Market Returns
Highlights MARKET FORECASTS Investment Strategy: Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. We think both preconditions will be realized. Until then, risk assets could come under pressure. Global Asset Allocation: Investors should overweight stocks relative to bonds over a 12-month horizon, but maintain higher-than-normal cash positions in the near term as a hedge against downside risks. Equities: EM and European stocks will outperform once global growth bottoms out. Cyclical sectors, including financials, will also start to outperform defensives when the growth cycle turns. Bonds: Central banks will remain dovish, but yields will nevertheless rise modestly on the back of stronger global growth. Favor high-yield corporate credit over government bonds. Currencies: As a countercyclical currency, the U.S. dollar should peak later this year. Commodities: Oil and industrial metals prices will move higher. Gold prices have entered a holding pattern, but should shine again late next year or in 2021 when inflation finally breaks out. Feature Dear Client, In lieu of this report, I hosted a webcast on Monday, October 7th at 10:00 AM EDT, where I discussed the major investment themes and views I see playing out for the rest of the year and beyond. Best regards, Peter Berezin, Chief Global Strategist I. Global Macro Outlook A Testing Phase For The Global Economy The global economy has reached a critical juncture. Growth has been slowing since early 2018, reaching what many would regard as “stall speed.” This is the point where economic weakness begins to feed on itself, potentially triggering a recession. Will the growth slowdown worsen? Our guess is that it won’t. Global financial conditions have eased significantly over the past four months, thanks in part to the dovish pivot by most central banks. Looser financial conditions usually bode well for global growth (Chart 1). Our global leading indicator has hooked up, mainly due to a marginal improvement in emerging markets’ data (Chart 2). Chart 1Easier Financial Conditions Will Boost Global Growth Chart 2Global LEI Has Moved Off Its Lows An important question is whether the weakness in the manufacturing sector will spread to the much larger services sector. There is some evidence that this is happening, with yesterday’s weaker-than-expected ISM non-manufacturing release being the latest example. Nevertheless, the deceleration in service sector activity has been limited so far (Chart 3). Even in Germany, with its large manufacturing base, the service sector PMI remains in expansionary territory. This is a key difference with the 2001/02 and 2008/09 periods, when service sector activity collapsed in lockstep with manufacturing activity. Chart 3AThe Service Sector Has Softened Less Than Manufacturing (I) Chart 3BThe Service Sector Has Softened Less Than Manufacturing (II) The Drive-By Slowdown If one were to ask most investors the reasons behind the manufacturing slowdown, they would probably cite the trade war or the Chinese deleveraging campaign. These are both valid reasons, but there is a less well-known culprit: autos. According to WardsAuto, global auto sales fell by over 5% in the first half of the year, by far the biggest decline since the Great Recession (Chart 4). Production dropped by even more. Chart 4Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Chart 5U.S. Auto Demand Is Recovering The weakness in the global auto sector reflects a variety of factors. New stringent emission requirements, expiring tax breaks, lagged effects from tighter auto loan lending standards, and trade tensions have all played a role. In addition, the decline in gasoline prices in 2015/16 probably brought forward some automobile purchases. This suggests that the 2015/16 global manufacturing downturn may have helped sow the seeds for the current one. The fact that automobile output is falling faster than sales is encouraging because it means that excess inventories are being worked off. U.S. auto loan lending standards have started to normalize, with banks reporting stronger demand for auto loans in the latest Senior Loan Officer Survey (Chart 5). In China, auto sales have troughed after having declined by as much as 14% earlier this year (Chart 6). The Chinese automobile ownership rate is a fifth of what it is in the U.S., a quarter of what it is in Japan, and a third of what it is in Korea (Chart 7). Given the low starting point, Chinese auto sales are likely to resume their secular uptrend. Chart 6Auto Sector In China Is Finding A Floor Chart 7China: Structural Outlook For Autos Is Bright The Trade War: Tracking Towards A Détente? Chart 8A Fairly Regular Three-Year Manufacturing Cycle Manufacturing cycles typically last about three years – 18 months of slowing growth followed by 18 months of rising growth (Chart 8). To the extent that the global manufacturing PMI peaked in the first half of 2018, we should be nearing the end of the current downturn. Of course, much depends on policy developments. As we go to press, high-level negotiations between the U.S. and China have resumed. While it is impossible to predict the outcome of these talks, it does appear that both sides have an incentive to de-escalate the trade conflict. President Trump gets much better marks from voters on his management of the economy than on anything else, including his handling of trade negotiations with China (Chart 9). A protracted trade war would hurt U.S. growth, while weakening the stock market. Both would undermine Trump’s re-election prospects. Chart 9Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Chart 10Who Will Win The 2020 Democratic Nomination? China also wants to bolster growth. As difficult as it has been for the Chinese leadership to deal with Donald Trump, trying to secure a trade deal with him after he has been re-elected would be even more challenging. This would especially be the case if Trump thought that the Chinese had tried to sabotage his re-election bid. Even if Trump were to lose the election, it is not clear that China would end up with someone more pliant to deal with on trade matters. Does the Chinese government really want to negotiate over environmental standards and human rights with President Warren, who betting markets now think has a better chance of becoming the Democratic nominee than Joe Biden (Chart 10)? The Democrats’ initiative to impeach President Trump make a trade resolution somewhat more likely. First, it brings attention to Joe Biden’s (and his son’s) own dubious dealings in Ukraine, thus delivering a blow to China’s preferred U.S. presidential candidate. Second, it makes Trump more inclined to want to put the China spat behind him in order to focus his energies on domestic matters. More Chinese Stimulus? Strategically, China has a strong incentive to stimulate its economy in order to prop up growth and gain greater leverage in the trade negotiations. The Chinese credit impulse bottomed in late 2018. The impulse leads Chinese nominal manufacturing output and most other activity indicators by about nine months (Chart 11). So far, the magnitude of China’s credit/fiscal easing has come nowhere close to matching the stimulus that was unleashed on the economy both in 2015/16 and 2008/09. This is partly because the authorities are more worried about excessive debt levels today than they were back then, but it is also because the economy is in better shape. The shock from the trade war has not been nearly as bad as the Great Recession – recall that Chinese exports to the U.S. are only 2.7% of GDP in value-added terms. Unlike in 2015/16, when China lost over $1 trillion in external reserves, capital outflows have remained muted this time around (Chart 12). Chart 11Chinese Stimulus Should Boost Global Growth Chart 12China: No Major Capital Outflows Better-than-expected Chinese PMI data released earlier this week offers a glimmer of hope. Nevertheless, in light of the disappointing August activity numbers, China is likely to increase the pace of stimulus in the coming months. The authorities have already reduced bank reserve requirements. We expect them to cut policy rates further in the coming months. They will also front-load local government bond issuance, which should help boost infrastructure spending. European Growth Should Improve A pickup in global growth will help Europe later this year. Germany, with its trade-dependent economy, will benefit the most. Chart 13Spreads Have Come In Across Southern Europe Chart 14Faster Money Growth Bodes Well For GDP Growth In The Euro Area Falling sovereign spreads should also support Southern Europe (Chart 13). The Italian 10-year spread with German bunds has narrowed by almost a full percentage point since mid-August, taking the Italian 10-year yield down to 0.83%. Greek 10-year bonds are now yielding less than U.S. Treasurys (the Greek manufacturing PMI is currently the strongest in the world). With the ECB back in the market buying sovereign and corporate debt, borrowing rates should remain low. Euro area money growth, which leads GDP growth, has already picked up (Chart 14). Bank lending to the private sector should continue to accelerate. A modest serving of fiscal stimulus will also help. The European Commission estimates that the fiscal thrust in the euro area will increase by 0.5% of GDP in 2019 (Chart 15). Assuming, conservatively, a fiscal multiplier of one, this would boost euro area growth by half a percentage point. Owing to lags between changes in fiscal policy and their impact on the real economy, most of the gains to GDP growth will occur over the remainder of this year and in 2020. Chart 15Euro Area Fiscal Stimulus Will Also Boost Growth Chart 17Brexit Angst: A Case Of Bremorse Chart 16U.K.: Brexit Uncertainty Is Weighing On Growth In the U.K., Brexit uncertainty continues to weigh on growth. U.K. business investment has been especially hard hit (Chart 16). Prime Minister Boris Johnson remains insistent that he will take the U.K. out of the EU with or without a deal at the end of October. We would downplay his bluster. The Supreme Court has already denied his attempt to shutter parliament. The public is having second thoughts about the desirability of Brexit (Chart 17). While we do not have a strong view on the exact plot twists in the Brexit saga, we maintain that the odds of a no-deal Brexit are low. This is good news for U.K. growth and the pound. Japan: Own Goal Recent Japanese data releases have not been encouraging: Machine tool orders declined by 37% year-over-year in August. Exports contracted by over 8%, with imports recording a drop of 12%. The September PMI print exposed further deterioration in manufacturing, with the index falling to 48.9 from 49.3 in August. In addition, industrial production contracted by more than expected in August, falling by 1% month-over-month, and close to 5% year-over-year. The ongoing uncertainty surrounding the U.S.-China trade negotiations, as well as Japan’s own tensions with neighboring South Korea, have also weighed on the Japanese economy. Japanese industrial activity will improve later this year as global growth rebounds. But the government has not helped growth prospects by raising the consumption tax on October 1st. While various offsets will blunt the full effect of the tax hike, it still amounts to unwarranted tightening in fiscal policy. Nominal GDP has barely increased since the early 1990s. What Japan needs are policies that boost nominal income. Such reflationary policies may be the only way to stabilize debt-to-GDP without pushing the economy back into a deflationary spiral.1 The U.S.: Hanging Tough Chart 18U.S. Has A Smaller Share Of Manufacturing Than Most Other Developed Economies The U.S. economy has fared relatively well during the latest global economic downturn, partly because manufacturing represents a smaller share of GDP than in most other economies (Chart 18). According to the Atlanta Fed GDPNow model, real GDP is on track to rise at a trend-like pace of 1.8% in the third quarter (Chart 19). Personal consumption is set to increase by 2.5%, after having grown by 4.6% in the second quarter. Consumer spending should stay robust, supported by rising wage growth. The personal savings rate also remains elevated, which should help cushion households from any adverse shocks (Chart 20). Chart 19U.S. Growth Has Softened, But Is Still Close To Trend Residential investment finally looks as though it is turning the corner. Housing starts, building permits, and home sales have all picked up. Given the tight relationship between mortgage rates and homebuilding, construction activity should accelerate over the next few quarters (Chart 21). Low inventory and vacancy rates, rising household formation, and reasonable affordability all bode well for the housing market (Chart 22). Chart 20The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth Chart 21U.S. Housing Will Rebound Chart 22U.S. Housing: On A Solid Foundation Chart 23U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels In contrast to residential investment, business capex continues to be weighed down by the manufacturing recession, a strong dollar, and trade policy uncertainty. Core durable goods orders declined in August. Capex intention surveys have also weakened, although they remain well above recessionary levels (Chart 23). The ISM manufacturing index hit its lowest level since July 2009 in September. The internals of the report were not quite as bad as the headline. The new orders-to-inventories component, which leads the ISM by two months, moved back into positive territory. The weak ISM print also stands in contrast to the more upbeat Markit U.S. manufacturing PMI, which rose to its highest level since April. Statistically, the Markit PMI does a better job of tracking official measures of U.S. manufacturing output, factory orders, and employment than the ISM. Taking everything together, the U.S. economy is likely to see modestly stronger growth later this year, as the global manufacturing recession comes to an end, while strong consumer spending and an improving housing market bolster domestic demand. II. Financial Markets Global Asset Allocation Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. As such, investors should maintain larger-than-normal cash positions for the time being to guard against downside risks. Chart 24Stocks Will Outperform Bonds If Growth Recovers Fortunately, any pullback in risk asset prices is likely to be temporary. If trade tensions subside and global growth rebounds later this year, as we expect, stocks and spread product should handily outperform government bonds over a 12-month horizon (Chart 24). Admittedly, there are plenty of things that could upend this sanguine 12-month recommendation: Global growth could continue to deteriorate; the trade war could intensify; supply-side shocks could cause oil prices to spike up again; the U.K. could end up leaving the EU in a “hard Brexit” scenario; and last but not least, Elizabeth Warren or some other far-left candidate could end up becoming the next U.S. president. The key question for investors today is whether these risks have been fully discounted in financial markets. We think they have. Chart 25 shows our estimates for the global equity risk premium (ERP), calculated as the difference between the earnings yield and the real bond yield. Our calculations suggest that stocks still look quite cheap compared to bonds. Chart 25AEquity Risk Premia Remain Quite High (I) Chart 25BEquity Risk Premia Remain Quite High (II) One might protest that the ERP is high only because today’s ultra-low bond yields are reflecting very poor growth prospects. There is some truth to that claim, but not as much as one might think. While trend GDP growth has fallen in the U.S. over the past decade, bond yields have declined by even more. The gap between U.S. potential nominal GDP growth, as estimated by the Congressional Budget Office, and the 10-year Treasury yield is close to two percentage points, the highest since 1979 (Chart 26). Chart 26Bond Yields Have Fallen More Than Trend Nominal GDP Growth At the global level, trend GDP growth has barely changed since 1980, largely because faster-growing emerging markets now make up a larger share of the global economy (Chart 27). For large multinational companies, global growth, rather than domestic growth, is the more relevant measure of economic momentum. Gauging Future Equity Returns A high ERP simply says that equities are attractive relative to bonds. To gauge the prospective return to stocks in absolute terms, one should look at the absolute level of valuations. Chart 27The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM Chart 28S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector As we argued in a recent report entitled “TINA To The Rescue?,”2 the earnings yield can be used as a proxy for the expected real total return on equities. Empirically, the evidence seems to bear this out: Since 1950, the earnings yield on U.S. equities has averaged 6.7%, compared to a real total return of 7.2%. Today, the trailing and forward PE ratio for U.S. stocks stand at 21.1 and 17.4, respectively. Using a simple average of the two as a guide for future returns, U.S. stocks should deliver a long-term real total return of 5.2%. While this is below its historic average, it is still a fairly decent return. One might complain that this calculation overstates prospective equity returns because the U.S. earnings yield is temporarily inflated by abnormally high profit margins. The problem with this argument is that virtually all of the increase in S&P 500 margins has occurred in just one sector: technology. Outside of the tech sector, S&P 500 margins are not far from their historic average (Chart 28). If high IT margins reflect structural changes in the global economy – such as the emergence of “winner take all” companies that benefit from powerful network effects and monopolistic pricing power – they could remain elevated for the foreseeable future. Regional And Sector Equity Allocation The earnings yield is roughly two percentage points higher outside the U.S., suggesting that non-U.S. stocks will best their U.S. peers over the long haul. In the developed market space, Germany, Spain, and the U.K. appear especially cheap. In the EM realm, China, Korea, and Russia stand out as being very attractively priced (Chart 29). At the sector level, cyclical stocks look more appealing than defensives (Chart 30). Chart 29U.S. Stocks Appear Expensive Compared To Their Peers Chart 31Economic Growth Drives Stocks Over A 12-Month Horizon Chart 30Cyclical Stocks Are More Attractive Than Defensives Chart 32EM And Euro Area Equities Usually Outperform When Global Growth Improves Valuations are useful mainly as a guide to long-term returns. Over a horizon of say, 12 months, cyclical factors – i.e., what happens to growth, interest rates, and exchange rates – matter more (Chart 31). Fortunately, our cyclical views generally line up with our valuation assessment. Stronger global growth, a weaker dollar, and rising commodity prices should benefit cyclical stocks relative to defensives. To the extent that EM and European stock markets have more of a cyclical sector skew than U.S. stocks, the former should end up outperforming (Chart 32). We would put financials on our list of sectors to upgrade by year end once global growth begins to reaccelerate. Falling bond yields have hurt bank profits (Chart 33). The drag on net interest margins should recede as yields start rising. European banks, which currently trade at only 7.6 times forward earnings, 0.6 times book value, and sport a hefty dividend yield of 6.3%, could fare particularly well (Chart 34). Chart 33AHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Chart 33BHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) As Chart 35 illustrates, a bet on financials is similar to a bet on value stocks. Growth has trounced value over the past 12 years, but a bit of respite for value is in order over the next 12-to-18 months. Chart 34European Banks Are Attractive Chart 35Is Value Turning The Corner? Fixed Income Chart 36AYields Should Rise On Stronger Growth (I) Dovish central banks and, for the time being, still-subdued inflation will help keep government bond yields in check over the next 12 months. Nevertheless, yields will still rise from currently depressed levels on the back of stronger global growth (Chart 36). Chart 36BYields Should Rise On Stronger Growth (II) Bond yields tend to rise or fall depending on whether central banks adjust rates by more or less than is anticipated (Chart 37). Investors currently expect the Fed to cut rates by another 80 basis points over the next 12 months. While we think the Fed will bring down rates by 25 basis points on October 30th, we do not anticipate any further cuts beyond then. The cumulative 75 basis points in cuts during this easing cycle will be equivalent to the amount of easing delivered during the two mid-cycle slowdowns in the 1990s (1995/96 and 1998). All told, the U.S. 10-year Treasury yield is likely to move back into the low 2% range by the middle of 2020. Chart 37AStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Chart 36BStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Chart 38U.S. Government Bond Yields Are More Procyclical Than Yields Abroad Unlike U.S. equities, which tend to have a low beta compared to stocks abroad, U.S. bonds possess a high beta. This means that U.S. Treasury yields usually rise more than yields abroad when global bond yields, in aggregate, are increasing, and fall more than yields abroad when global bond yields are decreasing (Chart 38). Moreover, U.S. Treasurys currently yield less than other bond markets once currency-hedging costs are taken into account (Table 1). If U.S. yields were to rise more than those abroad over the next 12-to-18 months, this would further detract from Treasury returns. As a result, investors should underweight Treasurys within a global government bond portfolio. Stronger global growth should keep corporate credit spreads at bay. Lending standards for U.S. commercial and industrial loans have moved back into easing territory, which is usually bullish for corporate credit (Chart 39). According to our U.S. bond strategists, high-yield corporate spreads, and to a lesser extent, Baa-rated investment-grade spreads, are still wider than is justified by the economic fundamentals (Chart 40).3 Better-rated investment-grade bonds, in contrast, offer less relative value. Table 1Bond Markets Across The Developed World Chart 39Easier Lending Standards Bode Well For Corporate Credit Chart 40U.S. Corporates: Focus On Baa And High-Yield Credit Looking beyond the next 18 months, there is a high probability that inflation will start to move materially higher. The unemployment rate across the G7 has fallen to a multi-decade low (Chart 41). The share of developed economies that have reached full employment has hit a new cycle high (Chart 42). For all the talk about how the Phillips curve is dead, wage growth has remained tightly correlated with labor market slack (Chart 43). Chart 41Unemployment Rates Keep Trending Lower Chart 42Developed Markets: Full Employment Reaching New Cycle Highs Chart 43The Phillips Curve Is Alive And Well As wages continue to rise, prices will start to move up, potentially setting off a wage-price spiral. The Fed, and eventually other central banks, will have to start raising rates at that point. Once interest rates move into restrictive territory, equities will fall and credit spreads will widen. A global recession could ensue in 2022. Currencies And Commodities Chart 44The Dollar Is A Countercyclical Currency The U.S. dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 44). We do not have a strong near-term view on the direction of the dollar at the moment, but expect the greenback to begin to weaken by year end as global growth starts to rebound. EUR/USD should increase to around 1.13 by mid-2020. GBP/USD will rise to 1.29. USD/CNY will move back to 7. USD/JPY is likely to be flat, reflecting the yen’s defensive nature and the drag on Japanese growth from the consumption tax hike. The trade-weighted dollar will continue to depreciate until late-2021, after which time a more aggressive Fed and a slowdown in global growth will cause the dollar to rally anew. During the period in which the dollar is weakening, commodity prices will move higher (Chart 45). Chart 45Dollar Weakness Is A Boon For Commodities BCA’s commodity strategists are particularly bullish on oil over a 12-month horizon (Chart 46). They see Brent crude prices rising to $70/bbl by the end of this year and averaging $74/bbl in 2020 based on the expectation that stronger global growth and production discipline will drive down oil inventory levels. OPEC spare capacity – the difference between what the cartel is capable of producing and what it is actually producing – is currently below its historic average (Chart 47). Crude oil reserves have also been trending lower within the OECD. Saudi Arabia’s own reserves have fallen by over 40% since peaking in 2015 (Chart 48). Chart 46Supply Deficit To Continue Chart 47Limited Availability Of Spare Capacity To Offset Outages Chart 48Key Strategic Petroleum Reserves Higher oil prices should benefit currencies such as the Canadian dollar, Norwegian krone, Russian ruble and Colombian peso. Finally, a few words on gold. We closed our long gold trade on August 29th for a 20-week gain of 20.5%. We still see gold as an excellent long-term hedge against higher inflation. In the near term, however, rising bond yields may take the wind out of gold’s sails, even if a weaker dollar does help bullion at the margin. We will reinitiate our long gold position towards the end of next year or in 2021 once inflation begins to break out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “Are High Debt Levels Deflationary Or Inflationary?” dated February 15, 2019. 2Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 3Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed,” dated September 17, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Highlights Portfolio Strategy The contracting manufacturing sector that rekindled recession fears, the harsh reality of the Sino-American trade war weighing on profits, downbeat business confidence and mushrooming capex slowdown signals all warn that investors should tread carefully in the historically difficult equity market months of September and October. It no longer pays to be overweight gold mining equities as sentiment is stretched, the restarting of global QE will likely reverse or at least halt the drubbing in global yields and the U.S. dollar inverse correlation should reassert itself and weigh on global gold miners. EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Recent Changes Trim the Global Gold Mining index to neutral, today. Downgrade the S&P Materials sector to underweight, today. Table 1 Feature Equities broke out of their trading range last week, but in order for this short-covering rally to become durable, and for volatility to subside, either global growth needs to turn the corner and alleviate recession fears or the trade war needs to de-escalate materially. On the recession front Central Banks (CBs) are doing their utmost to reflate their respective economies, but the early stages of looser monetary policy have been insufficient to change the global growth trajectory. With regard to the trade war, markets cheered the news that talks between the U.S. and China will resume in September and October. The dates for talks are conveniently chosen to follow the September FOMC meeting and the October 1 70th anniversary of the People's Republic of China. The latter date implies that Washington is considering delaying the October 1 tariff hike – and it could imply that Washington does not anticipate any violent suppression of Hong Kong protesters by that time. However, the harsh reality is that the two sides are just “kicking the can down the road”. The longer the Sino-American trade war takes to conclude, the more likely it will serve as a catalyst for a repricing of risk significantly lower (top panel, Chart 1). A technical correction may be necessary to force Trump to reduce the trade pressure significantly. Even if the October 1 tariff hike is postponed it will remain a source of uncertainty ahead of the final tariff tranche slated for December 15. The bond market may offer some clues as to the extent that the escalating trade war will eventually get reflected into stocks (bottom panel, Chart 1). The equity transmission mechanism is through the earnings avenue. Simply put, rising trade uncertainty deals a blow to global trade that boosts the U.S. dollar which in turn makes U.S. exports uncompetitive in global markets, deflates the commodity complex and with a lag weighs on SPX earnings. Chart 1Tracking Trade Uncertainty Speaking of the economically hypersensitive manufacturing sector, last week’s ISM release made for grim reading, further fueling recession fears (the New York Fed now pegs the recession probability just shy of 38% by next August). Not only did the overall survey fall below the boom/bust line (middle panel, Chart 2), but also new orders collapsed. In fact, the drubbing in new orders is worrying and it signals that the economy is going to get worse before it gets better (top panel, Chart 2). Tack on the simultaneous rise in inventories, and the sinking new orders-to-inventories ratio (not shown) warns of additional manufacturing ills in the coming months. Importantly, export orders suffered the steepest losses plunging to 43.3. The last three times that this trade-sensitive survey subcomponent was in such a steep freefall were in 1998, 2001 and 2008, when the SPX suffered peak-to-trough losses of 20%, 49% and 57%, respectively. In fact, since the history of the data, ISM manufacturing export orders have never been lower with the exception of the GFC (Chart 3). Such a retrenchment will either mark the bottom for equities or is a harbinger of a steep equity market correction. We side with the latter as the odds of President Trump striking a real trade deal (including tech) with China any time soon are low. Chart 2Like Night Follows Day Similar to the ISM manufacturing/non-manufacturing divergence (bottom panel, Chart 2), business confidence is trailing consumer conference by a wide mark. Historically this flaring chasm has been synonymous with a sizable loss of momentum in the broad equity market (Chart 4). One plausible explanation is that as business animal spirits suffer a setback, CEOs are quick to prune/postpone capex plans and, at the margin, corporations retrench and short-circuit the capex upcycle. Chart 3Export Carnage Chart 4Mind The Gap Circling back to last week’s capex update, national accounts corroborate the financial statement data deceleration, and in some cases contraction, in capital outlays (Chart 5). As a reminder our thesis is that the EPS-to-capex virtuous upcycle is morphing into a vicious down cycle.1 This week, we downgrade a deep cyclical sector by taking profits in a niche subgroup that has served as a reliable portfolio hedge. Crucially, tech investment, that comprises almost 30% of total investment according to national accounts, is decelerating, R&D and other intellectual property investment have also hooked down, non-residential structures are on the verge of contraction, and industrial, transportation and other equipment –that have the largest weight in U.S. capex – are also quickly losing steam (Chart 6). Chart 5Capex Blues Chart 6All Capex Segments… In more detail, Charts 7 & 8 further break down capital outlays in the respective categories and reveal that worrisomely the investment spending slowdown is broad based. Chart 7…Have Rolled Over… Chart 8…Except For One Adding it all up, the contracting manufacturing sector that rekindled recession fears, the harsh reality of the Sino-American trade war weighing on profits, downbeat business confidence and mushrooming capex slowdown signals all warn that investors should tread carefully in the historically difficult equity market months of September and October. As a reminder, this is U.S. Equity Strategy service’s view and it contrasts with BCA’s sanguine equity market house view. This week, we downgrade a deep cyclical sector by taking profits in a niche subgroup that has served as a reliable portfolio hedge. Downgrade Materials To Underweight… Heightened economic and trade policy uncertainty has claimed the S&P materials sector as one of its victims (Chart 9). Given that our Geopolitical Strategy service’s base case remains that there will be no Sino-American trade deal by the U.S. November 2020 election, there is more downside for materials stocks and we are downgrading this niche deep cyclical sector to a below benchmark allocation.2 Beyond the U.S./China trade war inflicted wounds that materials stocks have to nurse, there are four major headwinds that they will also have to contend with in the coming months. Chart 9Trade Uncertainty Sinking Materials First, the emerging markets (EM) in general and China in particular are in a prolonged soft patch that predates the Sino-American trade war. EM stocks and EM currencies are both deflating at an accelerating pace warning that relative share prices will suffer the same fate (Chart 10). Nothing epitomizes the infrastructure spending/capex cycle more than China’s insatiable appetite for commodities and the news on that front remains dire. The Li Keqiang index continues to emit a distress signal and that is negative for materials top line growth (bottom panel, Chart 10). Second, global inflation is in hibernation and select EM producer price inflation growth series are on the verge of contraction or already outright contracting. Chinese raw materials wholesale prices are in the deflation zone and warn that U.S. materials sector profits will underwhelm (Chart 11). Chart 10Bearish EM… Chart 11…And China Backdrops Base metal prices are a real time indicator of the wellness of the S&P materials sector. Currently, base metals are deflating both on the back of a firming U.S. dollar and contracting global manufacturing. Such a commodity price backdrop is dampening prospects for a profit-led materials sector relative share price recovery (top & middle panels, Chart 12). Third, the materials exports outlook is darkening. Apart from the deflating effect the appreciating U.S. dollar has on commodities it also clips basic materials companies’ exports prospects. How? It renders materials related exports uncompetitive in international markets leading to market share losses. Netting it all out, EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Chart 12Weak Pricing Power And Declining Exports In addition, the latest ISM export order subcomponent plunged to multi-year lows reflecting trade war pessimism and falling global end-demand. The implication is that the export relief valve is closed for materials equities (bottom panel, Chart 12). Finally, materials sector financial statement metrics are moving in the wrong direction. Net debt-to-EBITDA is rising anew and interest coverage has likely peaked for the cycle at a time when free cash flow generation has ground to a halt (Chart 13). U.S. Equity Strategy’s S&P materials sector profit growth model encapsulates all these moving parts and warns that a severe profit contraction phase looms (Chart 14). Chart 13Financial Statement Red Flags Chart 14Model Says Sell Netting it all out, EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Bottom Line: The time is ripe to downgrade the S&P materials sector to underweight. …Via Trimming Gold Miners To Neutral The way we are executing this downgrade in the materials sector to an underweight stance is by trimming the global gold mining index to a benchmark allocation. Our thesis that gold stocks serve as a sound portfolio hedge remains intact and underpinned when: economic and trade policy uncertainty are on the rise (top panel, Chart 15) global CBs start cutting interest rates and in some cases doubling down on negative interest rates currency wars are overheating Nevertheless, what has changed is the price, and we deem that global gold miners that have gone parabolic are in desperate need of a breather. The top panel of Chart 16 shows that gold stocks have rallied 58% since the May 5, 2019 Trump tweet. This outsized four-month relative return is remarkable and likely almost fully reflects a very dovish Fed and melting real U.S. Treasury yields (TIPS yield shown inverted, bottom panel, Chart 15). A much needed pause for breath is required before the next leg of the relative rally resumes, and we opt to move to the sidelines. Chart 15Positive Backdrop… Chart 16…But Reflected In Prices Moreover, on the eve of the ECB’s September meeting, were President Mario Draghi to re-commence QE in the form of sovereign and corporate bond purchases as markets participants expect, counterintuitively a selloff in the bond markets would confirm that QE and its signaling is working (bottom panel, Chart 16). Ergo, this would likely exert upward pressure on global interest rates including the U.S., especially given the one-sided positioning in the respective global risk free assets. The implication is that the shiny metal and global gold miners would suffer a setback as real yields would rise further. As a reminder, gold bullion yields nothing and gold mining equities next to nothing, thus when competing safe haven assets at the margin start yielding higher, investors flee gold and gold miners and flock to risk free assets. Sentiment toward gold and global gold miners is stretched. Gold ETF holdings are at multi-year highs (second panel, Chart 17) and gold net speculative positions are at a level that has marked previous reversals. In addition, bullish consensus on gold is near 72%, a percentage last reached in 2012 (third & bottom panels, Chart 17). Similarly, relative share price momentum is also warning that global gold mining equities are currently extended (bottom panel, Chart 18). Chart 17Extreme… Chart 18…Sentiment Finally, while the bond market’s view of 100bps in Fed cuts in the next 12 months should have undermined the trade-weighted U.S. dollar, it has actually defied gravity and slingshot to fresh cycle highs. This is a net negative both for gold and gold mining equities as the underlying commodity is priced in U.S. dollars and enjoys an inverse correlation with the greenback. The implication is that the multi-decade inverse correlation will hold and will likely pull down gold and gold mining equities at least in the short-run (U.S. dollar shown inverted, Chart 19). In sum, the exponential rise in global gold miners is in need of a breather. Sentiment is stretched, the restating of global QE will likely reverse or at least halt the drubbing in global yields and the U.S. dollar inverse correlation should reassert itself and weigh on relative share prices Chart 19Gold Miners/Dollar Correlation Re-establishment Risk Bottom Line: Downgrade the global gold mining index to neutral, but stay tuned. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see U.S. Equity Strategy Weekly Report, “Capex Blues” dated September 3, 2019, available at uses.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report, “Big Trouble In Greater China” dated August 29 , 2019, available at bca.bcaresearch.com Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps
Highlights The lingering global manufacturing recession and the substantial drop in U.S. bond yields have been behind the decoupling between both EM stocks and the S&P 500, and cyclical and defensive equities. Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to indicate either further bifurcation in global markets or a risk-off period. We review some of our long-standing themes and associated recommendations. Feature Global financial markets have become bifurcated. On one hand, numerous segments of global financial markets leveraged to global growth, including EM stocks, have already sold off (Chart I-1). On the other hand, share prices of growth companies, defensive stocks and global credit markets have remained resilient. Chart I-2 shows that a similar divergence has taken place within EM asset classes: EM share prices have plummeted while EM corporate credit excess returns have not dropped much. Chart I-1Bifurcated Equity Markets Chart I-2Bifurcated Markets In EM How to explain this market bifurcation? Financial markets sensitive to global trade and manufacturing cycles have been mirroring worsening conditions in global trade and manufacturing. Some of the affected segments include: Global cyclical equity sectors. Emerging Asia manufacturing-related currencies (KRW, TWD and SGD) versus the U.S. dollar (Chart I-3). EM and DM commodity currencies (Chart I-4). Chart I-3Total Return (Including Carry): KRW, TWD And SGD Vs. USD Chart I-4EM And DM Commodity Currencies Industrial and energy commodities prices. U.S. high-beta stocks as well as U.S. small caps (Chart I-5). Chart I-5U.S. High-Beta Stocks DM bond yields. Crucially, the current global trade and manufacturing downturns have taken place despite robust U.S. consumer spending. In fact, our theme for the past several years has been that a global business cycle downturn would occur despite ongoing strength in American household spending. The rationale has been that China and the rest of EM combined are large enough on their own to bring down global trade and manufacturing, irrespective of strength in U.S. consumer spending. At the current juncture, one wonders whether such a market bifurcation is justified. It is not irrational. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Corporate bonds have also done well, given the background of a falling risk-free rate. Will the current market bifurcation continue? Or will these segments in global financial markets recouple and in which direction? What To Watch China rather than the U.S. has been the epicenter of this slowdown, as we have argued repeatedly in the past. Hence, a major rally in global cyclical equities and EM risk assets all hinge on a recovery in the Chinese business cycle. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Even though Caixin’s PMI for China was slightly up in August, many other economic indicators remain downbeat: The latest hard economic data out of Asia suggest that global trade/manufacturing continues to contract. Korea’s total exports in August contracted by 12.5% from a year ago, and its shipments to China plunged by 20% (Chart I-6). The import sub-component of China’s manufacturing PMI is not showing signs of amelioration (Chart I-7). The mainland’s import recovery is very critical to a revival in global trade and manufacturing. Chart I-6Korean Exports: No Recovery Chart I-7Chinese Imports To Remain Weak Chart I-8German Manufacturing Confidence German manufacturing IFO business expectations and current conditions both suggest that it is still early to bet on a global trade recovery (Chart I-8). Newly released August data points reveal that U.S., Taiwanese, and Swedish manufacturing new export orders continue to tumble. To gauge whether bifurcated markets will recouple and whether it will occur to the downside or the upside, investors should watch the relative performance of China-exposed markets, global cyclicals and high-beta plays – the ones that have already sold off substantially. The notion is as follows: These markets’ relative performance will likely bottom before their absolute performance recovers. If so, their relative performance will likely foretell the outlook for their absolute performance. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. In other words, they could sell off even if a global recession is avoided. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. To assess the outlook for global cyclicals and China-related plays, we are monitoring the following financial market indicators: The Risk-On/Safe-Haven currency ratio is the average of high-beta commodity currencies such as the CAD, AUD, NZD, BRL, CLP and ZAR total return (including carry) indices relative to the average of JPY and CHF total returns (including carry). This ratio is dollar-agnostic. This ratio is making a new cyclical low (Chart I-9). Hence, it presently warrants a negative view on global growth, China’s industrial sector and commodities. Global cyclical equity sectors seem to be on the edge of breaking down versus defensives (Chart I-10). This ratio does not signal ameliorating global growth conditions. Chart I-9The Risk-On/Safe-Haven Currency Ratio Chart I-10Global Cyclicals Versus Defensives Chart I-11U.S. High-Beta Stocks Versus S&P 500 Finally, U.S. high-beta stocks continue to underperform the S&P 500 (Chart I-11). This is consistent with overall U.S. growth deceleration. Bottom Line: Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to foreshadow either further bifurcation in global markets or a risk-off period. Continue trading EM stocks and currencies on the short side, and underweighting EM risk assets versus DM. Our Investment Themes And Positions Some of our open positions often run for years because they reflect our long-standing themes. Our core theme has for some time been that a global trade/manufacturing recession will be generated by a growth relapse in China. To capitalize on this theme, we have been recommending a short EM stocks / long 30-year U.S. Treasurys strategy since April 2017. This recommendation has produced a 25% gain since its initiation (Chart I-12). Continue betting on lower local interest rates in emerging economies where the central bank can cut rates despite currency depreciation. To implement this theme, we have been recommending receiving swap rates in Korea and Chile for the past several years. Our reluctance to recommend an outright buy on local bonds stems from our bearish view on both currencies – the Korean won and Chilean peso. In fact, we have been shorting both the KRW and the CLP against the U.S. dollar. Chart I-13 shows that swap rates in Korea and Chile have dropped substantially since our recommendations to receive rates in these countries. More rate cuts are forthcoming in these economies, and we are maintaining these positions. Chart I-12EM Stocks Have Massively Underperformed U.S. Bonds Chart I-13Continue Receiving Rates In Korea And Chile We have been bearish on EM banks in general and Chinese banks in particular. We have expressed these themes in a number of ways: Short EM and Chinese / long U.S. bank stocks. Short EM banks / long EM consumer staples (Chart I-14). Within Chinese banks, we have been short Chinese medium and small banks / long large ones. All these strategies remain valid. In credit markets, we have been favoring U.S. corporate credit versus EM sovereign and corporate credit. Ability to service debt is better among U.S. debtors than EM/Chinese borrowers. We have been playing this theme in the following ways: Underweight EM sovereign and corporate credit / overweight U.S. investment-grade corporates (Chart I-15). Chart I-14Short EM Banks / Long EM Consumer Staples Chart I-15Underweight EM Credit / Overweight U.S. Investment-Grade Corporates Underweight Asian high-yield corporate credit / overweight emerging Asian investment-grade corporates. As a bet on a deteriorating political and business climate in Hong Kong, in our Special Report on Hong Kong SAR from June 27, we reiterated the following positions: Short Hong Kong property stocks / long Singapore equities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Mexico: Crying Out For Policy Easing The Mexican economy is heading into a full-blown recession. Most segments of the economy are in contraction, and leading indicators point to further downside. Both manufacturing and non-manufacturing PMIs are well below 50 (Chart II-1). Monetary policy remains too restrictive: Nominal and real interest rates are both very high and plunging narrow money (M1) growth is signaling further downside in economic activity (Chart II-2). Chart II-1The Economy Is Deteriorating Chart II-2Narrow Money Points To Negative Growth An inverted yield curve signifies that the central bank is behind the curve and foreshadows growth contraction (Chart II-3). Fiscal policy has tightened as the government has remained committed to achieving a primary fiscal surplus of 1% of GDP in 2019 (Chart II-4, top panel). Consequently, nominal government expenditures have been curbed (Chart II-4, bottom panel). The government’s fiscal stimulus has not been large and has been implemented too late. Chart II-3A Message From The Inverted Yield Curve Chart II-4Fiscal Policy Has Tightened A Lot Finally, business confidence is extremely low due to uncertainty over President Andrés Manuel López Obrador’s (AMLO) policies towards the private sector. The president is attempting to revive business confidence, but it will take time. Chart II-5Mexico Versus EM: Domestic Bonds And Sovereign Credit Our major theme for Mexico has been that both monetary and fiscal policies are very tight. Consequently, we have been recommending overweight positions in Mexican domestic bonds and sovereign credit relative to their respective EM benchmarks. (Chart II-5). Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Meanwhile, we have been favoring the Mexican peso relative to other EM currencies due to the fact that AMLO is not as negative for the country as was initially perceived by markets. With inflation falling and the Federal Reserve cutting rates, Banxico will ease further. Yet, it will likely cut rates slower than warranted by the economy. The longer the central bank takes to ease, the lower domestic bond yields will drop. Concerning sovereign credit, investors should remain overweight Mexico within an EM credit portfolio. Mexico’s fiscal position is healthier, and macroeconomic policies will be more prudent relative to what the market is currently pricing. We continue to believe concerns about Pemex’s financing and its impact on government debt are overblown, as we discussed in detail in our previous Special Report. In July, the government released an action plan for Pemex financing. We view this plan as marginally positive. To supplement this plan, the government can use the $14.5 billion federal budget stabilization fund to fill in financing shortfalls in the coming years. Importantly, the starting point of Mexican public debt is quite low, which will allow the government to finance Pemex in the years to come by borrowing more from markets. Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Lastly, our overweight recommendation in Mexican stocks has not played out. However, we are maintaining it for the following reasons: Chart II-6 illustrates that when Mexican domestic bond yields decline relative to EM ones (shown inverted on Chart II-6), Mexican share prices usually outperform their EM counterparts in common currency terms. Consistent with our view that Mexican local currency bonds will outperform their EM peers, we expect Mexican stocks to outpace the EM equity benchmark. The Mexican bourse’s relative performance against EM often swings with the relative performance of EM consumer staples versus the EM equity benchmark. This is due to the large share of consumer staples stocks in Mexico (34.5%) compared to that in the EM benchmark (7%). Consumer staples stocks are beginning to outpace the EM equity index, raising the odds of Mexican equity outperformance versus its EM peers (Chart II-7). Chart II-6Local Bond Yields And Relative Stocks: Mexico Versus EM Chart II-7Consumer Staples Have A Large Weight In Mexican Bourse We do not expect a major rally in this nation’s stock market given the negative growth outlook. Our bet is that Mexican share prices - having already deflated considerably - will drop less in dollar terms than the overall EM equity index. Bottom Line: We continue to recommend an overweight stance on Mexican sovereign credit, domestic bonds and equities relative to their respective EM benchmarks. The main risk to the Mexican peso stems from persisting selloff in EM currencies. Traders’ net long positions in the MXN are elevated posing non-trivial risk (Chart II-8). We have been long MXN versus ZAR but are taking profit today. This trade has generated a 9.7% gain since March 29, 2018. A plunging oil-gold ratio warrants a caution on this cross rate in the near term (Chart II-9). Chart II-8Investors Are Long MXN Chart II-9Take Profits On Long MXN / Short ZAR Trade Juan Egaña, Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Sovereign bond yields have cratered over the last few months, … : Over the last three months, 10-year yields in the U.S., France, Germany, Switzerland and Australia have fallen by 71, 64, 53, 54, and 67 basis points, respectively. … and the Treasury curve has experienced a significant bull flattening, … : Month-to-date total returns for the Barclays Bloomberg Long, Intermediate and 1-3-Year Treasury Indexes are 9.2%, 1.6% and 1.1%, respectively. … indicating that the bond market thinks more rate cuts are in store: The textbook interpretation of an inverted curve is that monetary policy is too tight and needs to be loosened, but technical factors have amplified the flattening pressure. Is the bond market reacting to weakening growth prospects, or uber-dovish central banks?: The answer has implications well beyond the fixed-income universe. It could mean the difference between an economic slowdown and a market melt-up. Feature BCA researchers convened last week for our monthly View Meeting, much of which was given over to the global decline in sovereign bond yields. Does their plunge owe more to weakening growth prospects or central banks’ synchronized dovish pivot? There have surely been elements of both; after all, central banks wouldn’t be so dovish if they weren’t concerned about the growth outlook. It is clear to our fixed-income strategists that the yield move has overshot the data, however, and they mainly attribute the overshoot to monetary policy. No central bank wants a stronger currency while confronting a demand deficiency aggravated by trade tensions and a global manufacturing slowdown. The New York Times Business section put the prevailing policy winds into living color in a nearly full-page, four-column graphic spotlighting the 32 central banks that have cut their policy rate so far this year.1 The pell-mell rush to cut rates is emblematic of a global scramble for competitiveness. No central bank wants its economy to be caught without a buffer while other economies are busily reinforcing theirs. The Message From The Bond Market Trade tensions are a legitimate threat to global economic growth already challenged by a downswing in the global manufacturing cycle. A recession is a possibility, but it is hardly a foregone conclusion. We agree with our fixed-income colleagues that the yield selloff has overrun the economic fundamentals. Last week’s preliminary European manufacturing PMIs suggested that manufacturing may finally be stabilizing, and there is still no evidence that the manufacturing downturn has infected the services sector (Chart 1). A recession is hardly a foregone conclusion. 10-year Treasury yields have been falling sharply since their 3.25% peak in early November, and the current leg down is the third in a series of sharp declines (Chart 2, top panel). Global sovereign yields have followed the same pattern (Chart 2, bottom panel), but the latest plunge is as much a reflection of ubiquitous easing biases as it is of new concerns about economic weakness. That may sound like a minor point, of interest only to macro specialists, but it has import for all investors. If the yield decline isn’t signaling new softness, then easier financial conditions will be free to act as a tailwind for risk assets. Chart 1Services Are Holding Up ... Chart 2A Brief Inversion ... But Yields Are Freefalling Neither investment-grade (Chart 3, top panel) nor high-yield corporate bond spreads evince any particular concern about the economy (Chart 3, bottom panel). Although they’ve ticked up, they remain near the bottom of their post-crisis range, and are nowhere near the levels they reached in 2011-12, during the federal budget showdown/U.S. downgrade and the flare-up of the Eurozone crisis, or in 2015-16, during the last manufacturing recession. With banks still easing lending standards for corporate and industrial borrowers (Chart 4), spreads won’t undergo a systematic widening. Borrowers do not default as long as there is a lender willing to roll over their maturing obligations, so tighter credit standards are a precondition for spread-widening cycles. Chart 3No Sign Of Stress Among Corporate Borrowers ... Chart 4... And Banks Aren't Applying Any Pressure The Message From The Housing Market Chart 5Lower Rates Have Yet To Impact Housing ... We have been disappointed by residential investment’s muted response to the significant year-to-date decline in mortgage rates (Chart 5, bottom panel). The trajectory of starts and permits (Chart 5, top panel) hasn’t changed, new and existing home sales haven’t perked up (Chart 5, second panel), and mortgage purchase applications (Chart 5, third panel) appear not to have heard the news that rates are much lower. We thought that the swift fall in mortgage rates would promote more residential investment than it has to date. There is a difference, however, between disappointing growth and a full-on contraction. With affordability remaining high relative to history (Chart 6), and apartment rents exceeding monthly mortgage payments in several locales (Chart 7), housing demand should remain well supported. There are no excesses in the housing market in terms of inventory or oncoming supply that would make housing a source of economic or financial instability. Inventory relative to the number of households is bumping around its all-time lows (Chart 8), and cumulative household formations have easily outstripped housing starts since the crisis broke (Chart 9). Structural factors like a lack of supply geared to first-time and first-move-up buyers, and the ravenous appetite of pools of capital purchasing single-family homes for rent, are squeezing out some would-be buyers, but housing is not about to induce a recession. There are plenty of things for investors to be concerned about, but the housing market isn’t one of them. Chart 6... Though They Have Placed Homeownership In Easier Reach Chart 8... Inventories Are At Record Lows, ... The View From Broad And Wall We concede that stocks are not behaving as if all is well. Big daily swings are not a feature of healthy markets, and eight of this month’s sixteen sessions have registered moves of at least 1%. The second quarter’s 3% year-over-year earnings growth is three percentage points better than the consensus expected when earnings season kicked off, however, and despite the single-day moves, the S&P 500 has spent all but the first day of the month in a well-defined range between 2,825 and 2,945 (Chart 10). The market may be jumpy from one day to the next, but investors have not been concerned enough to engage in sustained selling. The equity market’s verdict on housing is more optimistic than ours. Inspired by earnings reports, the S&P 1500 Homebuilders Index have broken out to a new 52-week high (Chart 11). Retailers were the stars of last week’s earnings releases, with Lowe’s, Nordstrom and Target posting double-digit percentage gains after reporting numbers that failed to live up to investors’ worst fears. Equities are validating the view that the U.S. consumer is alive and kicking. Chart 11Homebuilder Stocks Have Broken Out The GDP Outlook Chart 12Capex Intentions: Elevated But Slipping If consumers are well positioned, the U.S. economy should be, too. Consumption accounts for two-thirds of the U.S. economy, with investment and government spending equally dividing the other third. Federal expenditures amount to about 40% of government spending, and between this year’s fiscal thrust and next year’s hotly contested presidential election, D.C. can be counted upon to do its part for the economy. At the state and local level, healthy household income should support state sales and income tax receipts, while still-rising home prices will provide the property taxes to keep municipal coffers full. That leaves fixed asset investment as the economy’s Achilles heel. We are confident, as noted above, that residential investment will not decline enough to pose a problem for the economy, but corporate investment is in the crosshairs of the uncertainty surrounding the multiple trade squabbles. The NFIB survey and the regional Fed surveys indicate that capital expenditure plans are rolling over, even if they remain at a fairly high level (Chart 12). Our base case remains that investment will not fall enough to offset robust consumption and trend-level government spending, but a marked worsening in trade tensions could erode business confidence enough to drag the economy below stall speed. Busted Thesis In our mutual-fund days, we followed one rule without exception. If our thesis for owning a stock was disproved, we got rid of the stock without a backward glance. We no longer manage money, but our clients do, and we try to set a good example, especially in the inevitable instances when things go wrong. We are closing out our agency mREIT recommendation on the ground that we got the rates call underpinning it very wrong. Things went wrong with our agency mortgage REIT recommendation right from the get-go. In retrospect, we should have waited until the FOMC meeting dust settled before putting on a curve-dependent position. We are closing it out now, though, because we recommended the group in anticipation of a steeper yield curve. Given that we think it will take some time for investors to become convinced that a recession is not imminent, and given that mechanical factors may push yields even lower, we do not expect sustained curve steepening for several months. Although we only held it for four weeks, the recommendation left a mark. Through Thursday’s close, our defined subset of agency mREITs lost 11%, while the S&P 500 is down 3.1% and the Barclays High Yield Index is flat. We’re taking our medicine and moving on, but we will take another look at the group when the curve eventually does begin to steepen. Investment Implications Even if recession fears are overblown, as we and a majority of our colleagues believe, it will likely take some time for investors to overcome their concerns. That leads us to believe that equities may be unable to make new highs in the near term, and that Treasury yields have more downside risk than upside risk in the next few months, as rising convexity2 compels investors following asset-liability management strategies to seek out long-maturity bonds. The yield point may sound complex and esoteric, but our Global Fixed Income Strategy team increasingly believes it’s a key to understanding the negative-yield phenomenon and is researching the issue for an upcoming Special Report. Monetary accommodation is not a silver bullet. If the economy has already flipped from expansion to contraction, modest rate cuts parceled out at a deliberate pace will be insufficient to turn things around, and equities and spread product will suffer. If the expansion remains intact, however, rate cuts will help shore up the economy at the margin and quite possibly fuel a new phase of the bull markets in risk assets. Our money is on the latter, and we expect that this bull cycle has one more burst in it that will allow it to sprint to the finish line like the majority of its predecessors. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Smialek, Jeanna and Russell, Karl, “Rates Are Falling Again. That May Be Dangerous.” New York Times, August 17, 2019, p. B1. 2 Duration measures a bond’s sensitivity to changes in interest rates. Convexity measures duration’s sensitivity to changes in interest rates, which increases as rates fall. Investors like life insurers and pension funds, who match the duration of their investment portfolios with the duration of their liabilities, are forced to increase the duration of their bond holdings at an increasing rate as interest rates fall.
Analyses on the Philippines, Colombia and Argentina are available below. Highlights Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, U.S. bonds are overbought and technical factors might exert upward pressure on them in the near term. Our ubiquitous premise remains that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. There are no signs of investor capitulation that mark a major bottom in EM risk assets. Feature Given the recent plunge in bond yields around the world, we are devoting this week’s report to discussing the implications of low U.S. bond yields on EM risk assets. Our key takeaway is that lower U.S. bond yields are not a reason to be long EM risk assets and currencies. Low Bond Yields: Reflective Or Stimulative? With respect to ultra-low bond yield, investors and commentators generally subscribe to one of the following two arguments: Bond yields are reflective – i.e. they are indicative of an upcoming economic calamity and thereby signal a bearish outlook for equity and credit markets; The current low levels of bond yields signify a dovish monetary policy stance and hence are bullish for global risk assets. In our opinion, it is not a certainty that the bond market always has perfect foresight of the economic outlook. At the same time, falling global bond yields and easing central banks do not automatically ensure a pickup in global economic activity. Hence, low bond yields do not justify a bullish stance on global stocks and credit markets. Like any other financial market, bonds are driven by time-varying forces. In certain times, bond yields signal a correct trajectory for growth, inflation and monetary policy. At other times, bond prices are driven by investor sentiment and momentum-chasing trading strategies. In times where the latter is occurring, the bond market can send the wrong signal on growth and inflation, as well as misprice the future path of interest rates. U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing. Presently, we have the following observations and reflections on U.S. bond yields: U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing. However, this does not imply that U.S. bond yields will be a reliable leading indicator at the bottom of this business cycle. The basis is that U.S. bond yields did not lead at the top of the cycle. On the contrary, U.S. bond yields lagged the global business cycles by a considerable margin in both 2015-‘16 and in 2018-’19, when the growth slowdown emanated from China/EM. Chart I-1 illustrates that Chinese nominal manufacturing output and import volume growth rolled over in December 2017, yet U.S. bond yields rolled over in October 2018. In recent years, U.S. bond yields have also lagged the global manufacturing PMI index by about six to nine months (Chart I-2, top panel). Chart I-1China’s Business Cycle Led U.S. Bond Yields Chart I-2Global Manufacturing And EM Stocks Led U.S. Bond Yields Remarkably, EM financial markets have been leading U.S. bond yields in recent years, not the other way around (Chart I-2, bottom panel). For some time we have held the view that the ongoing growth slump in China would culminate into a global manufacturing and trade recession that would be negative for the rest of the world, especially for EM, Japan, commodities producers, and Germany. This theme has been the main reason for our negative view on global stocks, especially cyclicals, as well as our positive stance on safe-haven bonds and bullish view on the dollar. Understanding the origins of this global manufacturing and trade downtrend is critical to gauging the evolution of the business cycle. China is the epicenter of this global trade and manufacturing recession. In turn, the root cause of the mainland’s growth slump is money/credit tightening that has occurred in China in both 2017 and early 2018. Money and credit growth remain lackluster in the Middle Kingdom, despite ongoing fiscal and monetary policy easing (Chart I-3). Notably, domestic credit growth and its impulse have been muted, especially when issuance of government bonds is excluded (Chart I-4). The aggregate credit and fiscal stimulus have so far been insufficient to engineer a recovery. Chart I-3China: Fiscal Deficit And Broad Money Growth Chart I-4China: Private Sector Credit Growth Is Weak Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. U.S. domestic demand has not been the source of the ongoing global manufacturing and trade recession. U.S. final domestic demand was robust until Q4 2018 and has so far downshifted only modestly (Chart I-5, top panel). Corroborating this, U.S. manufacturing was the last shoe to drop in the global manufacturing recession (Chart I-5, bottom panel). Accordingly, the Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. It follows that lower U.S. interest rates might not be essential to instigate a global economic recovery. Critically, the latest plunge in EM currencies and widening in EM credit spreads has occurred amid falling U.S. bond yields and Fed easing. Chart I-5U.S. Economy And Bond Yields Have Lagged In This Cycle Chart I-6U.S. Bond Yields And EM: No Stable Correlation We have long argued against the consensus view that EM equities, credit markets and currencies are much more sensitive to U.S. interest rates than to the global business cycle. Chart I-6 reveals that there has been no stable correlation between U.S. bond yields and EM credit spreads and currencies. Therefore, a bottom in EM currencies and risk assets will occur when global trade and Chinese demand ameliorate rather than as a result of Fed policy. An important question is whether low bond yields are going to support global share prices. Our hunch is that it is not likely.1 First, if U.S. bond yields had not dropped by as much as they have, global equity prices would be lower. In short, reduced long-term interest rate expectations have led investors to pay higher multiples, especially for non-cyclical and growth stocks. The U.S. equity rally since early this year has been due to multiples expansion, especially among non-cyclical and growth stocks. Chart I-7Global Ex-U.S. Share Prices: No Bull Market Here The latter has allowed the S&P 500 to reach new highs recently at a time when global ex-U.S. share prices are not far from their December lows (Chart I-7). Second, falling interest rates are positive for share prices when profits are growing, even if at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Going forward, U.S. equities remain at risk due to a potential profit contraction. We do not foresee a recession in U.S. household spending. However, America’s corporate earnings will be under pressure from a stronger dollar and shrinking profit margins due to rising unit labor costs (Chart I-8), notwithstanding the manufacturing recession that is taking hold. Chart I-8U.S. Corporate Profits Are At Risk From Margins One popular narrative attributes exceptionally low bond yields to excess savings over investments. Yet this is not always accurate. Box I-1 below explains why bond yields have little relation to savings and investments in any economy. Chart I-9U.S. Bonds Are High-Yielders Among DM Finally, some investors wonder if the low/negative bond yields in DM ex-U.S. could push U.S. Treasury yields lower. Our take is that it is possible. The spread of U.S. Treasury yields over DM ex-U.S. is very wide, which could entice foreign fixed-income investors to purchase Uncle Sam’s bonds (Chart I-9). What is preventing foreign fixed-income investors from piling into Treasuries is exchange rate risk. If for whatever reason a consensus emerges among global fixed-income investors that the greenback is not going to depreciate in the next 12-18 months, there could be a stampede of foreign investors into U.S. Treasuries, pushing yields considerably lower. In our opinion, the odds are that the broad trade-weighted dollar will stay firm for now and could make new cycle highs. In such a scenario, investor expectations of U.S. currency depreciation will diminish. This could trigger a stampede of foreign fixed-income investors into U.S. bonds. This is not a forecast but a consideration that bond investors should take into account. Bottom Line: Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, bonds are overbought and technical factors discussed in Box I-1 below might exert upward pressure on U.S. bond yields in the near term. Implications For EM We explore three scenarios for the direction of U.S. bond yields in the coming weeks and months and the corresponding potential dynamics for EM risk assets and currencies. Scenario 1: U.S. bond yields continue to fall as the global trade and manufacturing recession endures, suppressing global growth. Outcome: EM currencies will depreciate and EM risk assets will suffer more. Scenario 2: U.S. Treasury yields increase because U.S. domestic demand firms up, even if the global trade contraction persists. Outcome: EM currencies will weaken and EM risk assets will sell off further. Scenario 3: U.S. bond yields rise because the global manufacturing recession abates and a recovery in China leads to a global trade revival. Outcome: EM currencies will appreciate and risk assets will rally considerably. Please note that Scenario 3 is not our baseline scenario. The ubiquitous premise in these deliberations is that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. Chart I-10Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy To capitalize on our view of weaker global growth emanating from China/EM, we have been recommending the following strategy: short EM stocks / long U.S. 30-year Treasuries. This recommendation has panned out nicely, delivering a 21.5% gain since its initiation on April 10, 2017 (Chart I-10). Barring Scenario 3 above, this trade has more upside. EM Financial Markets: No Capitulation So Far Major bottoms in financial markets typically occur after investor capitulation has already taken place. Having reviewed various financial market variables, we conclude that signposts of capitulation in EM risk assets and global equities are absent: The S&P 500 SKEW index is very low. This index reflects the probability that investors are assigning to downside risk in share prices. The SKEW index is currently at one of its lowest readings of the past 30 years (since its existence), which suggests that investors are not hedging themselves against large price swings (Chart I-11). This usually occurs prior to a heightened period of volatility. Chart I-11Are U.S. Equity Investors Complacent? The volatility measures for EM and commodity currencies are still very subdued (Chart I-12). The same is true for EM equity volatility (Chart I-12, bottom panel). Even though EM and commodities currencies as well as EM share prices have fallen substantially, the price of buying insurance is still low – meaning investors are still not particularly worried. This habitually is a sign of complacency. Chart I-12Cyclical Risk Markets: Implied Volatility Remains Low Chart I-13No Capitulation Among EM Equity And Currency Investors Finally, Chart I-13 shows that asset managers’ and leveraged funds’ net long positions in EM equity index futures and high-beta liquid currencies futures were still elevated as of August 15. Bottom Line: There are no signs of investor capitulation that often mark a major bottom in risk assets. BOX 1 Do Bond Yields Equilibrate Savings And Investment? Mainstream economic theory regards bond yields as the interest rate that balances desired savings and desired investment. According to mainstream theory, when desired savings rise relative to desired investment, bond yields drop. The latter induces less savings and more investment equilibrating the system. Conversely, when desired investment increases relative to desired savings, bond yields climb, discouraging investment and incentivizing more savings. The fundamental shortcoming of this economic model stems from the misrepresentation of banking. When a commercial bank buys any security from a non-bank, it originates a new deposit “out of thin air.” The bank does not allocate someone’s deposit into bonds. Diagram I-1 below exhibits this point. When a U.S. bank purchases a dollar-denominated bond from a pension fund, it does not use someone’s deposit to do so. Rather, a new deposit in the U.S. banking system (often at another bank) is created “out of thin air” as a result of the transaction. The amount of bonds commercial banks can purchase is limited only by regulatory norms, liquidity provision by the central bank as well as its management’s willingness to do so. Nobody needs to save for a bank to buy a bond or make a loan. We have written in past reports on money, credit and savings that deposits in the banking system have no relationship with national or household savings. When an individual or company saves, the amount of deposits in the banking system does not change. All in all, banks do not intermediate savings/deposits into credit/loans. They create new deposits “out of thin air” when they originate a loan to or buy any security from a non-bank. Provided that banks do not utilize national savings or existing deposits to acquire bonds, fluctuations in bond yields do not reflect changes in national savings. Holding everything else constant, bond yields could drop if commercial banks buy bonds en masse. The opposite also holds true. Chart I-14 demonstrates that U.S. commercial banks have been augmenting their purchases of various types of bonds. This partially explains why bond yields have plunged (bond yields shown inverted on this chart). If U.S. banks’ bonds purchases mean revert, as they often do, U.S. bond yields could rise. Chart I-14Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? This along with more bond issuance by the U.S. Treasury to refill its Treasury’s General Account at the Fed as well as the existing overbought conditions in government bonds could produce a pick-up in yields. Such a rebound in bond yields would be technical and would not signal fundamental changes in the U.S. or global business cycles, or in the savings-investment balance. Closing Some Positions Long Latin American / short emerging Asian equity indexes. This position has generated a 6% loss since its initiation on October 11, 2018 and we have low confidence that it will generate positive returns going forward. Long Chinese small cap / short EM small-cap stocks. Our bet has been that Chinese private sector companies trading in Hong Kong and represented in the MSCI small-cap index will perform better than the average EM small cap. This strategy has not worked out and has produced a 4.4% loss since its recommendation on November 20, 2013. We are downgrading Colombian equities from neutral to underweight. Please refer to pages 17-20 for a detailed analysis. Instead, we are upgrading the Peruvian bourse from underweight to a neutral allocation within an EM equity portfolio. Our view remains that gold prices will continue outperforming oil.2 Peru benefits from higher gold and silver prices while Colombia is largely an oil play. Consistently, the Peruvian currency will depreciate less than the Colombian peso. These justify this allocation shift between these two bourses. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Philippines: The Currency Holds The Key Government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Chart II-1Philippine Current Account Deficit Funded By Volatile Portfolio Flows Declining U.S. interest rates coupled with slumping oil prices have supported Philippine financial markets. However, the country’s balance of payments dynamics are still precarious. In particular, Philippine’s wide current account (CA) deficit will need to be funded by volatile foreign portfolio inflows as the basic balance – the sum of CA balance and net FDI – has turned negative (Chart II-1). Critically, the already wide current account deficit is set to balloon even further: First, the 2019 fiscal spending was back-loaded because a Congress impasse delayed the government budget approval to April. Hence, government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Higher infrastructure spending will drive imports of capital goods higher (Chart II-2). The latter accounts for 32% of total imports. Second, Philippine export growth is likely to contract anew as global trade is not recovering (Chart II-3). Chart II-2Philippine Government Infra Spending Will Accelerate Chart II-3Philippine Exports Will Contract We continue to expect broad portfolio capital outflows from EM. Potential for foreign outflows from the Philippines is large. Foreign ownership of local equities is high at 42%. As to foreign ownership of local currency bonds, it stands at around 13%. A renewed decline in the peso will drive away portfolio flows reinforcing additional currency depreciation. The falling peso will prevent the central bank from reducing interest rates further. Even if the central bank does not hike rates to support the peso, market-driven local rates could rise for a period of time. This is bad news for property stocks – which account for about 27% of the MSCI Philippines index. Having rallied considerably, they are at major risk as local interest rates rise. In addition, these stocks have benefited from strong real estate demand emanating from the Philippine Offshore Gaming Operators (POGO) sector – which itself has been largely driven by Chinese capital flows. Both the Chinese and Philippine authorities have begun cracking down fiercely on these operations because they are link to capital flight out of China. This crackdown will curtail capital flows into these areas and depress revenues of Philippine real estate companies. This will occur at a time when the residential market is experiencing weak demand. We continue to recommend shorting/underweighting property stocks. Finally, small cap stocks are in a bear market and are sending an ominous signal (Chart II-4). Furthermore, this bourse is neither attractive in absolute terms nor relative to EM (Chart II-5). Chart II-4Small-Cap Stocks Are In A Bear Market Chart II-5Philippine Equities Are Expensive Bottom Line: We continue recommending to short the Philippine peso against the U.S. dollar. Overall, EM dedicated investors should continue underweighting the Philippine equity, fixed income and sovereign credit markets within their respective EM universes. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Colombia: A Top In The Business Cycle? Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. Falling oil prices and fiscal tightening will cause the Colombian economy to slow down in the next 12 months. What’s more, a depreciating peso and sticky inflation will prevent the central bank (Banrep) from frontloading rate cuts to mitigate the downtrend. The Colombian peso is making new cyclical lows and more weakness is in the cards. While the currency is slightly cheap according to the real effective exchange rate based on unit labor costs (Chart III-1), our negative view on oil prices entails further currency depreciation. Colombia is still very heavily reliant on oil exports – the current account deficit is 4.3% of GDP with oil, but 8.4% excluding it (Chart III-2). Moreover, a chunk of FDIs are destined for the energy sector, and foreign portfolio flows are contingent on exchange rate stability. Therefore, falling oil prices and a weaker peso will result in diminishing FDIs and foreign portfolio flows, reinforcing downward pressure on the currency. Chart III-1The Colombian Peso Is Not That Cheap Chart III-2Current Account Deficit Is Large And Widening Notably, there is a significant pass-through effect from the currency to inflation (Chart III-3). Even though Banrep does not target the exchange rate, having both headline and core inflation above the 3% central target will constrict it from cutting interest rates soon. On the whole, odds are that Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. The yield curve is signaling an economic slowdown ahead (Chart III-4). Chart III_3The Exchange Rate And Inflation Chart III-4Domestic Demand Is About To Roll Over Our credit and fiscal spending impulse might be peaking, signifying a top in domestic demand growth (Chart III-5). The impulse is rolling over primarily due to the substantial fiscal tightening. Duque’s administration has slashed expenditures and the latter are contracting in inflation-adjusted terms (Chart III-6). Chart III-5A Top In The Business Cycle? Chart III-6Severe Fiscal Tightening Government revenues are highly dependent on oil exports, and the recent fall in oil prices will bring about a contraction in fiscal revenues. This, and the government’s strong adherence to fiscal surplus, implies no loosening up on the fiscal side. Finally, our proxy for marginal propensity to spend for businesses and households is indicating that growth is about to roll over (Chart III-7). Auto sales are also weakening, and housing sales are contracting (Chart III-8). Chart III-7The Business Cycle Is Peaking Chart III-8Colombia: Certain Segments Have Turned Over Given that both fiscal and monetary policies are unlikely to be relaxed soon, the peso will come under renewed selling pressure, acting as a release valve for the Colombian economy. Investment Recommendations We are downgrading this bourse from neutral to an underweight allocation within a dedicated EM equity portfolio. In its place, we are upgrading Peruvian stocks from underweight to neutral. Continue shorting COP versus RUB. This trade has generated a 14% return since its initiation on May 31st of last year. Finally, within EM local currency bond and sovereign credit portfolios, Colombia warrants a neutral allocation. We also recommend fixed-income investors continue to bet on further yield curve flattening: receive 10-year / pay 1-year swap rates. Juan Egaña, Research Associate juane@bcaresearch.com Argentina: Do Not Catch A Falling Knife The latest rout in Argentine markets has brought fears of another sovereign debt default or restructuring. Are conditions right for buying Argentine markets? Politics complicate the assessment of a debt restructuring and we do not recommend bottom fishing in Argentine financial markets. Looking at the profile of past financial crises and debt defaults, there might be more downside in Argentine asset prices. Sovereign U.S. dollar bond prices remain well above their 2002 and 2008 lows (Chart IV-1). Compared with previous EM financial crises, Argentine stocks might still have considerable downside in U.S. dollar terms (Chart IV-2). Chart IV-1Things Could Get Worse Chart IV-2Historical Patterns Suggest More Downside In Bank Stocks The equity market index has relapsed below its 2018 lows in dollar terms, which technically qualifies as a breakdown and entails fresh lows ahead (Chart IV-3). Chart IV-3A Technical Breakdown In Argentine Equities In addition to political uncertainty and rising possibility of a left-wing run government, the nation’s ability to service its foreign currency debt has deteriorated with the currency plunging to new lows. Specifically, the country has large foreign debts of $275 billion. Foreign obligation payments in the next 12 months are about $40 billion. The government lacks foreign currency reserves and export revenues necessary to service its external debt. The central bank’s net foreign exchange reserves (excluding FX swaps and gold) are about $17 billion. The country’s annual exports are $77.5 billion. With agricultural commodities prices falling, exports will likely shrink. By and large, our downbeat stance from April remains intact. Bottom Line: Investors should continue avoiding and underweighting Argentine financial markets. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes 1 Please note this is the view of BCA’s Emerging Markets Strategy service and is different from BCA’s house view. Clients can read the debate between various BCA strategists in the report What Goes On Between Those Walls? BCA’s Diverging Views In The Open. Please click on the link to access it. 2 We recommended the long gold / short copper and oil trade on July 11, 2019 and this position remains intact. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations
Hard-to-predict policy risks and trade-war uncertainty will continue to hinder oil-demand growth, as will USD strength. The cost of oil in local-currency terms remains close to highs not seen since Brent and WTI traded above $100/bbl in 2014 in key EM economies, which partly explains the fall-off in demand begun in 2H18 that carried into 1H19 (Chart of the Week). We continue to expect oil demand to revive on the back of global fiscal and monetary stimulus, which, along with continued production discipline by OPEC 2.0 and capital discipline by U.S. shale producers, keeps our 2020 Brent forecast at $75/bbl. For 2019, however, our Brent forecast falls to $66/bbl from $70/bbl, following a re-basing of estimated demand in 2017-18 to bring it in line with lower historical data, and the lingering impact of a stronger USD.1 We also are revising our WTI expectation, as markets price in the last bits of ~ 2mm b/d of new pipeline takeaway capacity coming online in the Permian Basin. For 2019, we expect WTI to trade $6.50/bbl under Brent, and $4/bbl under next year, vs. $7/bbl and $5/bbl we expected last month. Chart of the WeekUSD Strength Hinders Oil-Demand Rebound Highlights Energy: Overweight. Distillate fuel accounted for 29.6% of the product derived from refining crude oil in the U.S. during July, a record for the month, according to the Energy Information Administration (EIA). Refiners are gearing up for the global change-over to low-sulfur marine fuels ahead of the January 1, 2020, implementation of IMO 2020. Base Metals: Neutral. Increased infrastructure spending will add ~ $2 billion (14 billion RMB) to China’s total infrastructure spending of 524 billion RMB, according to a Fastmarkets MB analyst survey. Copper usage is expected to increase as 2H19 grid spending picks up. Precious Metals: Neutral. Gold and silver continue to mark time close to recent highs. USD strength could slow the metals’ rally. We remain long both metals as portfolio hedges. Ags/Softs: Underweight. This week’s USDA’s Crop Progress report showed 56% of the corn crop was in good or excellent condition, vs. 68% in 2018. For beans, 53% of the crop is in good or excellent condition, vs. 65% last year. Feature We expect global fiscal and monetary stimulus to lift demand in EM economies, which will be visible over the balance of this year and next. In this month’s assessment of supply-demand balances, we are lowering our 2019 Brent forecast to $66/bbl from $70/bbl, after re-basing our demand estimates so that they are more in line with EIA’s historical data (Chart 2). We lowered our historical demand estimates up to and including 2017, in line with the EIA data. This reduces the base level for 2018-20 demand. As a result, the level of our 2018 demand is down by 200k b/d to 100.1mm b/d, vs. last month’s estimate, and the level of our 2019 and 2020 demand estimates is down by 250k b/d to 101.3mm b/d and to 102.8mm b/d. The adjustments are mainly due to the revision of historical level of demand in 2017-2018. In addition, we lowered our growth estimate for 2019 slightly to 1.2mm b/d from 1.25mm b/d last month, but kept our 2020 growth rate expectation at 1.5mm b/d. Chart 2Lower 2019 Demand Estimate, Price; Keeping 2020 Unchanged As noted above, we expect global fiscal and monetary stimulus to lift demand in EM economies, which will be visible over the balance of this year and next. Continued production discipline by OPEC 2.0 and capital discipline by U.S. shale producers leaves our 2020 Brent forecast unchanged at $75/bbl. In addition, this combination of stronger demand and tighter supply will create a physical supply deficit (Chart 3). This deficit will force inventories lower, which remains OPEC 2.0’s paramount goal, and backwardate the Brent and WTI forward curves (Chart 4). Chart 3Stronger Demand, Tighter Supply Produces Physical Deficit Chart 4Inventory Draws Will Resume For WTI, we now expect it to trade $6.50/bbl under Brent in 2019 and $4/bbl under in 2020, vs. the $7/bbl and $5/bbl differentials we expected last month. This narrowing of the differential comes on the back of the build-out of takeaway pipeline capacity in the Permian Basin, which amounts to ~ 2mm b/d by the end of this year. The expansion of deep-water harbor capacity in the U.S. Gulf is being delayed by regulatory action, which means the Brent vs. WTI differential will not significantly contract further until later in 2020 or 2021 when we expect crude-oil export volumes to pick up sharply. Over the course of the coming year, we do expect exports to pick up before 2021, as they have done in 2018-2019. This trend likely continues. We calculated there is ~ 4.5 mm b/d of current export capacity in the Gulf, therefore exports still can increase before being fully constrained. In addition, small capacity expansion projects already are under construction, which will lift capacity next year. That said, any delays could pressure differentials (LLS-Brent, WTI-Brent). But, as long as shale-oil production keeps increasing and foreign demand remains strong, exports can increase – likely at a slower pace – while differentials hold around the $4/bbl level next year. Digging Into The Oil Demand Slow-Down This was a stealthy USD rally, overshadowed by the Sino-U.S. trade war, and exogenous foreign-policy shocks re U.S. Venezuela and Iran policy. For 2019, a grouping of negative demand-side effects have proven to be quite strong – uncertainty spawned by the Sino-U.S. trade-war, tightening financial conditions globally, and the strong USD. Over the past year, these effects have combined to lower actual demand, and forced us to lower our growth expectation for this year for a fourth time to 1.2mm b/d. In hindsight, it is apparent the strong USD has affected EM demand by raising the local-currency cost of oil in particular over the past year to levels not seen since crude was trading above $100/bbl in 2014 (Charts 5A and 5B). Chart 5AAs USD Strengthened Local-Currency Costs Skyrocketed Chart 5BAs USD Strengthened Local-Currency Costs Skyrocketed This was a stealthy USD rally, overshadowed by the Sino-U.S. trade war, and exogenous foreign-policy shocks re U.S. Venezuela and Iran policy. In addition to raising the cost of commodities priced in USD, in local-currency terms, the stronger dollar lowered the cost of producing commodities for countries like Russia, whose currencies are not pegged to the USD. So, in one fell swoop, USD strength lowered demand via higher prices, and increased supply via lower costs of production. In addition, weaker local currencies catalyze capital outflow, which reduces the supply of savings available to EM economies for investment. At the margin, this also stunts income growth.2 The effects of USD strength could persist, and continue to have a deleterious influence on oil demand into next year, given the way in which monetary policy – and its effects on FX rates – can act with “long and variable lags.” Our BCA Commodity-Demand Nowcasting model continues to point toward a revival of demand as EM economic growth picks up (Chart 6).3 Given the dollar is a counter-cyclical currency vis-à-vis the rest of the world, we expect this will weaken the USD and be supportive of commodity prices. Chart 6BCA Commodity-Demand Nowcast Remains Upbeat Chart 7Expect Further Backwardation In Crude Oil Forward Curves Higher oil demand and lower supply likely will further backwardate Brent and WTI forward curves, which will diminish the impact of the USD’s strength (Chart 7), and lead to higher volatility, as fundamentals once again dominate price formation (Chart 8). Still, the effects of USD strength could persist, and continue to have a deleterious influence on oil demand into next year, given the way in which monetary policy – and its effects on FX rates – can act with “long and variable lags," to borrow Milton Friedman's well-turned phrase.4 We will monitor this risk closely, and will be offering further research into it. Supply Concerns Persist E&P companies are using their accumulated inventory of excess Drilled-but-Uncompleted (DUC) wells to reach their production targets, while controlling capital expenditures (i.e. flat/lower rig count). We continue to expect OPEC 2.0 to manage production, and to keep a laser focus on reducing inventories. The producer coalition continues to get a huge assist in this effort from the U.S. sanctions against Iran, which, according to the American Secretary of State Mike Pompeo have taken almost all of that country’s oil exports – some 2.7mm b/d – out of the market (Chart 9).5 In our balances estimates, we show OPEC producing 29.8mm b/d of crude oil on average this year, and 29.7mm b/d next year. This is down sharply from the 32mm b/d we estimate the Cartel produced last year, which included a surge in 2H18 undertaken in response to pressure from the U.S. to build inventories ahead of oil-export sanctions being re-imposed against Iran (Table 1). Given the lower demand estimate OPEC is forecasting for this year and next – 99.9mm b/d, and 101.1mm b/d this year and next – we expect OPEC’s leader, KSA, to keep production closer to 10mm b/d vs. its 10.33mm b/d quota. We expect the other putative leader of OPEC 2.0, Russia, to produce 11.43mm b/d and 11.41mm b/d this year and next, versus 11.4mm b/d last year. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Once again, U.S. shale-oil output provides the largest increase in supply globally. That said, shale-oil producers are being forced to temper production growth, as investors’ demand higher profits or greater return of capital. We revised down our U.S. shale production growth to 8.2mm b/d in 2019 and 9.1mm b/d in 2020 (Chart 10). In 2018, we estimated U.S. shale production at 7.2mm b/d. Chart 10Shale Output Reduced Slightly Lower-than-expected WTI prices and capital discipline will limit U.S. shale production growth this year, and temper it next year. E&P companies are using their accumulated inventory of excess Drilled-but-Uncompleted (DUC) wells to reach their production targets, while controlling capital expenditures (i.e. flat/lower rig count).6 Year to date, DUC completions increased in the Big Five tight-oil basins, overtaking new wells drilled (Chart 11).7 However, the Permian’s excess DUC inventory increased in July despite the ongoing pipeline capacity expansion and falling rig count. The Permian’s completion rate will be important to monitor. At current oil prices, producers need to tap into their excess DUC inventories to reach both their free-cash-flow and production goals. Bottom Line: We are reducing our Brent price forecast for 2019 to $66/bbl, on the back of weaker demand. Our forecast for 2020 remains unchanged at $75/bbl. Our expectations are driven by our expectation fiscal and monetary stimulus to lift commodity demand – oil in particular – and that production discipline by OPEC 2.0 and capital discipline from U.S. shale-oil producers will tighten markets and lift prices from here. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 OPEC 2.0 is the name we coined for the producer coalition formed in late 2016 by the Kingdom of Saudi Arabia (KSA) and Russia. The producer coalition’s mission was – and remains – managing global supply so as to reduce inventories. We expect OPEC 2.0 production to be at or below quota levels agreed December 7, 2018, when KSA and Russia and their respective allies set about once again to drain global inventories of the 62-million-barrel overhang that resulted from the production ramp-up undertaken in response to demands from U.S. President Donald Trump. 2 The International Energy Agency (IEA) noted that, on the back of higher prices last year, oil once again was “the most heavily subsidized” energy source, expanding its share of the $400 billion provided consumers by their governments to 40%. Please see Commentary: Fossil fuel consumption subsidies bounced back strongly in 2018, published by the IEA June 13, 2019. 3 For a description of our nowcast model, please see Just In Time For Christmas! U.S. Tariff Delay Rocks Oil published last week by BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. We noted last week that our expectation of stronger EM growth and a weaker USD is contrary to the view of BCA Research’s Emerging Markets Strategy, which expects continued weakness in EM GDP growth. Moreover, as mentioned in last week's report, our nowcast’s last data point was observed in July, which is before the latest escalation in trade tensions. We could see a move down in some of the indicators used as input in our nowcast model in the coming month. 4 Friedman, the 1976 Nobel Laureate in Economics, noted monetary policy operates with long and varying lags, which makes it difficult to be precise as to when its effects will be noticed in the macroeconomy. Please see Milton Friedman’s article, “The Lag in Effect of Monetary Policy,” Journal of Political Economy Vol. 69, No. 5 (Oct., 1961), pp. 447-466. 5 To date, OPEC and non-OPEC producers have had no apparent trouble replacing lost Iranian and Venezuelan barrels taken off the market as a result of U.S. sanctions. This indicates spare capacity remains sufficient to meet short-term supply disruptions and unplanned outages. Please see U.S. removed almost 2.7 million barrels of Iranian oil from market - Pompeo, published by uk.reuters.com August 20, 2019. 6 The process of drilling and completing wells produces a normal inventory of uncompleted wells, because of the time lag between the moment wells are drilled and the time they are completed. The development of multi-well pad drilling in U.S. shales structurally increased the time lag between drilling and completion to ~ 5 months. This implies a normal level of DUC inventory that corresponds to ~ 5 - 6 months’ worth of drilling activity. We define any DUC above our estimate of normal as an excess DUC well. On average, completion accounts for ~ 65% of the total well costs. 7 The Big Five shale basins are the Permian; the Eagle Ford; Niobrara; the Bakken, and the Anadarko. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades