart 16Global Government Bonds Are Expensive Without the initial starting point of cheap valuations, fixed income return expectations for 2020 should be tempered. This means that rather than loading up on maximum duration risk and/or credit risk to capture big yield and spread moves, bond investors should be more selective in country, maturity and credit exposure to generate outperformance in 2020. Chart 17Favor Lower-Beta Government Bond Markets In 2020 For government bonds, that means focusing country exposures on lower-beta markets where yields are less correlated to moves in the overall level of global bond yields. Our preferred way to measure this is to look at the beta of monthly yield changes for the benchmark 10-year government yields of the major developed market countries to the overall Bloomberg Barclays Global Treasury index yield for the 7-10 year maturity bucket, over a rolling three-year window. We define a “high-beta” bond market as having a yield beta of 1.25 or higher, and a “low-beta” bond market as having a yield beta of 0.75 or lower. Under that definition, global bond investors should underweight higher-beta Canada, the US and Italy, and overweight low-beta Japan and Spain (Chart 17). Bond markets with betas between 1.25 and 0.75 (Germany, Australia, Sweden, the UK) can also be considered on their own fundamental merits. Of that list, we see Germany and Australia having a better chance of outperforming the UK and Sweden, given the greater odds that the Bank of England or Riksbank could signal a need to hike rates in 2020 compared to the ECB or Reserve Bank of Australia. Chart 18Stay Overweight Global Spread Product In 2020, But Be Selective For spread product, that means focusing exposure on sectors that are less risky, either defined by interest rate duration or spread volatility (i.e. spread duration). With credit spreads remaining near the low end of long-run historical ranges for nearly all major markets (Chart 18), it is hard to find examples of spread product being cheap in absolute terms. On a risk-adjusted basis, however, negatively-convex spread product like US and euro area high-yield debt and US agency MBS actually look more interesting in the rising yield environment we expect in 2020, since the interest rate durations of those fixed income sectors fell as bond yields declined in 2019. Thus, we recommend owning high-yield corporates over higher-duration investment grade corporates in the US and euro area, while also favoring US agency MBS over higher-quality credit tiers of US investment grade corporate credit. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2020: Heading Into The End Game”, dated November 22, 2019, available at bca.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, “The Lowdown On Low-Rated High-Yield”, dated November 27, 2019, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The key risk to a dollar bearish view is a US-led rebound in global growth. This would allow the Federal Reserve to tighten monetary conditions much faster than other central banks, supporting the dollar in the process. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for this risk. Feature We were on the road last week, visiting clients in South Africa. The biggest preoccupation was what could put a dollar bearish view offside, especially vis-à-vis the rand. Many understand that the dollar is a countercyclical currency and tends to depreciate when global growth is rebounding. Yet there was still a good amount of trepidation on the totality of this argument. The dollar has been in a bull market since 2011, but there have been a couple of growth cycles during that period. One of our last meetings was in the beautiful city of Stellenbosch, a university town lined with majestic landscapes and rooted deep in South African history. A multi-asset fund manager had just met with two FX strategists before meeting with us. One of them was a dollar bull, and the other a bear. We could sense from his demeanor that indecisiveness was not part his ‘modus operandi,’ and he definitely wanted some clarity from our meeting. What transpired was an honest conversation on currencies, especially vis-à-vis our bearish dollar view. The conversation embodied the sentiment we had been getting from most other fund managers, which is that the view on the dollar is highly polarized. As we went through a swathe of charts, I noted his insightful questions, many of which drilled to the core of where the view could go wrong. Is The Dollar That Countercyclical? The observation that the dollar is a countercyclical currency rests on two pillars. The first is that the US economy is driven more by services than manufacturing. As such, when global growth is rebounding, more cyclical economies benefit most from this growth dividend, and as such, capital tends to gravitate to their respective economies. This is aptly illustrated by the fact that whenever global cyclical sectors (higher concentration outside the US) are outperforming defensive ones, the dollar is in a bear market (Chart I-1). In the US, a wider fiscal deficit tends to be partly financed by new money creation. More importantly, the Fed tends to be the lender of last resort to the global economy, not least because the US dollar remains a reserve currency. In times of crises, the authorities pursue macroeconomic policies that tend to weaken the dollar, such as lowering rates and/or running a wider fiscal deficit. In the US, a wider fiscal deficit tends to be partly financed by new money creation. Part of the feedback loop in this mechanism is that it leads to a flow of greenbacks outside US borders. This eases offshore rates while greasing the international money supply chain (Chart I-2). Chart I-1The Dollar Tends To Weaken When Cyclicals Are Outperforming Chart I-2An Increasing Supply##br## Of Dollars Where can this view go wrong? If the Fed’s mandate is vis-à-vis the domestic US economy rather than maintaining international financial stability, then the biggest risk to a bearish dollar view is one in which global growth rebounds (or decelerates), but the US economy holds up well, allowing the Fed to pursue a relatively tighter monetary stance. This week, we got the US Markit and ISM PMIs, and the gaping wedge between the two is the highest since the 2015 manufacturing recession. Given sampling differences, where the Markit PMI surveys more domestically oriented firms, it is fair to assume it is also a barometer of US domestic growth relative to global output. Put another way, whenever the US services PMI is outperforming its manufacturing component, the dollar tends to appreciate (Chart I-3). If global growth rebounds but the US is leading the rebound (the Fed has been one of the most dovish central banks after all), the dollar can continue to rally. Our view is that this remains a tail risk. The slowdown in the global economy has been driven by the manufacturing sector, so it is fair to assume that this is the part of the economy that is ripe for mean reversion. Not to mention, cyclical swings in most economies tend to be driven by manufacturing and exports rather than services. Meanwhile, on the services front, the US economy appears to be rolling over relative to global. Even relative to China, the US appears to remain victim to the repercussions of the trade war (Chart I-4). This divergence is likely to keep the Fed on the sidelines, at least relative to other central banks. Meanwhile, on the political spectrum, our geopolitical strategists observe that historically, it has been extremely rare for the Fed to raise interest rates a few months ahead of an election cycle. Chart I-3The Risk To A Bearish Dollar View Chart I-4Conflicting Messages A source of support for this view arises from the German bund versus US Treasury spread. In short, it is a battle of manufacturing versus services. Ever since the European debt crisis, the velocity of money in the euro area has collapsed relative to that of the US. In the financial world, relative long bond yields have followed suit in tight correlation (Chart I-5). If this reverses, it will be a key sign that the neutral rate of interest in the Eurozone is rising relative to that of the US, albeit from a low starting point. The message from bond markets is that such a shift is already taking place. Chart I-5R-Star For The Euro Area Could Move Higher There have been two powerful disinflationary forces for the velocity of money in the US. The first is the lagged effect from the Fed’s tightening policies in 2018. This is especially important given that the fed funds rate was eerily close to the neutral rate of interest, providing little incentive for firms to borrow and invest. Inflation is a lagging indicator, and it will take a sustained rise in economic vigor to lift US inflation expectations. This will not be a story for 2020 (Chart I-6A). Second, the recent rise in the dollar and fall in commodity prices is likely to continue to anchor US inflation expectations downward (Chart I-6B). This should keep the Fed on the sidelines. Chart I-6AVelocity Of Money Versus Inflation Chart I-6BVelocity Of Money Versus Inflation Bottom Line: The key risk to a bearish dollar view is a US-led global growth rebound, allowing the Fed to adopt a much more hawkish stance relative to other central banks. This would be an environment in which US inflation would also surprise to the upside. So far, the move in bond markets suggests this remains a tail risk (Chart I-7). Chart I-7Stalemate Equity (And Bond) Capital Flows The nascent upturn in a few growth indicators is also coinciding with a positive signal from financial variables. Global cyclical stocks have started to outperform defensives, and the traditional negative correlation with the dollar appears to be holding (previously referenced Chart I-1). Correspondingly, flows into more cyclical ETF markets are accelerating. These are usually a small portion of overall FX flows, but the information coefficient is directionally quite good. The key risk to a bearish dollar view is a US-led global growth rebound, allowing the Fed to adopt a much more hawkish stance relative to other central banks. The S&P 500 has been the best performing market for a few years now, so a crucial part of the dollar call lies in international equity markets outperforming the US. Markets such as the Swedish OMX, the Swiss Market Index and the TSX, among others, have broken out – indices with large international exposure and which are very much tied to the global cycle. Such market breakouts also tend to correspond with a weaker dollar, especially when the return on capital appears marginally higher outside the US. In a nutshell, the performance of more cyclical currencies will require confirmation of a breakout in their relative equity market performance. This applies to both the South African rand and other emerging and developed market currencies (Chart I-8A and Chart I-8B). The catalyst will have to be rising relative returns on the capital outside the US, but the starting point is also extremely attractive valuations. Chart I-8ACapital Flows And Exchange Rates Chart I-8BCapital Flows And Exchange Rates Over a shorter horizon, sentiment might drive stock market performance, but valuations matter a lot for the longer term. Chart I-9A shows the composite valuation indicator for the US relative to other developed markets. The message is quite clear: Any investor deploying fresh capital into the US today is doing so with the prospect of much lower longer-term returns, at least compared to the euro area and Japan. With inflows into US assets having rolled over, this will likely remain a source of concern for longer-term investors. This is compounded by the fact that expectations for the US technology sector going forward are likely to be hampered by regulatory concerns and lofty valuations. For South African investors, structural reforms will be needed for much more juicy long-term equity returns, beyond a terms-of-trade benefit (Chart I-9B). Chart I-9AReturns To US Equities Look Dire Chart I-9BReturns To US Equities Look Dire On the fixed-income front, international investors may still find US bond markets attractive in an absolute sense due to higher interest rate spreads. However, the currency risk is just too big a potential blindside to bear. Markets with the potential for currency appreciation such as Australia, Canada, Norway or even Sweden might be better bets. Flow data also highlight just how precarious it is to be long US dollars. As of September, overall flows into the US Treasury market have been negative, which may have contributed to the bottom in bond yields. Net foreign purchases by private investors are still positive, but the momentum in these flows is clearly rolling over. This is more than offset by official net outflows that are running at $350 billion (Chart I-10). As interest rate differentials have started moving against the US, so has foreign investor appetite for Treasury bonds. Chart I-10A Growing Dearth Of Treasury Buyers Bottom Line: Flows into US assets are rapidly dwindling. This may be partly because as the S&P 500 makes new highs amid lofty valuations, long-term investors are slowly realizing that future expected returns will pale in historical comparison. Given that being long Treasurys and the dollar remains a consensus trade, international investors run the risk of being potentially blindsided by a sharp drop in the dollar. Rebuy NOK/SEK We were stopped out of our long NOK/SEK position last week. We are reinstating this trade as relative fundamentals, especially from an interest rate perspective, still favor the cross. We are reinstating long NOK/SEK as relative fundamentals, especially from an interest rate perspective, still favor the cross. We remain oil bulls on the back of a pickup in global demand and OPEC production discipline. This should lead to the outperformance of energy stocks, benefiting inflows into Norway (Chart I-11). Chart I-11No Near-Term Replacement For Oil Chart I-12Interest Rates Favor NOK/SEK Interest rate differentials continue to favor NOK over SEK. The Riksbank will probably – at the margin – be more hawkish than the Norges Bank in an attempt to exit negative interest rates, but the carry will remain wide (Chart I-12). Meanwhile, Norway mainland GDP growth continues to outpace that of Sweden (Chart I-13). Finally, the cross has approached an important technical level, with our intermediate-term indicator signaling oversold conditions. Should the NOK/SEK pattern of higher lows and higher highs in place since the 2015 bottom persist, we should be on the cusp of a powerful rally (Chart I-14). Chart I-13Growth Favors NOK/SEK Chart I-14Rebuy NOK/SEK Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The ISM and Markit data are sending conflicting signals: the Markit manufacturing PMI edged up to 52.6, while the ISM number dipped towards 48.1 in November. On the services front, the Markit PMI was unchanged at 51.6, while the ISM PMI fell to 53.9. ADP employment recorded an increase of 67K jobs in November, well below expectations. The jobs report on Friday will be especially important. The trade deficit narrowed by $4 billion to $47.2 billion in October. The DXY index fell by 0.9% this week. Incoming data have been consistent with our base case view that global growth has bottomed and will rebound in 2020. Along with a manufacturing sector recovery, pro-cyclical, or higher-beta currencies are poised to outperform the US dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 201 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area signal a tentative recovery: Preliminary headline and core inflation both rebounded to 1% and 1.3% year-on-year, respectively in November. The Markit manufacturing PMI increased to 46.9 in November. The Services PMI also edged up to 51.9. Retail sales grew by 1.4% year-on-year in October, lower than the 2.7% yearly growth from the previous month. GDP growth was unchanged at 1.2% year-on-year in Q3. EUR/USD appreciated by 0.6% this week. The recent rebound in both inflation and PMI has brightened the outlook for the euro area and boosted investor confidence. Our Global Investment Strategy upgraded euro area equities to overweight recently. We continue to remain positive on the euro against the US dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: Construction orders soared by 6.4% year-on-year in October. Manufacturing PMI increased to 48.9 from 48.6 in November. Consistently, the services PMI also increased to 50.3. Vehicle sales fell by 14.6% year-on-year in November. This series is extremely volatile, especially given the front-loading of purchases ahead of the consumption tax hike. USD/JPY fell by 0.8% this week. Sluggish growth in Asia, together with the consumption tax hike have weighed on the Japanese economy through 2019. However, the Japanese yen remained resilient due to its safe-haven nature. The Abe government has revealed a sizeable fiscal stimulus, but the potential impact on the economy is still being digested. At the margin, fiscal stimulus reduces the scope for the BoJ to adopt more experimental monetary policies, which is bullish the yen. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been upbeat: On the PMI front, both Markit manufacturing and services PMIs increased to 48.9 and 49.3, respectively in November. The construction PMI also rebounded to 45.3 from 44.2. Consumer credit increased by £1.3 billion in October. The British pound has appreciated by nearly 2% against the US dollar this week, making it the best performing G10 currency over the past few weeks. Our Geopolitical strategists believe that the UK election will not reintroduce a no-deal Brexit risk, either in the short-term or long-term. This is positive for the UK economy overall, and bullish for the British pound especially given it is still trading well below its long-term real effective exchange rate. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been robust: GDP growth soared to 1.7% from 1.4% year-on-year in Q3. On the PMI front, both AiG manufacturing and services PMIs fell to 48.1 and 53.7, respectively in November. The Commonwealth manufacturing PMI was little changed at 49.9, while the services PMI increased to 49.7. The current account balance increased to 7.9 billion from 4.7 billion in Q3. AUD/USD increased by 0.8% this week. On Monday, the RBA kept interest rates unchanged at 0.75%. Governor Lowe implied that after 3 rate cuts this year, the current low cash rate is already boosting Australian asset prices and household spending. Combined with government spending and a growing population, this should help underpin the Australian economy and the Aussie dollar in the long run. We remain overweight the Aussie dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data from New Zealand this week: Terms-of-trade increased by 1.9% quarter-on-quarter in Q3. NZD/USD increased by 1.7% this week. As a small open economy, New Zealand should benefit once global growth stabilizes. Moreover, rising terms-of-trade, mainly in dairy and meat prices, are lifting New Zealand exports and the trade balance this year. We remain positive on the kiwi against the US dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 201 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mixed: Annualized GDP increased by 1.3% quarter-on-quarter in Q3, well below the 3.5% quarterly growth in the second quarter. The Markit manufacturing PMI slightly increased to 51.4 in November. The Ivey PMI also soared to 60 from 48.2 on a seasonally-adjusted basis in November. Imports slightly increased to C$51 billion in October. Exports also increased to C$49.9 billion. The trade deficit, as a result, narrowed to C$1.1 billion. USD/CAD fell by 1% this week. On Wednesday, the BoC held interest rates unchanged at 1.75%. A catalyst was probably early signs of a global growth recovery. The BoC is one of the few central banks that haven't eased monetary policy this year amid the trade war and a manufacturing sector slowdown. Going forward, we are positive on energy prices, and believe that the loonie is primed for a breakout. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been soft: The KOF leading indicator fell to 93 from 94.8 in November. Real retail sales increased by 0.7% year-on-year in October, from 1.6% the previous month. Headline inflation increased from -0.3% to -0.1% year-on-year in November. The Swiss franc increased by 1.2% against the US dollar this week, amid broad dollar weakness. Inflation has been negative for a second consecutive month in November, and a strong franc does not offer any help. While we remain positive on the Swiss franc, the biggest risk to an appreciating franc is intervention from the central bank. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Retail sales fell by 0.8% month-on-month in October. The current account surplus narrowed by NOK 2.6 billion to NOK 23.9 billion in Q3. The Norwegian krone increased by 0.8% this week against the US dollar, supported by rising oil prices and a brightened outlook for global growth. The EIA reported a decrease of crude oil stocks by 4.9 million barrels for the week ended November 29th. Combined with a revival in oil demand, this is bullish for the oil prices and the Norwegian krone. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mostly positive: GDP increased by 1.6% year-on-year in Q3, an improvement from 1% the previous quarter. The manufacturing PMI fell to 45.4 from 46 in November. This was in contrast to other euro area countries. The current account surplus improved to SEK 69 billion from SEK 37 billion in Q3. USD/SEK decreased by 1% this week. Typically, a weak krona helps the manufacturing sector by a lag of about 12 months. Moreover, the weak krona is also improving balance of payments dynamics in Sweden. Going forward, we remain bullish on the Swedish krona, and are playing krona strength via the New Zealand dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights A 400k b/d addition to OPEC 2.0’s official production cut of 1.2mm b/d will have little effect on actual supplies. The market already has seen ~ 2.0mm to 2.5mm b/d of output removed from the market via excess voluntary cuts (e.g., from Saudi Arabia and others) and involuntary cuts (e.g., from Iran and Venezuela). The incremental 400k b/d would just be another target for free-rider states to ignore. However, if Iraq and other states with on-and-off compliance at the margin can be persuaded to follow through on producing at lower quotas following OPEC 2.0’s meetings today and tomorrow, markets could rally as actual output falls (Chart of the Week). A rally on the back of lower OPEC 2.0 production would support the IPO of Saudi Aramco, which is expected to price while the producer coalition is meeting in Vienna. Production from the “Other Guys” – our moniker for all producers excluding Gulf OPEC, US shale and Russia – will account for a lesser and lesser share of global output. New production – much of it from the last of the big conventional projects sanctioned prior to the 2014 price collapse – from Norway, Brazil, Guyana and the US Gulf of Mexico will come on strong in 2020 – but most of this has been priced in already. The rate of growth of US shale-oil production will slow. Feature Brent crude oil prices could get a boost from OPEC 2.0, if free-rider states – specifically Iraq and states with marginal quota compliance shown in the Chart of the Week – actually were to abide by production cuts they agree to. This would be amplified if cuts are extended to end-June, from end-March. The impact would be marginal, to be sure, given most of the production cuts that matter to the market already are in place – i.e., Saudi Arabia’s overcompliance of ~ 400k b/d, and Iran and Venezuela’s involuntary production cuts of ~ 1.8mm b/d resulting from US sanctions, as of October 2019. Ahead of the Vienna meetings today and tomorrow, the putative leaders of the producer coalition – the Kingdom of Saudi Arabia (KSA) and Russia – have been lobbying at cross purposes. KSA is seeking support for deeper cuts and an extension to mid-year of the deal. Russia is lobbying to keep the original deal’s expiry at end-March, and also is seeking to have its ultra-light crude (i.e., condensates) production excluded from its quota, as it is from OPEC members’ production calculations. Russia is creating additional volumes of condensate – ~ 800k b/d this year of its total 11.2mm b/d output – to dispose of as it ramps natural gas production to new feed markets, particularly China.1 Our expectation is the production-cutting deal will be extended to end-June with an official target of 1.6mm b/d removed from the market. Whether the new deal matters to the market will depend on the actions of heretofore free-rider OPEC 2.0 states. Prices could go up, but market share for the producer coalition will remain under pressure (Chart 2). Chart of the WeekAdditional OPEC 2.0 Cuts Could Be Bullish For Crude Oil Chart 2OPEC 2.0 Market Share Under Pressure Saudi Aramco IPO Due To Price Follow-through by all OPEC 2.0 members on additional production cuts would benefit Saudi Arabia, as it is expected to price the Saudi Aramco IPO while the producer coalition is meeting in Vienna. The Aramco IPO price is expected to value the company between $1.5 and $1.8 trillion. We recently looked at the IPO and believe Aramco will be valued closer to $2 trillion than to $1 trillion, the literal range in which the offering was being valued by banks and analysts.2 To briefly recap, in the first six months of this year, Aramco produced 10.0mm b/d of crude oil and condensates. Aramco accounted for 12.5% of global crude output in 2016 - 18 and reported in its red herring that its proved liquids reserves were ~ five times larger than the combined proved liquids reserves of the five major independent oil companies. Aramco’s 3.1mm b/d of refining capacity makes it the fourth largest integrated refiner in the world. In 2018, Aramco’s free cash flow amounted to almost $86 billion. Net income last year was $111 billion, more than the combined profits of the next six largest oil companies in the world. For its first year as a public company, Aramco has indicated it will pay an annual dividend of $75 billion. Improving compliance with the OPEC 2.0 production-cutting deal is of obvious importance for the Aramco IPO. The member states are quick to stress they support the deal and will do their part, but free riding has been a problem in terms of compliance. As we noted above, full compliance will lower OPEC 2.0 crude oil production from current levels, but Saudi Arabia’s voluntary over-compliance, coupled with the involuntary production losses from Iran and Venezuela already are doing most of the work in restraining production. The “Other Guys” Continue Treading Water Since 2010, most of the growth in world oil production came from three regions: US onshore shale-oil producers, Gulf OPEC and Russia. These regions added 14mm b/d of supply between 2010 and 2019. The “Other Guys” often are overlooked in the oil market, but they still accounted for 45% of global oil production this year on average. Production from the “Other Guys” – our moniker for all producers excluding Gulf OPEC, US shale and Russia – has been falling as a share of global production for years, due to a lack of domestic and foreign direct investment in their energy sectors. We expect their production will remain flat next year and could start falling in 2021. The “Other Guys” often are overlooked in the oil market, but they still accounted for 45% of global oil production this year on average: Their combined output was ~ 45mm b/d of crude and liquids (Chart 3). The “Other Guys’” production is mostly long-cycle projects and these countries do not possess spare capacity. Thus, they are reacting to oil prices and maximizing production now, if they can. Even so, their share of global production continues to fall (Chart 4). Chart 3The "Other Guys" Production Is Stagnant Chart 4The "Other Guys" Market Share Plummets The 3- to 5-year lag between final investment decisions and first production for projects in these states strongly suggests the global oil market is entering a period of lower supply additions from the “Other Guys,” given the last mega-projects were probably sanctioned in 2014 while prices still were above $100/bbl for both Brent and WTI. The "Other Guys’" rig count recovered, along with oil prices, since the 2016 downturn. However, this is still a low level of rigs vs. the 2010-2014 period – a period during which production from this group barely grew despite prices averaging more than $100/bbl. We expect their rig count to remain weak next year (Chart 5). Conventional production takes time to ramp up, therefore we should not expect a large increase in production over the next few years. Chart 5The "Other Guys" Rig Counts Will Remain Under Pressure Oil Supply Looks Tighter Toward 2021 Globally, the last of the big projects sanctioned prior to the oil-price collapse beginning in 2H14 and lasting to 1H16 are coming online in Norway, Brazil, Guyana and the US Gulf. Up to this year, US onshore production was the sole growing region globally. If capital discipline caps growth prospects in key US shale basins, global oil supply will grow only modestly in 2020 and 2021. For the most part, the “Other Guys” haven't been attracting the capital needed to sustain and grow their production. Given the ongoing drive by E&P companies globally to return capital to shareholders via buybacks or dividends, and the insistence of capital markets to fund only solid, profitable projects, capital likely will remain constrained for the “Other Guys.” States that were able to attract capital prior to the 2014 oil price collapse – Canada, Brazil, Norway, Guyana and the US – are expected to increase production next year; however, we believe much of this production increase already has been priced in by the market, as it has been by BCA (Chart 6). In our balances, we have oil production for Canada up 50k b/d next year vs 2019; Brazil +330k b/d and Norway +360k b/d. This is 740k b/d ex-Guyana in 2020. Guyana is still doing exploratory drilling and recently announced they expect to have their first commercial flows online this month. Oil markets are expecting initial commercial flows of ~ 120k b/d between December and 1Q20, and a ramp to 750k b/d by 2025, which would be significant. We will be updating our balances in two weeks, in our final publication of the year. Up to this year, US onshore production was the sole growing region globally. If capital discipline caps growth prospects in key US shale basins, global oil supply will grow only modestly in 2020 and 2021 (Chart 7). US shale output reaches ~ 9.35mm b/d on average next year in the Big Five basins (Permian, Eagle Ford, Bakken, Niobrara and Anadarko), in our modeling. This amounts to an 800k b/d increase in our US lower 48 production estimate for the US, vs. a 900k b/d increase we expected earlier.3 Chart 6"The New Guys" Production vs. The "Other Guys" Production Chart 7US Shale Oil Production Growth Will Slow Going forward, it is important to re-emphasize that even the prolific shales in the US are being constrained by investors demanding the shale guys either return capital to shareholders via share buybacks or steady dividends and dividend increases. If they don’t accommodate investor interests, these shale producers – and all oil producers for that matter – will simply be denied access to funding markets. Capital is, finally, the binding constraint on the growth of global oil supplies. This has not always been the case, as we’ve noted. 2020 Could See Stronger Prices Markets generally are responding as expected to more accommodative financial conditions globally, which will allow oil demand growth, particularly in the EM economies, to revive in 2020. As a result, we are maintaining our expectation for growth of 1.4mm b/d next year, which is up 300k b/d from our expectation for growth this year. The rebound in demand we expect next year will force prices higher to incentivize additional supply and the release of inventories – mostly in 2H20. This will push the entire futures curve up, especially nearby futures, which will steepen the backwardation in Brent and WTI futures. Bottom Line: Further actual production cuts by OPEC 2.0, emerging threats to US shale growth, and stagnant output from the “Other Guys” facing off against higher demand growth next year could result in higher prices than we currently expect for 2020 – i.e., $67/bbl for Brent and $63/bbl for WTI. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Market Round-Up Energy: Overweight Brent prices remain stuck between $60/bbl and $65/bbl awaiting clear signals about the US-China trade negotiations and OPEC 2.0’s decisions on its supply management beyond March 2020. Money managers are increasing their net long position, expecting bullish news on both these developments. They are increasing their Brent exposure to 414k long contracts vs. 64k short. Base Metals: Neutral SHFE copper inventories fell 11% on a week on week basis to 120k MT as of last Friday. Combined, the LME, COMEX and SHFE fell by 6%. The larger decline in Chinese inventory is partly attributed to the reduced import quotas on copper scraps, which limited the total available supply to meet domestic demand. As discussed in last week’s report, fundamentals in the two largest components of the LMEX – i.e. copper and aluminum – are tight and the rebound in demand showing up in our proprietary indicators will support prices. We remain long the LMEX tactically. Last week, we recommended getting long the LMEX index. We have subsequently learned the LME ceases trading the index. We will, nonetheless, continue to track the reported level of the index, as if it were tradeable. Precious Metals: Neutral Closing at $1479/bbl on Tuesday, gold prices broke out of the narrow range in which the metal has traded over the past month. Gold’s daily-return 1-year rolling correlation with the U.S. dollar is at its weakest level since 2011 and is below the 5th percentile of its distribution since 2004. On the other hand, the correlation with U.S. 10-year TIPS yields is strengthening and is now above the 95th percentile of its distribution. As safe-haven demand dissipates – alongside the rebound in global growth we expect – we believe these correlations will move back to their historical relationships, supporting gold as the U.S. dollar depreciates. Ags/Softs: Underweight CBOT Corn March Futures Contracts rallied at the beginning of the week on the back of a blizzard in the Midwest that stalled the already delayed corn harvest, which the USDA reported to be 89% complete as of Dec. 1, well behind the five-year average of 98%. After reaching multi-months highs last week, wheat futures fell due to profit taking and weaker than expected export figures. Soybean fell for the eighth straight day on Monday, with the most active contract closing at $8.73/Bu, the lowest in six months. A possible delay in the US-China trade deal together with expectations of a bumper crop in Brazil remain headwinds to prices. Footnotes 1 Please see Russia to press OPEC+ to change its oil output calculations published by reuters.com November 27, 2019. 2 Please see our Special Report Aramco’s IPO: The Tie That Binds KSA And China, published November 15, 2019. It is available at ces.bcaresearch.com. 3 We discuss further risks to shale oil production growth in Lingering Oil-Demand Weakness Will Fade, including the high levels of flaring in the Permian and Bakken basins. This report is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
Highlights Chart 1Manufacturing PMIs Track Bond Yields November’s manufacturing PMI data were released yesterday, giving us an update for two of our preferred global growth indicators: the Global Manufacturing PMI and the US ISM Manufacturing PMI (Chart 1). Unfortunately, the two indicators sent conflicting signals, providing us with very little clarity on the global growth outlook. On the positive side, the Global Manufacturing PMI jumped back above 50 for the first time since April. China is the largest weighting in the global index, and its PMI rose for the fifth consecutive month. Conversely, the US ISM Manufacturing PMI dipped further into contractionary territory in November – from 48.3 to 48.1. Optimistically, the index’s inventory component contracted by more than the new orders component, meaning that the difference between new orders and inventories rose to its highest level since May. The difference between new orders and inventories often leads the overall ISM index by several months. All in all, we continue to see tentative signs of stabilization in our preferred global growth indicators. But a more significant rebound will be necessary to push bond yields higher in the first half of next year, as we expect. Stay tuned. Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 63 basis points in November, bringing year-to-date excess returns up to +494 bps. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions and (iii) valuation.1 On balance sheets, our top-down measure of gross leverage is high and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. The third quarter’s tightening of C&I lending standards is a concern, because it suggests that monetary conditions may not be sufficiently stimulative for banks to keep the credit taps running (bottom panel). But the yield curve, another indicator of monetary conditions, has steepened significantly since Q3, suggesting that lending standards will soon move back into “net easing” territory. For now, we see valuation as the main headwind for investment grade credit spreads. Spreads for all credit tiers are below our targets, with the Baa tier looking less expensive than the others (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds, with a preference for the Baa credit tier. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher (see page 7). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 47 basis points in November, bringing year-to-date excess returns up to +671 bps. The index option-adjusted spread tightened 22 bps on the month and currently sits at 370 bps, 131 bps above our target (Chart 3). Ba and B rated junk bonds outperformed the Treasury benchmark by 79 bps and 76 bps, respectively, in November. But Caa-rated credit underperformed Treasuries by 89 bps. This continues the trend of Caa underperformance that has been in place since late last year (panel 3). We analyzed the divergence between Caa and the rest of the junk bond universe in last week’s report and came to two conclusions.3 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for this year’s Caa underperformance that make us inclined to downplay any potential negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of this year’s underperformance (bottom panel). With elevated spreads, accommodative monetary conditions and a looming recovery in global economic growth, we expect junk spreads to tighten during the next 6-12 months. MBS: Overweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in November, bringing year-to-date excess returns up to +22 bps. The conventional 30-year zero-volatility spread tightened 3 bps on the month, as a 5 bps tightening of the option-adjusted spread (OAS) was offset by a 2 bps increase in expected prepayment losses (aka option cost). We recommend an overweight allocation to Agency MBS, particularly relative to corporate bonds rated A or higher, for three reasons.4 First, expected compensation is competitive. The conventional 30-year MBS OAS is now 50 bps (Chart 4). This is very close to its pre-crisis average and only 3 bps below the spread offered by Aa-rated corporate bonds (panel 4). Also, spreads for all investment grade corporate bond credit tiers trade below our targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most homeowners have already had at least one opportunity to refinance their mortgages. This burnout will keep refi activity low, and MBS spreads tight (panel 2). Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 14 basis points in November, bringing year-to-date excess returns up to +197 bps. Sovereign debt outperformed duration-equivalent Treasuries by 36 bps on the month, bringing year-to-date excess returns up to +513 bps. Local Authorities outperformed the Treasury benchmark by 24 bps, bringing year-to-date excess returns up to +245 bps. Meanwhile, Foreign Agencies outperformed by 4 bps, bringing year-to-date excess returns up to +266 bps. Domestic Agencies outperformed by 11 bps in November, bringing year-to-date excess returns up to +51 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +36 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Foreign Agencies and Local Authorities, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 70 basis points in November, bringing year-to-date excess returns up to +6bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell 4% in November, and currently sits at 83% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Specifically, 2-year and 5-year M/T yield ratios are somewhat below average pre-crisis levels at 68% and 72%, respectively. However, M/T yield ratios for longer maturities (10 years and higher) are all above average pre-crisis levels. M/T yield ratios for 10-year, 20-year and 30-year maturities are 84%, 93% and 97%, respectively. Fundamentally, state & local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve shifted higher in November, steepening out to the 7-year maturity and flattening beyond that. The 2/10 Treasury slope was unchanged on the month. It currently sits at 17 bps. The 5/30 slope flattened 7 bps to end the month at 59 bps (Chart 7). In a recent report we discussed the 6-12 month outlook for the 2/10 Treasury slope.8 We considered the main macro factors that influence the slope of the yield curve: Fed policy, wage growth, inflation expectations and the neutral fed funds rate. We concluded that the 2/10 slope has room to steepen during the next few months, as the Fed holds down the front-end of the curve in an effort to re-anchor inflation expectations. However, we see the 2/10 slope remaining in a range between 0 bps and 50 bps, owing to strong wage growth and downbeat neutral rate expectations. Despite the outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers strong positive carry (bottom panel), due to the extreme overvaluation of the 5-year note, and looks attractive on our yield curve models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 47 basis points in November, bringing year-to-date excess returns up to -70 bps.The 10-year TIPS breakeven inflation rate rose 8 bps on the month and currently sits at 1.62%. The 5-year/5-year forward TIPS breakeven inflation rate rose 9 bps on the month and currently sits at 1.73%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.9 That being said, the 10-year TIPS breakeven inflation rate is currently 29 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +74 bps. Chart 9ABS Market Overview The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month. It currently sits at 34 bps; its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS rank among the most defensive US spread products and also offer more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate is still low, but has put in a clear bottom. The is true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating ABS credit metrics are also a cause for concern. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in November, dragging year-to-date excess returns down to +221 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month. It currently sits at 72 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer Survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). CRE prices are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +107 bps. The index option-adjusted spread tightened 2 bps on the month, and currently sits at 54 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 26 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of November 29 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 29, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 45 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 45 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of November 29, 2019) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 For details on how we arrive at our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 9 Please see US 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 Corporate Sector Relative Valuation And Recommended Allocation
Highlights BCA still sees green shoots: Our latest view meeting reinforced BCA strategists’ optimistic global outlook, and we are methodically adding international and cyclical exposures to reflect it. Relatively modest M&A activity is not a sign of a top, … : Last Monday was the busiest Merger Monday of the year, but relative merger volumes are not anywhere near the peaks that coincided with the end of the last two expansions. … and neither is small-cap equity underperformance: There is no empirical basis for concluding that small-cap underperformance heralds economic weakness, stock market weakness or heightened risk aversion. Feature Onward. At our latest editorial view meeting, held last week, we completed the step we first began discussing in the spring, upgrading Eurozone equities to overweight in global equity portfolios. BCA continues to recommend investors remain underweight sovereign bonds in balanced and dedicated fixed income portfolios, and we expect that a top in the dollar versus the more cyclical major currencies is coming soon. We downgraded US equities to underweight to make room for the Eurozone overweight, along with new overweights in British and Japanese equities. The move reflects the BCA consensus that global growth has bottomed and is poised to accelerate. Against an improved growth backdrop, the dollar should cede leadership to more cyclically sensitive currencies, providing non-US equities with a relative tailwind.1 The narrowing of the growth differential between the US and the rest of the world should give international equities an additional boost. A revived growth outlook, and a cooling of trade tensions signaled by a signed Phase 1 China-US agreement, would ease some of the safe-haven demand for sovereign bonds, and help interest rates unwind some of the downward pull that dragged them lower across the first eight months of the year. The US equity downgrade is only a relative call, however; US Investment Strategy remains constructive on the absolute return outlook for US stocks. Other economies with a greater reliance on trade will benefit more from a global upswing than the US, which suffered less from the global slowdown than its peers. The S&P 500 has much more exposure to the rest of the world than the US economy, though, and its earnings would get a boost from accelerating global growth and a weaker dollar. At the same time that the fundamental picture is poised to improve, the wall of worry continues to renew itself, and this week we discuss concerns about M&A activity and small-cap stocks’ underperformance, which have come to the fore as Sino-American tensions have relaxed their grip on the collective investor psyche. Mergers And Animal Spirits Mergers and acquisitions (M&A) generated some attention-getting headlines last month. Just last Monday, nearly $60 billion of deals were struck: Charles Schwab purchased TD Ameritrade for $26 billion, LVMH bought jewelry icon Tiffany for $18 billion, Novartis paid nearly $10 billion for drugmaker Medicines Company, and Ebay sold StubHub for $4 billion. Earlier last month, Xerox launched a hostile bid for HP ($32 billion), and KKR reportedly discussed an acquisition of Walgreens that could top $70 billion. A Walgreens transaction is a long shot, as it would potentially be the largest leveraged buyout of all time, but it has set tongues wagging in investment banking and private equity circles and fingers wagging among observers with an inclination to be scolds. M&A overtures cannot be viewed as a pure proxy for animal spirits, but M&A activity has aligned closely with the business cycle over the past two full cycles. The value of completed transactions as a share of equity values and GDP has troughed soon after the recession ends and peaked just before the recession begins, both here and abroad (Chart 1). In early 2016, proportional M&A volumes approached the levels that marked a top in 2000 and 2007, but the signal turned out to be a head fake, at least in terms of the US business cycle. Today’s volumes do not appear to be a concern, especially when compared to equity market value, which has consistently outpaced M&A activity since the 2016 peaks. Chart 1Peaks In M&A Activity Coincide With Business Cycle Peaks, ... It makes intuitive sense that peaks and troughs, or surges and slowdowns, in M&A might provide some insight into corporate confidence. Insight into confidence might in turn offer a preview of capex and hiring activity. Chart 2... But M&A Isn't Predictive Otherwise The empirical record does not support the intuition, however, as non-residential fixed investment growth has not shown much of a relationship with M&A volume as a share of GDP (Chart 2, top panel). Since the crisis, M&A volume has oscillated around the steady climb in hiring intentions (Chart 2, middle panel) and job openings (Chart 2, bottom panel) without exhibiting a clear relationship. What Is Small-Cap Performance Saying? The S&P 500 has made thirteen new all-time highs, or about one every other day, since the last week of October. The S&P SmallCap 600, on the other hand, just narrowly topped its year-to-date high, and remains more than 9% from its all-time high, set at the end of August 2018. Small-caps are more volatile than large-caps and many investors treat relative small-cap performance as a proxy for overall risk aversion. When small-caps are outperforming, investors are presumed to be more willing to embrace risk; when they’re underperforming, investors are supposedly more prone to shun it, with implications for all equities. Small-cap indices are simply too jumpy to predict large-cap equity moves. The empirical record does not support the view that relative small-cap underperformance leads broader market downturns. Because small-cap market cycles tend to be more compressed than large-cap market cycles, there are many more of them. There have been seven complete S&P 500 market cycles since 1970 (Table 1), versus fifteen complete market cycles for the equal-weighted all-cap Value Line Index2 (Table 2). Simple logic holds that all fifteen small-cap events can’t be portents of seven large-cap events, and the S&P 500 has been largely indifferent to small-cap outperformance and underperformance over time (Chart 3). Table 1The S&P 500 Is On Its Eighth Bull Market Since 1970 … Table 2… While The Value Line Index Is On Its Sixteenth Chart 3Independent Events We do not believe that small-cap relative performance is a reliable indicator of investor risk tolerance/aversion, or a proxy for animal spirits. We have found that relative performance is best explained by more prosaic elements like sector composition, valuation and earnings discrepancies, domestic/global performance shifts and cyclical/defensive performance shifts. These elements have sent mixed signals as group so far this year, but sector composition is likely to support small-caps going forward if our constructive economic view pans out. Relative small-cap performance doesn't tell us anything about the S&P 500's future direction. Compositional Factors: The S&P SmallCap 600 Index is not just a mini-me version of the S&P 500 because the benchmarks’ sector composition often varies considerably. The SmallCap 600 currently has much heavier weightings than the S&P 500 in Industrials, Financials, Consumer Discretionaries and Real Estate, and much lighter weightings in Technology, Communication Services and Consumer Staples stocks (Table 3). The small-cap index has a greater share of early cyclicals than the S&P 500, and an equivalently smaller share of defensives, but that hasn’t mattered this year, as small-caps have underperformed large-caps in every sector but Health Care (Table 4). Small-cap underperformance in Energy, Communication Services, Staples, and Financials has been especially stark. Table 3Not Quite Apples To Apples Table 4Year-To-Date Sector Performance Valuation/Earnings Discrepancies: Disparities in index valuation may bear on small- and large-cap performance without revealing anything about underlying business or economic trends, or without providing much insight into investors’ broader appetites for risk. Relative valuation does not appear to have been much of a factor for small- and mid-cap stocks’ relative performance this year, as standardized relative multiples have stayed close to the mean (Chart 4). Both of the SMID indexes have experienced relative de-rating this year, but their underperformance is better explained by lagging earnings growth. According to Refinitiv/I/B/E/S, MidCap 400 and SmallCap 600 earnings are expected to decline by 7% and 19%, respectively, versus the S&P 500’s modest 1% contraction. Chart 4Relative Valuations Are In Line Domestic/Global Discrepancies: Smaller companies are less likely to derive significant portions of earnings and revenues from overseas, and multinationals tend to be mega-caps. The formerly decent correlation between small-cap relative performance and domestic-versus-global industry group performance has unraveled since the 2016 presidential election (Chart 5, bottom panel). It’s possible that investors bid too eagerly for small-caps on expected policy changes after the election and in early 2018, following the cut in the top marginal corporate income tax rate that stood to disproportionately benefit small-caps with effective tax rates equivalent to the top marginal rate.3 It is much easier to buy a small-cap index ETF than it is to assemble portfolios of domestically- and globally-exposed industry groups, which may explain why small-caps decoupled from domestic-versus-global industry groups in two pronounced spikes. A continued small-cap slide would be consistent with BCA’s sanguine global view. Small-caps' relative performance has decoupled from global-facing stocks' relative performance. Could tariffs be hurting them more than expected? Chart 5Small Caps May Not Be Immune To Global Pressures After All Cyclical/Defensive Discrepancies: Differences in exposure to cyclical and defensive sectors offer another perspective on differences in sector composition. The SmallCap 600 Index has just 60% of the S&P 500’s exposure to defensive sectors. Absolute small-cap performance has moved with cyclical-to-defensive performance this year (Chart 6, top panel), but the relative breakdown in small-cap performance that began when defensives took the lead failed to reverse when cyclicals recently revived (Chart 6, bottom panel). We expect cyclicals to outperform defensives in line with our constructive view on global growth, which should translate to a boost for relative small-cap performance. Chart 6Cyclicals Investment Implications The conventional wisdom that small-cap underperformance signals a broader equity downturn does not hold up to examination. Small- and mid-cap earnings have contracted considerably more than S&P 500 earnings, and SMID stocks have de-rated versus large-caps since the fourth quarter of last year, but it is not clear why either of those trends will continue this year. We suspect that SMID underperformance largely reflects a downward revision in expectations that ran a little too high in the wake of the tax cut and the assumption that small-caps would emerge relatively unscathed from new tariff barriers. Large-caps are more globally-oriented, but it’s possible that overweights in Industrials and Discretionaries render small-caps more vulnerable to increased tariff-related input costs. M&A volumes as a share of market cap or GDP have served as a much more reliable proxy for overheated animal spirits. Peaks and troughs in M&A have aligned closely with peaks and troughs in the last two completed business cycles. M&A headlines have revved up in the last month, but the volume of completed deals is not yet at worrisome levels. Our main takeaway from last week’s internal view meeting is that 2019’s worldwide easing of monetary conditions will manifest itself in a pickup in global activity in the first half of 2020. Our bond strategists expect that the Fed’s primary concern is getting inflation expectations up to a level consistent with its inflation target, and that it will strive to maintain policy settings that are perceived as accommodative until it gets the inflation expectations response it seeks. Unless signs of financial instability compel it to tighten policy to contain bubble-like excesses, they expect the Fed to remain on hold for nearly all of 2020. We concur, and therefore expect the monetary backdrop to remain conducive for risk asset outperformance at least into 2021. Investors should maintain risk-friendly positioning against that backdrop. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 All of BCA’s global recommendations are made from a common-currency perspective. 2 A complete market cycle encompasses a completed bull market (at least 20% closing trough to closing peak gain) and a completed bear market (at least 20% closing peak to closing trough decline). We use the Value Line Index as a small-cap proxy here because it has a 50-year history, unlike the Russell 2000 or SmallCap 600. 3 Multinationals’ effective tax rates are often reduced by their ability to shift income among tax jurisdictions.
Highlights The seemingly interminable discussions around the “phase one” deal touted by US and Chinese trade negotiators notwithstanding, base metals prices are primed for a rally. The bottoming in base metals prices indicates industrial activity, particularly in EM economies, will turn higher, which will lift aggregate demand. The signaling from base metals markets is consistent with our proprietary industrial activity models, including our EM Commodity-Demand Nowcast, which continue to show industrial activity has bottomed and is turning up. Year-on-year growth in supply and demand of aluminum and copper – the largest components of the LMEX index – is diverging: Consumption is outpacing production, which is forcing inventories to draw hard. Any increase in demand will rally prices. Given our view, we are going long the LMEX index at tonight’s close. We recommend this as a tactical position at present and are including a 10% stop-loss; however, we could move this to a strategic position. Feature Despite the seemingly interminable back-and-forth between US and Chinese negotiators working on “phase one” of the Sino-US trade deal, base metals prices are signaling a revival of global economic growth, particularly in EM economies, in 2020. This is consistent with the growth indications being picked up in our proprietary models and reflected in global PMIs. The proximate cause of this revival in economic activity is the global monetary accommodation systemically important central banks have been pursuing for the better part of 2019, and the likely implementation of the long-awaited “phase one” Sino-US trade deal. Fiscal policy space remains available for systematically important economies – e.g., China, Germany and the US – and we expect such stimulus to be deployed next year. Fundamentally, global base metals inventories continue to draw hard, as the rates of growth in consumption and production diverge. Any recovery in organic growth – particularly in EM demand – would spark a rally. Base Metals In The Role Of Leading Economic Indicators We use metals prices to confirm the signals coming from the proprietary models we use to gauge economic growth prospects. Base metals prices often are used as indicators of global economic activity, particularly EM nominal and real GDP growth (Chart of the Week). Indeed, US Federal Reserve Board economists recently noted base metals prices are “often viewed by policymakers and practitioners as early indicators of swings in economic activity and global risk sentiment.”1 These metals prices are more sensitive to changes in global growth than other commodities (e.g., oil, which has its own idiosyncratic factors driving the evolution of prices). For this reason, we use these prices to confirm the signals coming from the proprietary models we use to gauge economic growth prospects. Our research indicates base metals prices are more closely linked to EM activity than DM activity, which makes them especially useful to our analysis of commodity markets generally, particularly oil. This is true also of our proprietary models by construction – EM demand drives commodity demand. Together, the base metals prices and our models contain complementary information that is useful in gauging growth prospects, particularly for EM economies (Chart 2).2 Chart of the WeekBase Metals Often Function As Gauges of GDP Growth Chart 2Base Metals Prices, BCA's GIA Model Both Are Sensitive to EM Growth Prospects We’ve found base metals prices to be timely indicators of turning points in EM GDP cycles, similar to the Fed’s findings (Table 1). In particular, the LMEX, IMF Base Metals index, and high-grade copper prices lead nominal and real EM GDP by anywhere from one to three months. However, for the entire sample correlation, which goes from 1995 to present, our Global Industrial Activity (GIA) index and Global Commodity Factor (GCF) have the highest correlation with nominal and real EM GDP. Table 1Correlation Between EM GDP And Indicators Of Global Activity Our proprietary indicators – GIA index, GCF, EM Import Volume Model (EMIV Model) – have been signaling a revival in commodity demand for several months (Chart 3). The model we’ve developed to track freight, similar to our EMIV Model, also is signaling a recovery in global trade (Chart 4).3 Chart 3BCA's Proprietary Models Also Closely Aligned with EM Growth Chart 4EM Import Volumes Closely Follow Freight Base Metals Stocks Drawing Hard Supply in the biggest components of the LMEX – copper and aluminum – is contracting, while demand is holding up or slightly growing. This is causing global stocks to draw hard, as incremental demand is met from inventory. Any stimulus coming out of China, which accounts for more than half of global base metals demand would propel prices in these markets higher. Global refined aluminum inventories have been drawing sharply as growth rates in production and consumption diverge (Chart 5). Global ali inventories now stand at 1.76mm MT, down 24% y/y. On average, global consumption has exceeded production by 7.2k MT this year. A similar set of fundamentals is forcing copper inventories to draw hard, as well, where consumption has exceeded production by 22.6k MT this year (Chart 6). Global copper inventories are down ~ 20% y/y, and continue to fall. Chart 5Ali Consumption Outpaces Production, Forcing Stocks To Draw Hard Chart 6Copper Stocks Draw Hard On Similar Fundamental Pressure The only thing preventing a sustained rally in these markets is organic demand growth, which the global accommodation by systematically important central banks is directed toward reviving. PBOC policymakers in China have drawn attention to their capacity for additional monetary stimulus, even though they have held off on goosing money and credit supply this year. A prolonged weakening of GDP growth in China likely would push policymakers to move to a more accommodative stance on monetary policy. Net, weak demand growth is offsetting upside price pressure as production contracts in key base metals markets. That said, EM demand ex-China for base metals likely will increase, if our economic activity gauges and prices are correct in the signals they are generating. Any stimulus coming out of China, which accounts for more than half of global base metals demand would propel prices in these markets higher. Expect Higher Base Metals Demand In 2020 Both our GIA index and base metals prices are good predictors of EM economic activity – overall EM and EM ex-China – which inclines us to expect growth to revive there as well. We are expecting base metals consumption to move higher next year, given the uptick we are seeing in base metals markets and from our economic activity gauges, particularly our EM Commodity-Demand Nowcast, which is a weighted combination of the individual models we use as a contemporaneous indicator (Chart 7).4 Chart 7Base Metals Demand Set To Recover in 2020 Chart 8Global Financial Easing Will Lift Base Metals Part of this will be led by improving Chinese demand, which accounts for more than 50% of base metals demand globally (Chart 8). We expect global financial conditions to remain supportive, and for total social financing in China to provide additional tailwinds to metal prices. This will keep aluminum demand in China stable-to-higher (Chart 9) along with copper demand (Chart 10). Both our GIA index and base metals prices are good predictors of EM economic activity – overall EM and EM ex-China – which inclines us to expect growth to revive there as well.5 Chart 9Chinese Aluminum Consumption... Chart 10...And Copper Demand Will Recover Given our view, we are going long the LMEX Index at tonight’s close. Bottom Line: Base metals prices and price indexes are telling a similar story to the gauges we’ve constructed to follow EM growth prospects, hence commodity demand prospects. Fundamentally, these markets continue to tighten, as supply growth remains significantly behind demand growth and stocks continue to draw hard. The y/y changes in the metals price indexes likely have bottomed and will be moving higher. Our GIA and GCF indicators concur. Taking the information contained in our proprietary indexes and base metals prices together drives our expectation for stronger base metals demand next year, which, given the state of supply growth and inventories, points to higher prices. Given our view, we are going long the LMEX Index at tonight’s close. We recommend this as a tactical position and will await confirmation of a robust recovery in demand before moving it to a strategic position. For that reason, we are including a 10% stop-loss; however, we could move this to a strategic position. Chart 11Global Economic Policy Uncertainty Also Works Against Base Metals Demand The same forces that are hindering a strong recovery in oil demand – chiefly the elevated level of global economic uncertainty, which keeps the USD well bid – also are at play in the base metals markets. USD strength keep the cost of base metals high in local-currency terms, which retards demand, and encourages increased supply at the margin, as the local-currency cost of production is suppressed (Chart 11). It will be difficult to go all-in on a commodity price rally until this uncertainty is resolved, or at least reduced. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Market Round-Up Energy: Overweight. Brent prices closed at one-month high on Tuesday, surpassing $64/bbl. We expect this trend to continue as demand – mainly from EM – picks up in the coming months, as signaled by our proprietary indicators. Next week will be critical for the 2020 oil market balance. OPEC’s Joint Technical Committee will meet on December 3, OPEC on December 5, and OPEC and non-OPEC countries – i.e. OPEC 2.0 – on December 6. The current market consensus seems to be that OPEC 2.0 will agree to maintain the current production curtailments for three additional months, which would take their deal to keep 1.2mm b/d off the market to the end of June. Non-complying countries – mainly Iraq – can be expected to encounter pressure to further reduce production in line with their quotas. In our global oil market balances, we assume OPEC 2.0 will extend the current quota until year-end 2020. Nonetheless, this could be announced gradually throughout the year. Base Metals: Neutral. Base metals moved higher on Tuesday following positive developments in the US-China trade talks. Top negotiators from both countries spoke by phone earlier this week and Trump signal its administration was in the “final throes of a very important deal.”6 We expect a ceasefire to be signed this year, which will revive sentiment at the margin. Moreover, copper and aluminum prices will be supported by rising EM GDP next year (see this week’s front section for details). Copper prices are up 2% since last Thursday. Precious Metals: Neutral. Gold prices held above our $1,450/oz stop-loss despite the risk-on sentiment fueled by encouraging discussions between the US’s and China’s top negotiators. For next year, we believe the Fed will remain accommodative and will not risk de-railing the recovery pre-emptively, even as inflation moves above target. This will support gold prices. The Fed will only tighten more aggressively once inflation breakeven rates are well anchored in the 2.3% to 2.5% range identified by our US Bond strategists. Appearing before the New York Association of Business Economics this week, Fed Governor Lael Brainard argued for a flexible average inflation target that would allow for a sustained period of inflation running above 2% to offset the last decade of inflation averaging far below the current 2% target.7 This is part of the undergoing review of how the Fed conducts monetary policy, led by Vice Chair Richard Clarida. Ags/Softs: Underweight. The slow corn harvest forced the USDA to delay the end of its weekly crop progress report. 84% of corn harvest was complete, below the five-year average of 96%. This season’s corn harvesting has been the slowest since 2009. Wheat rallied on Monday amid fund buying, with its most active contract for March delivery up almost 3%. The rally continued from last week when European wheat prices climbed over unfavorable weather conditions, particularly in France, where the condition of the grain was revised down to a four-year low. The soybean market has faced pressure over doubts a Sino-US trade deal will be concluded. China has turned to Brazil to lock in supplies. The January 2020 futures contract on the CME sank to its lowest level since September. Footnotes 1 In a recent study, The Fed researchers used the IMF’s Base Metals index as a leading indicator of GDP growth. The IMF’s index is highly correlated with the London Metal Exchange Index (LMEX) we use from time to time to assess base metals markets. However, the LMEX, unlike the IMF’s index, does not include iron ore, which can, at times, cause these indexes to diverge. Please see Caldara, Dario, Michele Cavallo, and Matteo Iacoviello (2016), Oil Price Elasticities and Oil Price Fluctuations, International Finance Discussion Papers 1173, published by the Board of Governors of the Federal Reserve System. 2 We find two-way Granger-causality between EM GDP and the IMF’s base-metals price index, the LMEX index, and our Global Industrial Activity Index (GIA), Global Commodity Factor (GCF), and shipping rates proxy, which we discuss below. Close to 75% of the LMEX Index is accounted for by aluminum and copper. Aluminum account for 14% of the IMF index, while copper makes up 30% of the index. 3 The GIA index uses trade data, FX rates, manufacturing data, and Chinese industrial activity statistics to gauge current global industrial activity. These statistics are highly correlated with trade-related activity, which, since most of this involve trade in manufactured goods, is important to global industrial activity. The GCF uses principal component analysis to distill the primary driver of 28 different real commodity prices. The EMIV model tracks EM import volumes which are reported with a two-month lag by the CPB in the Netherlands, which we update to current time using FX rates for trade-sensitive currencies, commodity prices and interest rates variables. We are also following shipping indexes, which are highly correlated with global trade volumes. 4 Our EM Commodity-Demand Nowcast is a coincident indicator of commodity demand, comprised of our Global Industrial Activity (GIA) Index, and our Global Commodity Factor (GCF) and EM Import Volume (EMIV) models. 5 EM GDP ex-China is more correlated with base metals prices and our GIA index, while US GDP and IP is only slightly impacted by them. 6 Please see U.S.-China trade deal close, Trump says; negotiations continue published November 26, 2019 by reuters.com. 7 Please see Fed's Brainard calls for 'flexible' average inflation target published November 26, 2019 by reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Summary of Closed Trades
Highlights Duration: Incoming data are consistent with our view that global growth is at an inflection point, and will improve during the next few months. As this plays out and recessionary fears fade into the background, we expect the 5-year/5-year forward Treasury yield to settle near 2.5%, 57 bps above its current level. High-Yield: Caa-rated debt has underperformed the duration-matched Treasury index so far this year, despite strong performance for junk bonds overall. We document that weak Caa returns often precede negative returns for the overall junk index. High-Yield: We show several ways in which this year’s Caa underperformance is unique compared to prior episodes. All in all, we conclude that we should not take too strong a signal from the recent Caa spread widening. Remain overweight high-yield in US bond portfolios. The Way Back To 2.5% Chart 1Target 2.5% Worries about a looming US recession peaked in late August when the 2/10 Treasury curve inverted and the 10-year yield hit 1.47%. Since then, some better economic data and the prospect of a “phase 1” US/China trade deal have lifted yields and un-inverted the curve. But the bond market is not yet sending the all-clear. Once recession fears completely fade into the background, we would expect the 5-year/5-year forward Treasury yield to settle near 2.5%. This is the FOMC’s median estimate of the longer-run fed funds rate, and also where the 5-year/5-year forward yield peaked during the last two global growth upturns (Chart 1). We expect that the 5-year/5-year forward Treasury yield will reach 2.5% in the first half of 2020, but global growth needs to rebound for that to happen. At present, we detect some positive signals from our preferred global growth indicators. The Global Manufacturing PMI troughed at 49.3 in July and came in at 49.8 in October (Chart 1, bottom panel). Then last week, Flash PMI data showed further gains in November for the US, Eurozone and Japan (Chart 2). Only the UK saw its manufacturing PMI drop in November, and it accounts for a mere 2% of the global index. There is no Flash PMI estimate for China. We detect some positive signals from our preferred global growth indicators. More signs of economic optimism are found in regional manufacturing PMIs, which continue to diverge positively from the national number (Chart 3). November data have already been released for New York, Philadelphia, Kansas City and Dallas. All four surveys point to a stronger national print. Chart 2A Bottom In Global PMIs Chart 3Regional PMIs Hooking Up Other data released last week include the Conference Board’s Leading Economic Indicator, which held flat at just above zero in year-over-year terms (Chart 4). The Leading Index is at a key inflection point. A rebound from here would be consistent with the 2015/16 episode (our base case expectation), while a dip into negative territory would sound some alarm bells. Chart 4Keep A Close Eye On Jobless Claims October existing home sales and housing starts came out last week (Chart 4, panels 2 & 3). Both series continue to rebound sharply from the depressed levels seen earlier in the year. This should not be too surprising, given this year’s large drop in mortgage rates. It will be more interesting to see what happens to the housing data as bond yields move higher and the stimulus from low rates fades. We have previously argued that the housing market will provide important clues about where bond yields will peak for the cycle. It will be critical to monitor the housing data as bond yields move higher in 2020.1 One note of caution comes from initial jobless claims, which printed at 227k in each of the past two weeks, slightly above recent levels (Chart 4, bottom panel). Claims remain roughly flat on a 6-month basis, consistent with continued economic recovery. However, a sustained increase would send an important warning sign about the labor market. We will be watching claims closely during the next few weeks. Bottom Line: Incoming data are consistent with our view that global growth is at an inflection point, and will improve during the next few months. As this plays out and recessionary fears fade into the background, we expect the 5-year/5-year forward Treasury yield to settle near 2.5%, 57 bps above its current level. The Puzzling Underperformance Of Caa-Rated Junk Bonds Chart 5The Puzzling Case Of Caa-Rated Junk Bonds Overall high-yield returns have been solid in 2019, but oddly, the lowest-rated junk bonds have not participated in the rally. So far this year, Ba and B-rated junk bonds have bested duration-matched Treasuries by 786 bps and 717 bps, respectively. But Caa-rated bonds have underperformed the duration-matched Treasury index by 87 bps (Chart 5). We usually think of the Caa-rated credit tier as being “higher beta” than the Ba and B tiers. That is, it should perform best in “risk on” environments, and worst in “risk off” environments. With that in mind, this year’s Caa underperformance is puzzling, and raises two important questions that we attempt to answer in this report. Is Caa underperformance a warning sign for the overall junk sector? Can we identify the reasons for this year’s Caa underperformance? And if so, do they suggest a buying opportunity? A Caa-nary In The Coal Mine? To assess whether this year’s Caa underperformance might be a warning sign for overall junk bond excess returns, we ran a few tests using historical data. First, we looked at calendar year excess returns going back to 1996 (Table 1). We then tested the performance of a couple trading rules to see whether Caa performance is a bellwether for the overall index. For the first test, we identified calendar years when junk index excess returns were positive but Caa was the worst performing credit tier. Four years fit this criteria: 1999, 2005, 2014 and 2019. Of the three years other than 2019, two (1999 and 2014) were followed by negative junk index excess returns the next year. Table 1Junk Excess Returns By Calendar Year We also posited that one difference between the Caa and Ba/B credit tiers might be that Caa-rated firms tend to be smaller. We therefore identified calendar years when junk index excess returns were positive but when small cap equities underperformed large cap equities. We identified eight such years. Of the seven years other than 2019, five were followed by negative junk index excess returns the next year. Both rules appear to give a good warning sign for the overall junk index. What if we combine them? We identify three years when junk index excess returns were positive, but Caa was the worst performing credit tier and small cap equities lagged large caps: 1999, 2014 and 2019. Both 1999 and 2014 were followed by negative junk index excess returns the next year. So far the evidence of Caa underperformance being a warning sign for the overall index is quite compelling. But let’s look more closely at the periods flagged by our trading rules. It is only this year that we have seen a large divergence in terms of direction between Caa spreads and overall junk index spreads. Recall that we identified 2019, 2014, 2005 and 1999 as the four years when overall junk index excess returns were positive, but when the Caa credit tier was the worst performer. If we look at the direction of junk spreads in those periods, we see that the direction of Caa spreads tracked the overall index very closely throughout 2014, 2005 and 1999. It is only this year that we have seen a large divergence in terms of direction between Caa spreads and overall junk index spreads (Chart 6). This divergence is odd, and it suggests that this year is unique compared to the other periods identified in our analysis (more on this below). Chart 62019 Is Unique Another reason to doubt the potential relevance of our calendar year analysis is that the decision to use calendar years is arbitrary, and it severely limits our sample size. We therefore run the same analysis using rolling 12-month periods. The results are presented in Table 2. Table 2Predictive Power Of Caa Returns: Rolling 12-Month Periods From December 1996 To October 2019 First, note the baseline result that there are 178 12-month periods of positive junk index excess returns in our sample. Of those 178 periods, 31% were followed by negative excess returns during the subsequent 12 months. If we apply our “Caa Return” filter and look only at 12-month periods when junk index excess returns were positive but Caa was the worst performing credit tier, our 178 examples fall to just 22. Of those 22 episodes, half were followed by negative junk index excess returns during the subsequent 12 months. Our “Small Cap/Large Cap Equity” filter provides a similar 51% hit rate with a larger sample size of 78. In this analysis we also test a “Caa Spread” filter where we scan for 12-month periods when junk index excess returns were positive, but when Caa spreads widened despite tightening in the overall index spread. We identify only 16 such periods, 56% of which were followed by negative index excess returns. We also looked at what happens when we combine two or more of our filters. Using our “Caa Return” and “Small Cap / Large Cap Equity” filters together, we identify only 18 episodes, 61% of which were followed by negative junk index excess returns during the next 12 months. If we take all three of our filters together, we find only 5 episodes, 4 of which preceded a period of negative junk excess returns. Please recall that the most recent 12-month period meets the criteria of all three of our filters. As was the case with our Table 1 results, an important caveat to this analysis is that of the 5 episodes identified by all three of our filters, the direction of Caa spreads never diverged from the direction of the overall index spread. In fact, we could find no historical period other than this year when Caa spreads diverged in direction from the overall index spread for so long. We conclude that Caa underperformance can provide advance notice of negative junk index excess returns, but also that the current period is so unique that it requires further analysis. Can We Explain The Divergence Between Caa Spreads And The Overall Index? As mentioned above, the current period of sharply widening Caa spreads alongside a rangebound overall index spread is unique historically. This not only raises questions about the relevance of the historical analysis we just presented, but also cries out for an explanation. Fortunately, several things appear to explain the odd behavior of Caa spreads. First, changes in index duration. Junk index duration fell dramatically in 2019, but the decline was much larger for Ba and B rated credits than for the Caa tier. If we control for changes in index duration by looking at 12-month breakeven spreads instead of the average index option-adjusted spread, we see that the spread divergence looks much less dramatic (Chart 7). Controlling for changes in index duration by looking at 12-month breakeven spreads instead of the average index OAS, we see that the spread divergence looks much less dramatic. Second, it’s possible that credit quality has deteriorated more for the lowest-rated credits than for the rest of the junk index. That would explain the spread divergence. However, this appears to not be the case. Our bottom-up sample of high-yield firms shows that debt-to-assets and interest coverage look similar compared to history for both the median high-yield firm and the worst 10% of firms (Chart 8). Chart 7A Duration Story Chart 8Credit Quality Is Not The Culprit Finally, we consider the sector composition of the different credit tiers. We look at year-to-date sector contributions to each credit tier’s excess returns and find that the difference between Caa and the rest of the index is concentrated in the Energy and Communications sectors (Chart 9). Caa-rated Communications firms underperformed the Ba and B credit tiers because of two Caa-rated firms – Frontier Communications Corp and Intelsat – that ran into problems. As for Energy, we note that the Caa tier has much more exposure to the Oil Field Services sub-sector than the other credit tiers. This sub-sector captures many of the shale players, who have struggled with falling oil prices. Notice that this year’s decline in the WTI oil price tracks Caa spread widening very closely (Chart 10). Chart 9Contribution To Year-To-Date Excess Returns* (%) Chart 10Blame Energy The Appendix at the end of this report provides a sector decomposition of the different junk credit tiers. Specifically, it presents three tables. One showing the sector weights in each credit tier. A second showing year-to-date excess returns for each sector by credit tier. A third showing the contribution from each sector to each credit tier’s year-to-date excess returns. Investment Conclusions Overall, we are hesitant to make too much of the recent Caa underperformance. Yes, we find compelling evidence that Caa underperformance can be a bellwether for negative high-yield excess returns. However, the behavior of Caa spreads in 2019 doesn’t resemble the prior periods in our analysis very closely. Specifically, the Caa spread doesn’t tend to diverge from the overall index spread in terms of direction, as it has this year. We are also able to identify two compelling reasons for this year’s divergence between Caa spreads and the overall index. The first is the change in relative index duration, and the second is stress in the shale oil sector due to a falling oil price. Spreads should adjust to changes in duration over time, and the stress in the shale sector should ease if oil prices rise as our commodity strategists expect.2 Given the uniqueness of the current period, and our base case outlook for a rebound in global growth, we are inclined to view Caa bonds (and junk bonds more generally) as an attractive buying opportunity in the current environment. But we will keep an eye on the performance of Caa bonds during the next few months. If global growth recovers and the oil price rises, but Caa continues to lag the overall index, then it may compel us to change our view. Appendix Table 3Sector Weights Within High-Yield Corporate Bond Credit Tiers* (%) Table 4Sector Year-To-Date Excess Return* By High-Yield Credit Tier (%) Table 5Sector Contribution To Year-To-Date Excess Return* For Each High-Yield Credit Tier (%) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 2 Our commodity strategists forecast an average price of $63/bbl for WTI crude oil in 2020. Please see Commodity & Energy Strategy Weekly Report, “Lingering Oil-Demand Weakness Will Fade”, dated November 21, 2019, available at ces.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification