Precious Metals
The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Recommended Allocation Global growth will rebound later this year, fueled by an end of lockdowns and generous fiscal stimulus. Despite that, central banks will not move towards tightening until 2023 at the earliest. This remains a very positive environment for risk assets like equities, though the upside is inevitably limited given stretched valuations. We continue to recommend a risk-on position, with overweights in equities and higher-risk corporate bonds. It is unlikely that long-term rates will rise much further over the coming months. But there is a risk that they could, and so we become more wary on interest-sensitive assets. Accordingly, we cut our overweight on the IT sector to neutral, and go overweight Financials. We continue to prefer cyclical sectors, and stay overweight Industrials and Energy. Chinese growth is slowing and so we cut our recommendation on Chinese equities to underweight. Some Emerging Markets will suffer from tighter US financial conditions, so we would be selective in our positions in both EM equity and debt. We stay firmly underweight government bonds, and recommend an underweight on duration, and favor linkers. Within alternatives, we raise Private Equity to overweight. The return to normality will give PE funds a wider range of opportunities, and allow them to pick up distressed assets at attractive valuations. Overview What Higher Rates Mean For Asset Allocation The past few months have seen a sharp rise in long-term interest rates everywhere (Chart 1). These have reflected better growth prospects, but also a greater appreciation of the risk of inflation over the next few years (Chart 2). Our main message in this Quarterly Portfolio Outlook is that we do not expect long-term rates to rise much further over the coming months, but that there is a risk that they could. This would be unlikely to undermine the positive case for risk assets overall, but it would affect asset allocation towards interest-rate sensitive assets such as growth stocks and Emerging Markets, and could have an impact on the US dollar. Chart 1Rates Are Rising Everywhere Chart 2...Because Of Both Growth And Inflation Expectations We accordingly keep our recommendation for an overweight on equities and riskier corporate credit on the 12-month investment horizon, but are tweaking some of our other allocation recommendations. The macro environment for the rest of the year continues to look favorable. Pent-up consumer demand will be released once lockdowns end. In the US, this should be mid-July by when, at the current rate, the US will have vaccinated enough people to achieve herd immunity (Chart 3). Excess household savings in the major developed economies have reached almost $3 trillion (Chart 4). At least a part of that will be spent when consumers can go out for entertainment and travel again. Chart 3US On Track To Hit Herd Immunity By July Chart 4Global Excess Savings Total Trillion Fiscal stimulus remains generous, especially in the US after the passing of the $1.9 trillion package in March (with another $2 trillion dedicated towards infrastructure spending likely to be approved within the next six months). The OECD estimates that the recent US stimulus alone will boost US GDP growth by almost 3 percentage points in the first full year and have a significant knock-on effect on other economies (Chart 5). Central banks, too, remain wary of the uneven and fragile nature of the recovery and so will not move towards tightening in the next 12 months. The Fed is not signalling a rate hike before 2024 – and it is likely to be the first major central bank to raise rates. In this environment, it is not surprising that long-term rates have risen. We showed in March’s Monthly Portfolio Update that, since 1990, equities have almost always performed strongly when rates are rising. This is likely to continue unless there is either (1) an inflation scare, or (2) the Fed turns more hawkish than the market believes is appropriate. Inflation could spike temporarily over the coming months, which might spook markets (see What Our Clients Are Asking on page 9 for more discussion of this). But sustained inflation is improbable until the labor market recovers to a level where significant wage increases come through (Chart 6). This is unlikely before 2023 at the earliest. Chart 5US Fiscal Stimulus Will Help Everyone Chart 6Labor Market Still Well Away From Full Employment BCA Research’s fixed-income strategists do not see the US 10-year Treasury yield rising much above 1.8% this year.1 Inflation expectations should settle down around the current level (shown in Chart 2, panel 2) which is consistent with the Fed achieving its 2% PCE inflation target on average over the cycle. Treasury yields are largely driven by whether the Fed turns out to be more or less hawkish than the market expects (Chart 7). The market is already pricing in the first Fed rate hike in Q3 2022 (Chart 8). We think it unlikely that the market will start to price in an earlier hike than that. Chart 7The Fed Unlikely To Hike Ahead Of What Market Expects... Chart 8...Since This Is As Early As Q3 2022 How much would a further rise in rates hurt the economy and stock market? Rates are still well below a level that would trigger problems. First, long-term rates are considerably below trend nominal GDP growth, which is around 3.5% (Chart 9). Second, short-term real rates are well below r* – hard though that is to measure at the moment given the volatility of the economy in the past 12 months (Chart 10). Finally, one of the best indicators of economic pressure is a decline in cyclical sectors (consumer spending on durables, corporate capex, and residential investment) as a percentage of GDP (Chart 11). This is because these are the most interest-rate sensitive parts of the economy. But, at the moment, consumers are so cashed up they do not need to borrow to spend. The same is true of corporates, which raised huge amounts of cash last year. The only potential problem is real estate, buoyed last year by low rates which are now reversing (Chart 12). But mortgage rates are still very low and this is not a big enough sector to derail the broader economy. Chart 9Long-Term Rates Well Below Damaging Levels... Chart 10...Such As The R-Star Chart 11Interest-Rate Sensitive Sectors Are Robust... Chart 12...With The Possible Exception Of Housing Chart 13Debt Levels Are High In Emerging Markets... Chart 14...Which Makes Them Vulnerable To Tightening Financial Conditions This sanguine view may not apply to Emerging Markets, however. Given the amount of foreign-currency debt they have built up in the past decade (Chart 13), they are very sensitive to US financial conditions, particularly a rise in rates and an appreciation of the US dollar (Chart 14). Accordingly, we have become more cautious on the outlook for both EM equity and debt over the next 6-12 months. Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com What Our Clients Are Asking What will happen to inflation? How can we tell if it is trending up? Chart 15Watch The Trimmed Mean Inflation Measure How much inflation rises will be a key driver of asset performance over the next 12-18 months. Too much inflation will push up long-term rates and undermine the case for risk assets. But the picture is likely to be complicated. US inflation will rise sharply in year-on-year terms in March and April because of the base effect (comparison with the worst period of the pandemic in 2020), pricier gasoline, rising import prices due to the weaker dollar, and supply-chain bottlenecks that are pushing up manufacturing costs. Core PCE inflation could get close to 2.5% year-on-year (Chart 15, panel 1). In the second half, too, an end to lockdowns could push up service-sector inflation – which has unsurprisingly been weak in the past nine months – as consumers rush out to restaurants and on vacation (panel 3). The Fed has signalled that it will view these as temporary effects. But they may spook the market for a while. Next year, however, it would be surprising to see strong underlying inflation unless employment makes a miraculous recovery. Payrolls would have to increase by 420,000 a month to get back to “maximum employment” by end-2022.2 Absent that, wage growth is likely to stay muted. Conventional inflation gauges may not be very useful at indicating underlying inflation pressures, in a world where consumers switch their spending depending on what is currently allowed under pandemic regulations. The Dallas Fed’s Trimmed Mean Inflation indicator (which excludes the 31% of the 178 items in the consumer basket with the highest price rises each month, and the 24% with the lowest) may be the best true measure. Research shows that historically it has been closer to trend headline PCE inflation in the long run than the core inflation measure, and predicts future inflation better (panel 4). Currently it is at 1.6% year-on-year and trending down. Investors should focus on this measure to see whether rising inflation is becoming a risk. How can investors best protect against rising inflation? In May 2019 we released a report describing how to best to hedge against inflation.3 In that report, we analyzed every period of rising inflation dating back to the 1970s. Our conclusions were the following: The level of inflation will determine how rising inflation affects assets. When inflation goes from 1% to 2%, the macro environment is entirely different from when it goes from 5% to 6%. Thus, inflation hedging should not be thought of as a static exercise but a dynamic one (Table 1). Table 1Winners During Different Inflationary Regimes As long as the annual inflation rate is below about 3%, equities tend to be the best performing asset during high inflation periods, surpassing even commodities. This is because monetary policy tends to stay accommodative and cost pressures remain benign for most companies. However, as inflation passes this threshold, things start to change. Central banks start to become restrictive as they seek to curb inflation. This rise in policy rates starts to choke off the bull market. Meanwhile cost pressures become more significant and, as a result, equities begin to suffer. It is at this time when commodities – particularly oil and industrial metals – and US TIPS become a much better asset to hold. Finally, if the central bank fails to quash inflation, inflation expectations become unanchored, creating a toxic cocktail of rising prices and poor growth. During such periods, the best strategy is to hold the most defensive securities in each asset class, such as Health Care or Utilities within the equity market, or gold within commodities. Can the shift to renewables drive a new commodities supercycle? Chart 16The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The rise in commodity prices in H2 2020 has made investors ask whether we are on the verge of a new commodities “supercycle” (Chart 16). Our Commodity & Energy strategists argue that the fundamental drivers of each commodities segment differ. Here we focus on industrial metals – particularly those pertaining to renewable energy and transport electrification. Prices of metals used in electric vehicles (EVs) have risen by an average 53% since July 2020, reflecting strong demand that is outstripping supply (Chart 16). In the short-term, metals markets are likely to be in deficit, especially as demand recovers after the pandemic. Modelling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency, recycling rates, and the share of renewables. A study by the Institute for Sustainable Futures showed that, in the most positive scenarios, demand for some metals will exceed available resources and reserves (Table 2).4 The most pessimistic scenarios – which, for example, assume no major electrification of the transport system – show demand at approximately half of available resources. It is likely that demand will lay somewhere between those scenarios. Table 2...As Future Demand Exceeds Supply Supply is concentrated in a handful of countries: For example, the DR Congo is responsible for more than 65% of cobalt production and 50% of the world’s reserves;5 Australia supplies almost 50% of the world’s lithium and has 22% of its reserves.6 Production bottlenecks could therefore put significant upside pressures on prices. Factoring in supply/demand dynamics, as well as an assessment of future technological advancements, we conclude that industrial metals might be posed for a bull market over the upcoming years. How can we add alpha in the bond bear market? Chart 17Government Bond Yield Sensitivities To USTs For a portfolio benchmarked to the global Treasury index, one way to add alpha is through country allocation. BCA’s Fixed Income Strategy recommends overweighting low yield-beta countries (Germany, France, and Japan) and underweighting high yield-beta countries (Canada, Australia, and the UK).7 The yield beta is defined as the sensitivity of a country’s yield change to changes in the US 10-year Treasury yield, as shown in Chart 17. BCA’s view is that the Fed will be the first major central bank to lift interest rate, therefore investors' underweights should be concentrated in the US Treasury index. It’s worth noting, however, that yield beta is influenced by many factors, and can change over time. When applying this approach, it’s important to pay attention to key factors in each country, especially those that are critical to central bank policy decisions (Table 3). Table 3A Watch List For Bond Investors Global Economy Chart 18US Growth Already Looks Strong... Overview: Growth continues to recover from the pandemic, although the pace varies. Manufacturing has rebounded strongly, as consumers spend their fiscal handouts on computer and household equipment, but services remain very weak, especially in Europe and Japan. Successful vaccination programs and the end of lockdowns in many countries should lead to strong growth in H2, as consumers spend their accumulated savings and companies increase capex to meet this demand. Perhaps the biggest risk to growth is premature tightening in China, but the authorities there are very aware of this risk and so it is unlikely to drag much on global growth. US: Although the big upside surprises to economic growth are over (Chart 18, panel 1), the US continues to expand more strongly than other major economies, due to its relatively limited lockdowns and large fiscal stimulus (which last year and this combined reached 25% of GDP, with another $2 trillion package in the works). Fed NowCasts suggest that Q1 GDP will come in at around 5-6% quarter-on-quarter annualized, with the OECD’s full-year GDP growth forecast as high as 6.5%. Nonetheless, there is still some way to go: Consumer expenditure and capex remain weak by historical standards, and new jobless claims in March still averaged 727,000 a week. Euro Area: More stringent pandemic regulations and slow vaccine rollout mean that the European service sector has been slow to recover. The services PMI in March was still only 48.4, though manufacturing has rebounded strongly to 64.2 (Chart 19, panel 1). Fiscal stimulus is also much smaller than in the US, with the EUR750 billion approved in December to be spent mostly on infrastructure over a period of years. Growth should rebound in H2 if lockdowns end and the vaccination program accelerates. But the OECD forecasts full-year GDP growth of only 3.9%. Chart 19...But Chinese Growth Has Probably Peaked Japan has seen the weakest rebound among the major economies, slightly puzzlingly so given its heavy weight in manufacturing and large exposure to the Chinese economy. Industrial production still shrank 3% year-on-year in February (Chart 19, panel 2), exports were down 4.5% YoY in February, and the manufacturing PMI is barely above 50. The main culprit remains domestic consumption, with confidence very weak and wages still declining, leading to a 2.4% YoY decline in retail sales in January. The OECD full-year GDP growth forecast is just 2.4%. Emerging Markets: The Chinese authorities have been moderately tightening policy for six months and this is starting to impact growth. Both the manufacturing and services PMIs have peaked, though they remain above 50 (panel 3). The policy tightening is likely to be only moderate and so growth this year should not slow drastically. Nonetheless, there remains the risk of a policy mistake. Elsewhere, many EM central banks are struggling with the dilemma of whether to cut rates to boost growth, or raise rates to defend a weakening currency. Real policy rates range from over 2% in Indonesia to below -2% in Brazil and the Philippines. This will add to volatility in the EM universe. Interest Rates: Policy rates in developed economies will not rise any time soon. The Fed is signalling no rise until 2024 (although the futures are now pricing in the first hike in Q3 2022). Other major central banks are likely to wait even longer. A crucial question is whether long-term rates will rise further, after the jump in the US 10-year Treasury yield to a high of 1.73%, from 0.92% at the start of the year. We see only limited upside in yields over the next nine months, as underlying inflation pressures should remain weak and central banks will remain highly reluctant to bring forward the pace of monetary policy normalization. Global Equities Chart 20Has The Equity Market Priced In All The Earnings Growth? The global equities index eked out a 4% gain in Q1 2021, completely driven by a rebound in the profit outlook, since the forward PE multiple slightly contracted by 4%. Forward EPS has now recovered to the pre-pandemic level, while both the index level and PE multiple are 52% and 43% higher than at the end of March 2020 (Chart 20). While BCA’s global earnings model points to nearly 20% earnings growth over the next 12 months and analysts are still revising up earnings forecasts, the key question in our mind is whether the equity market has priced in all the earnings growth. Equity valuations are still not cheap by historical standards despite the small contraction in PEs in Q1. In addition, the VIX index has come down to 19.6, right at its historical average since January 1990, and profit margins in both EM and DM have come under pressure. As an asset class, however, stocks are still attractively valued compared to bonds (panel 5). Given our long-held approach of taking risk where risk will most likely be rewarded, we remain overweight equities versus bonds at the asset-class level, but we are taking some risk off the table in our country and sector allocations by downgrading China to underweight (from overweight) and upgrading the UK to overweight (from neutral), and by taking profits in our Tech overweight and upgrading Financials to overweight (see next two pages). To sum up, we are overweight the US and UK, underweight Japan, the euro area, and China, while neutral on Canada, Australia, and non-China EM. Sector-wise, we are overweight Industrials, Financials, Energy, and Health Care; underweight Consumer Staples, Utilities, and Real Estate; and neutral on Tech, Consumer Discretionary, Communication Services, and Materials. Country Allocation: Downgrade China To Underweight From Overweight Chart 21China Is Risking Overtightening We started to separate the overall EM into China and Other EM in the January Monthly Portfolio Update this year. We initiated China with an Overweight and “Other EM” with a Neutral weighting in the global equity portfolio. The key rationale was that Chinese growth would remain strong in H1 2021 due to its earlier stimulus, while some EM countries would benefit from Chinese growth but others were still suffering from structural issues. In Q1, China underperformed the global benchmark by 4.5%, while the other EM markets underperformed slightly. China’s National People’s Congress (NPC) indicated that Chinese policymakers will gradually pull back policy support this year. BCA’s China Investment Strategists think that fiscal thrust will be neutral in 2021 while credit expansion will be at a lower rate compared to 2020. The Chinese economy should remain strong in H1 but will slow to a benign and managed growth rate afterwards. Therefore, the risk of policy overtightening is not trivial and could threaten China’s economic growth and corporate profit outlook. The outperformance of Chinese stocks since the end of 2019 has been largely driven by multiple expansion (Chart 21, panel 1), but the slowdown in the credit impulse implies that the recent underperformance of Chinese equities has not run its course because multiple contraction will likely have to catch up and will therefore put more downward pressure on price (panels 2 and 3). We remain neutral on the non-China EM countries, implying an underweight for the overall EM universe. We use the proceeds to fund an upgrade of the UK to Overweight from Neutral because the UK index is comprised largely of globally exposed companies and because we have upgraded GBP to overweight (see page 21). Sector Allocation: Upgrade Financials To Overweight By Downgrading Tech To Neutral Chart 22Financials And Tech: Trading Places One year ago, we upgraded Tech to overweight and downgraded Financials to neutral given our views on the impact of the pandemic and interest rates.8 This position has netted out an alpha of 1123 basis points in one year. BCA Research’s House View now calls for somewhat higher global interest rates and steeper yield curves (especially in the US) over the next 9-12 months. Accordingly, we are downgrading Tech to neutral and upgrading Financials to overweight. Financials have outperformed the broad market by about 20% since September 2020 after global yields bottomed in July 2020. We do not expect yields to rise significantly from the current level, nor do we expect Tech earnings growth to slow significantly (Chart 22, panel 5). So why do we make such shift between Financials and Tech? There are three key reasons: First, the Tech sector is a long-duration asset with high sensitivity to changes in the discount rate. In contrast, Financials’ earnings benefit from steepening yield curves. If history is any guide, we should see more aggressive analyst earnings revisions going forward in favor of Financials (Chart 22, panel 3). Second, the performance of Financials relative to Tech has been on a long-term structural downtrend since the Global Financial Crisis. A countertrend rebound to the neutral zone from the currently very oversold level would imply further upside (Chart 22, panel 1). Last, Financials are trading at an extremely large discount to the Tech sector (Chart 22, panel 2). In an environment where overall equity valuations are stretched by historical standards, it is prudent to rotate into an extremely cheap sector from an extremely expensive sector. Government Bonds Chart 23Policy Mix Is Bond-Bearish Maintain Below-Benchmark Duration. Global bond yields have climbed sharply in Q1, supported by strong economic growth, mostly smooth rollout of vaccination and the Biden Administration’s very stimulative fiscal package of USD1.9 trillion. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget. Going forward, the path of least resistance for global yields is still up, though the upside will be limited given the resolve of central banks to maintain accommodative monetary policies (Chart 23). Chart 24Stay Long TIPS Still Favor Linkers Vs. Nominal Bonds. Our overweight position in inflation-linked bonds relative to nominal bonds has panned out well so far this year, as has our positioning for a flattening inflation-protection curve. Even though inflation expectations have run up quickly, the 5 year-5 year forward inflation breakeven rate is still below 2.3-2.5%, the range that is consistent with core PCE reaching the Fed’s 2% target in a sustainable fashion (Chart 24). The US TIPS 5/10-year curve is inverted already, but our fixed income strategists are still reluctant to exit the curve-flattening position for two key reasons: 1) The Fed has indicated that it will tolerate core PCE overshooting the 2% target because it will try to hit the target from above rather than from below; and 2) the short end of the inflation expectation curve is more sensitive to actual inflation than the long end. There are signs (core producer prices, prices paid in the ISM manufacturing survey, and NFIB reported prices are all rising) that core PCE will reach 2% in the next 12 months. Corporate Bonds Chart 25High-Yield Offers Best Value In Fixed Income Since the beginning of the year, investment-grade bonds have outperformed duration-matched Treasurys by 62 basis points, while high-yield bonds have outperformed duration-marched Treasurys by 232 basis points. In the current reflationary environment, we believe that the best strategy within fixed-income portfolios is to overweight low-duration assets and maximize credit exposure where the spread makes a large portion of the yield. Thus, we remain overweight high-yield bonds. We believe that high yield offers much better value than higher quality credits. Currently spreads for high-yield bonds are in the middle of their historical distribution – a stark contrast from their investment-grade counterparts, which are trading at very expensive levels (Chart 25, panel 1). Moreover, the reopening of the economy should help the more cyclical sectors of the bond market, where the lower credit qualities are concentrated. But could a rise in yields start hurting sub-investment-grade companies and increase their borrowing costs? We do not think this is likely for now. Most of the bonds in the US high-yield index mature in more than three years, which means that high-risk corporates will not have to finance themselves with higher rates yet (Chart 25, panel 2). On the other hand, we remain underweight investment-grade credit. Not only are these bonds expensive, but they offer very little upside in any scenario. On the one hand, these bonds should underperform further if raise continue to rise – a result of their high duration. On the other hand, if a severe recession were to hit, spreads would most likely widen, which will also result in underperformance. Commodities Chart 26Limited Upside For Oil From Here Energy (Overweight): Despite the recent mid-March selloff, which was most likely triggered by profit taking, oil prices are still up 25% since the beginning of the year. This happened on the back of the restoration of some economic activity, the OPEC 2.0 coalition maintaining production discipline and therefore keeping supply in check, and the recovery in crude demand drawing down inventory. However, earlier forecasts of the 2021 oil demand recovery were a bit too optimistic amid continuing pandemic uncertainty. There is now, therefore, only limited upside for the oil price, at least this year. Our Commodity & Energy strategists expect the Brent crude price to average $65/bbl this year (Chart 26, panels 1 & 2). Industrial Metals (Neutral): We have previously highlighted that Chinese restocking activity in 2020 was a big factor behind the rally in industrial metals prices. As this eases, and Chinese growth slows, commodity prices might correct somewhat in the short term. However, fundamental changes in demand for alternative energy makes us ask whether we are now entering a new commodities “supercycle” for certain metals (for more analysis of this, see What Our Clients Are Asking on page 11). If history is any guide, however, the commodities bear market may have a little longer to run. Historically, commodity bear cycles lasted 17 years on average and we are only 10 years into this one (panel 3). On balance, therefore, we remain neutral on industrial metals for now. Precious Metals (Neutral): After peaking last August, the gold price has continued to tumble, down almost 19% since and 11% since the beginning of the year. We have been wary of the metal’s lofty valuation – the real price of gold remains near a historical high. The recent rise in real rates put more downside pressure on gold. However, the pullback in prices should provide investors who see gold as a long-term inflation hedge and do not buy the metal with a view to strong absolute performance over the next 12 months, with an attractive entry point. We maintain a slight overweight position to hedge against inflation and unexpected tail risks (panel 4). Currencies US Dollar Chart 27Vaccinations will help USD and GBP in 2021 While we still believe that the dollar is in a major bear market, the current environment could see a significant dollar countertrend. Thanks to its gargantuan fiscal stimulus as well as its relatively fast vaccination campaign, the US is likely to grow faster than the rest of the world during 2021 (Chart 27, panel 1). This dynamic should put further upward pressure on US real rates relative to the rest of the world, helping the dollar in the process. To hedge this risk, we are upgrading the US dollar from underweight to neutral in our currency portfolio. Euro The euro should experience a temporary pullback. Economic activity in Europe, particularly in the service sector is lagging the US – a consequence of Europe’s slow vaccination campaign. This sluggishness in economic activity will translate into a worse real rate differential vis-a-vis the US, dragging the euro lower in the process. Thus, we are downgrading the euro from overweight to neutral. British Pound One currency that might perform well in this environment is the British pound. Consumer spending in the UK was particularly hard hit during the pandemic, since such a high share of it is geared towards social activities like restaurants and hotels (Chart 27, panel 2). However, thanks to Britain’s successful vaccination campaign, UK consumption is likely to experience a sharp snapback. As growth expectations improve, real rates should grind higher vis-à-vis the rest of the world, pushing the pound higher. Moreover, valuations for this currency are attractive: The pound currently trades at a 10% discount to purchasing power parity fair value. As a result, we are upgrading the GBP from neutral to overweight. Alternatives Chart 28Turning More Positive On Private Equity Return Enhancers: In last October’s Quarterly Outlook, we advised investors to prepare for new opportunities in Private Equity (PE) as fund managers look to deploy record high dry power. A gradual return to normality is likely to provide PE funds with a wider range of opportunities, while still allowing them to pick up distressed assets at attractive valuations. This is illustrated by the annualized quarterly returns of PE funds in Q2 and Q3 2020, which reached 43% and 56% respectively. PE funds raised in recession and early-cycle years tend to have a higher median net IRR than those raised in the latter stages of bull markets. This suggests that returns from the 2020 and 2021 vintages should be strong. In recent years, capital flows have increasingly gone to the longer established and larger funds, which tend to have better access to the most attractive deals and therefore record the strongest returns. This trend is likely to continue. Given the time it takes to shift allocations in private assets, we increase our recommended allocation in PE to overweight. Inflation Hedges: It is not clear that inflation will come roaring back in the next couple of years. But what is certain is that market participants are concerned about this risk, which should give a boost to inflation-hedge assets. Given this backdrop, we continue to favor commodity futures (Chart 28, panel 2). In other circumstances, real estate would also have been a beneficiary in this environment. But the slowdown in commercial real estate, as many corporate tenants review whether they need expensive city-center space, makes us remain cautious on real estate. Volatility Dampeners: We continue to favor farmland and timberland over structured products, particularly mortgage-backed securities (MBS). Farmland offers attractive yields and should continue to provide the best portfolio protection in the event of any market distress (Chart 28, panel 3). Risks To Our View The main risks to our central view are to the downside. Because global equities have risen by 55% over the past 12 months, and with the forward PE of the MSCI ACWI index at 19.5x (Chart 29), the room for price appreciation over the next 12 months is inevitably limited. There are several things that could undermine the economic recovery and equity bull market. The COVID-19 pandemic remains the greatest unknown. The vaccination rollout has been very uneven (Chart 30). New strains, especially the one first identified in Brazil, are highly contagious and people who previously had COVID-19 do not seem to have immunity against them. Behavior once COVID cases decline is also hard to predict. Will people be happy again to fly, attend events in large stadiums, and socialize in crowded bars, or will many remain wary for years? This would undermine the case for a strong rebound in consumption. Chart 29Is Perfection Priced In? Chart 30Vaccination Has Been Spotty Vaccination Has Been Spotty Chart 31China Slowing Again? As often, a slowdown in China is a risk. The authorities there have signalled a pullback in stimulus, and the credit impulse has begun to slow (Chart 31). Our China strategists think the authorities will be careful not to tighten too drastically (with the fiscal thrust expected to be neutral this year), and that growth will slow only to a benign and moderate rate in the second half.9 But there is a lot of room for policy error. Finally, inflation. As we argue elsewhere in this Quarterly, it will inevitably pick up for technical reasons in March and April, and then again in late 2021 as renewed consumer demand for services (especially travel and entertainment) pushes up prices. The Fed has emphasized that these phenomena are temporary and that underlying inflation will not emerge until the economy returns to full employment. But the market might get spooked for a while when inflation jumps, pushing up long-term interest rates and triggering an equity market correction. Footnotes 1 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021. 2 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021, 3 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 4 Dominish, E., Florin, N. and Teske, S., 2019, Responsible Minerals Sourcing for Renewable Energy. Report prepared for Earthworks by the Institute for Sustainable Futures, University of Technology Sydney. The optimistic scenario is referred to as “total metals demand” scenario, which assumed current materials intensity and market share continues into the future without recycling or efficiency improvements. This study is based on 2018 production levels and therefore expansion of future production may vary results. 5US Geological Survey, Mineral Commodity Summaries 2021. 6 Chile is estimated to have the largest reserve of lithium. 7 Please see Global Fixed Income Strategy Report, “Harder, Better, Faster, Stronger,” dated March 16, 2021. 8 Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 9 Please see China Investment Strategy Report, “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021. GAA Asset Allocation
Gold looks set to stage a tactical rebound. It has become oversold and it is now trading at a significant discount relative to our short-term fair value model that encompasses both real interest rates and inflation expectations. The key for the near-term…
Dear client, In addition to this week’s abbreviated report, we are also sending you a Special Report on currency hedging, authored by my colleague Xiaoli Tang. Xiaoli’s previous work mapped out a dynamic hedging strategy for developed market equity investors in various home currencies. In this report, she extends the work to emerging market exposure. I hope you will find the report insightful. Next week, in lieu of our weekly report on Friday, we will be sending you a joint Special Report on the UK on Tuesday, together with our Global Fixed Income colleagues. Kind regards, Chester Highlights The DXY index is up for the year, but further gains will be capped at 2-3% from current levels. Long yen positions are offside amid the dollar rally. This should wash out stale longs, and underpin the bull case. Lower the limit-sell on the gold/silver ratio to 68. We were stopped out of our short AUD/MXN position amidst a broad-based selloff in EM currencies. We are reinitiating the trade this week. Feature Chart I-1The Dollar Has Been Strong In 2021 The DXY index has once again kissed off the 90 level and is gaining momentum in March. Year-to-date, the DXY index is up 1.1%. This performance has been particularly pronounced against other safe haven currencies, such as the Swiss franc and the Japanese yen. GBP and AUD have fared rather well in this environment (Chart I-1). As the “anti-dollar,” the euro has also suffered. Our technical indicators continue to warn that the dollar still has upside. Net speculative positions are at very depressed levels, consistent with many sentiment indicators that are bearish USD. However, this time around, any dollar rally could be capped at 2-3%, in sharp contrast to the bounce we witnessed in March 2020. The Message From Dollar Technical Indicators Our dollar capitulation index has bounced from very oversold levels, and is now sitting above neutral territory (Chart I-2). The index comprises a standardized measure of sentiment, net speculative positioning and momentum. It is very rare that a drop in this index below the -1.5 level does not trigger a rebound in the dollar. This time around, the bounce has been rather muted. Chart I-2BCA Dollar Capitulation Index Suggests Some Upside Part of the reason has been concentration around dollar short positions. Investors throughout most of the pandemic executed their bearish dollar bets through the euro, yen and the Swiss franc (countries that already had negative interest rates). Positioning on risk on currencies such as the Australian dollar and the Mexican peso were neutral. This also explains the underperformance of the yen, as the dollar rises. From a sizing standpoint, ever since the dollar peaked in March 2020, counter-trend moves have been in the order of 2-3%. We expect this time to be no different. What To Do About The Yen The yen has been one of our core holdings on three fundamental pillars: it is cheap, it tends to rise during dollar bear markets and the economy in Japan is more hostage to deflation than the US. This bodes well for real rates in Japan, relative to the US. Over the last month, our long yen position has been put offside. First, demand for safe havens has ebbed as US interest rates have gapped higher (Chart I-3, panel 1). King dollar has once again become the safe haven of choice. As Chart I-1 illustrates, low beta currencies such as the Swiss franc and yen, that tend to do relatively well when the dollar is rallying, have underperformed. Yield curve control (YCC) in Japan is also negative for the yen as interest rates rise (panel 2). Economic momentum in Japan is also rolling over (panel 3). Prime Minister Yoshihide Suga’s mulling to extend the state of emergency in the Tokyo region could further cripple any Japanese economic recovery. Chart I-3A Healthy Reset In The Yen Chart I-4USD/JPY Support Should Hold For short-term investors, USD/JPY is very overbought and is approaching strong resistance (Chart I-4). In our view, a washing out of stale shorts would provide a healthy reset for the bear market to resume. Meanwhile, USD/JPY and the DXY change correlations during risk-off periods, where the yen appreciates versus the dollar. Therefore, a market reset is also positive for the yen. Housekeeping Chart I-5Remain Short AUD/MXN We were stopped out of our short AUD/MXN trade last week for a loss of 6.1%. We are reinitiating the trade this week. The case for the trade, made a month ago, remains intact. A short-term recovery in the US economy, relative to the rest of the world, argues for an AUD/MXN short. In fact, a divergence has occurred between the BRL/MXN and the AUD/MXN exchange rate (Chart I-5). Domestic factors have certainly tempered the Brazilian real, but the underperformance of metal prices relative to oil in recent months is also a factor. We expect some convergence to occur, with MXN appreciating much faster than the AUD. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have stepped up: Personal income rose by 10% in January, while personal spending rose by 2.4% month-on-month. The ISM report was stellar. The manufacturing PMI improved from 58.7 to 60.8 in February. Prices paid rose to 86. Factory orders were slightly above expectations at 2.6% month-on-month in January. The DXY index rose by 165 bps this week. The narrative of a counter-trend reversal in the DXY index isn playing out. As the story unfolds, it will be important to establish targets. Our bias is that the DXY stalls before 93-94 is reached. Report Links: Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 Sizing A Potential Dollar Bounce - January 15, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area remain weak: Core CPI in the Eurozone came in at 1.1%, in line with expectations. The unemployment rate declined from 8.3% to 8.1% in January. January retail sales were weak at -6.4% year-on-year. The euro fell by 1.7%% against the US dollar this week. It will be almost impossible for the euro to rise in an environment where the dollar is in a broad-based decline. Given elevated sentiment on the euro, a healthy reset is necessary for the bull market to resume. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been marginally positive: The employment report was positive, with the unemployment rate dipping to 2.9% and an improvement in the jobs-to-applicants ratio in January. Consumer confidence in February is rebounding from very low levels. The Japanese yen fell by 1.5% against the US dollar this week. The recovery in the Japanese economy is fragile, and tentative signs of a renewed lockdown will knock down confidence. In this transition phase, yen long positions could be hostage to losses. Longer-term, the yen is cheap and will benefit from a broad-based dollar decline. Report Links: On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been in line: Mortgage approvals rose 99K in January, in line with expectations. The construction PMI rose from 49.2 to 53.3 in February. Nationwide house prices are soaring, rising 6.9% in February on a year-on-year basis. The pound fell by 0.8% against the dollar this week. It is however the best performing currency this year. Our short EUR/GBP trade has benefited from faster vaccination in the UK (that could give way to a faster reopening of the economy) and a nice valuation starting point. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia was robust: Home lending remained in an uptrend. Owner-occupied loans increased by 11% in January, while investor loans increased by 9.4%. Terms of trade are soaring, rising 24% year-on-year in February. The current account surplus came in near a record A$14.5 billion in Q4. GDP grew by 3.1% QoQ in Q4. The Aussie fell by 1.8% his week. Terms of trade will continue being a tailwind for the AUD/USD. We also like the AUD/NZD cross, as a valuation and terms-of-trade bet. However, we expect that any positive surprises in the US will hurt AUD relative to the Americas. One way to play this is by shorting AUD/MXN. Report Links: Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 An Update On The Australian Dollar - September 18, 2020 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: Terms of trade rose by 1.3% in Q4. CoreLogic home prices rose 14.5% in February. The New Zealand dollar fell by 2.4% against the US dollar this week. The kiwi ranks as the most unattractive currency in our FX framework. For one, it has catapulted itself to the most expensive currency in our PPP models. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada was positive: The Nanos confidence index rose from 58.2 to 59.4 in February. Annualized 4Q GDP came in at 9.6%, above expectations. Building permits rose 8.2% month-on-month in January. The Canadian dollar fell 0.4% against the US dollar this week. Oil prices remain very much in an uptrend, which is underpinning the loonie. Better US economic performance in the near term should also help the CAD. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland have been improving: Swiss GDP rose by 0.3% quarter-on-quarter in 4Q. The KOF leading indicator rose from 96.5 to 102.7 in February. The February manufacturing PMI rose from 59.4 to 61.3. Switzerland remains in deflation, with the core CPI that came in at -0.3% year-on-year in February. The Swiss franc fell by 2.6% against the US dollar this week. Safe -haven currencies continue to be laggards, as rates rise and gold falls to the wayside. This is bullish on procyclical currencies, and negative the Swiss franc. We are long EUR/CHF on this basis, but short USD/JPY purely as portfolio insurance. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The data out of Norway has been robust: The unemployment rate fell from 4.4% to 4.3% The manufacturing PMI increased from 51.8 to 56.1 in February. The current account balance was robust in Q4. It should increase significantly in Q1 this year given the large trade balance in January. Being long the Norwegian krone is one of our high-conviction bets in the FX portfolio. The Norwegian krone fell by 1% against the US dollar this week, but outperformed the euro, amongst other currencies. The NOK ticks all the boxes of an attractive currency – cheap valuations, a liquidity discount, and primed to benefit from a global growth rebound. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Most Swedish data releases were in line with expectations: GDP came in at -0.2% quarter-on-quarter, below expectations. Retail sales rose 3.1% year-on-year, above expectations. The trade balance came in at a surplus of SEK 5.2 billion in January. The manufacturing PMI remained elevated at 61.6 in February. The Swedish krona fell by 2.4% against the US dollar this week. Manufacturing data is improving in Sweden but the economy remains hostage to COVID-19, compared to Norway. That is weighing on the krona. That said, Sweden is a highly levered play on the global cycle. Therefore, once the pandemic is behind us, the SEK will outperform. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Underweight Last December when we penned the 2021 high-conviction calls Strategy Report, we put global gold miners in the “also rans” section as we did not have the courage to go underweight despite our view of an economic reopening. But it is better late than never, and in this Monday’s Strategy Report we pulled the trigger and downgraded this niche materials sub-sector to a below benchmark allocation. The economic reopening theme remains healthy and still dominates the market as is evident in 5-year/5-year forward real yields that have been soaring year-to-date signaling that investors should shy away from gold miners (Chart 1). Not only is the real economy standing on its own two feet, but the financial economy is also being propelled higher thanks to the Fed, ECB, BoJ, and a plethora of other central banks (CBs) including EM ones. CBs are still embarking on QE, effectively engineering a “risk on” asset price inflation phase that melts away the global equity risk premium and reduces the allure of the safe haven global gold mining industry (Chart 2). Chart 1Avoid Gold Miners Chart 2Avoid Gold Miners Bottom Line: Downgrade global gold miners to underweight. This move also pushes the S&P materials sector back to the neutral zone.
Highlights Portfolio Strategy The selloff in the long end of the Treasury bond market and related yield curve steepening, rising loan growth and a turnaround in bank net interest margins, all signal that a durable re-rating phase is in the offing in the beaten down financials sector. Soaring real and nominal yields on the back of a US economic reopening, sinking policy uncertainty, and the specter of a countertrend USD rally, all undermine global gold mining stocks. Downgrade to underweight. We deem there is an exploitable opportunity within the reopening theme and we reiterate our recent pair trade recommendation: long USES “Laggards” basket/short USES “Overshooters” basket (excluding the GICS1 sectors). Recent Changes Downgrade the global gold mining index to underweight, today. This move also pushes the S&P materials sector to a neutral allocation. Last week our rolling 2.5% stop was triggered and we booked gains of 17% in the deep cyclicals/defensives portfolio bent that is now on even keel. On February 10, we closed the S&P consumer staples and the S&P homebuilding high-conviction underweights for 8% and -11% returns, respectively, since the December 7 inception. On February 11, we rolled over the synthetic long SPY options structure from March expiry (long $390/$410 call spread/short $340 put) to June expiry (long $400/$420 call spread/short $340 put) netting gains of $5.41/contract or 676% since the January 12 inception. Feature While stocks swiftly gyrated last week and the selloff in Treasury bonds dominated the news flow, the corporate bond market remained as placid as ever. This eerie calmness is slightly unnerving as junk spreads, all the way out to the CCC poor-quality spectrum, have been steadily sinking. But, resurging commodities likely confirm that there is no real reason to panic as global growth remains on an upward trajectory courtesy of pent-up demand that will get unleashed in the back half of the year as the global economy reopens (Chart 1). We recently reinitiated the long “Back-To-Work” basket as the expense of our “COVID-19 Winners” basket and this trade is already up another 21.3% since the second inception on Feb 3, 2021. With regard to monetary policy that remains a key pillar of equity euphoria, the Fed has vociferously signaled that they will not be backing down from QE and their ZIRP policy. The FOMC is not even thinking about thinking about tapering asset purchases, despite a looming inflation spike in the coming months due to base effects and bottlenecks that they vehemently deem transitory. Chart 1Eerie Calm? Importantly, Charts 2 & 3 show that both the ISM’s manufacturing prices paid index and a sideways move in retail gasoline prices predict a surge in headline CPI in the April/May time frame as we first showed in a recent Special Report. Chart 2The Bond Market Is Already… Chart 3…Testing The Fed Tack on a plethora of anecdotes regarding shortages and price hikes in a slew of industries and an inflationary spurt is already here. In more detail, an inflationary impulse is not only evident in chip and car shortages and in container freight shipping rates, but also in dry bulk transport rates. Drilling beneath the surface of the Baltic Dry Index, and looking beyond Capesize carriers, reveals that Panamax and Handysize vessel freight rates are on a tear, probing 11-year highs and more than quadrupling since the March lows (Chart 4). These smaller ships are more nimble and rarely take voyage empty as recent container ships have been when returning to China to reload. Thus, the sizable increase in Handysize and Panamax shipping rates suggests that commodity demand is robust, especially industrial commodities. Returning to US shores, the most recent retail sales report also caused a jump in the Atlanta Fed’s GDPNow and the NY Fed’s Nowcast forecasts for Q1 near double digit real GDP growth. For calendar 2021, according to daily data from Bloomberg, economists expect US real GDP growth north of 4.9% (Chart 5). More blow out quarters are in the offing courtesy of the inoculation of the population, the reopening of the economy and persistent government largesse. Chart 4Look Beneath The Surface… Chart 5…And The Economic Recovery Is Gaining Steam… Crudely put, while consumers will not buy 10 coffees or eat 10 meals at a restaurant all at once when the economy fully reopens, they may choose to fly business on their next vacation and indulge on a more lavish hotel. Add on that the hospitality industry specifically has aggressively shut down capacity and an inflationary impulse is likely as consumer purse strings will loosen very quickly. Thus, trust in the Fed’s ultra-dovishness represents the biggest equity market risk in the coming months as the FOMC allows the economy to run hot and there are high odds that the bond market will continue to test the Fed’s resolve. Our sense is that the Fed will initially ignore the spike in inflation, at least until the summer, thus refraining from removing the proverbial “punch bowl”. However, if the market detects any signs of a “less dovish” Fed, especially if high inflation prints persist for whatever reason, risk premia will get repriced a lot higher (Chart 6). Chart 6…But A Lot Of Good News Is Baked In Staying on the topic of interest rates, we have a long-held rule of thumb that stocks cannot stomach more than 100-125bps tightening via a selloff in the 10-year US Treasury bond in a less than a year time frame basis. In other words, were the 10-year US Treasury yield to surpass and stay over 1.55% by March, 2.05% by June, and 1.75% by August, then the equity market will likely suffer a pullback, especially given the absence of a valuation cushion. In fact, last Thursday the 10-year US Treasury yield cleared the 1.6% hurdle and stocks sold off violently. In more detail, we examined data from 2009 onward, therefore only covering the QE era, which would increase the applicability of our analysis. Importantly, the 2009-2011 iterations provide the closest parallels as to what will likely take root this cycle as those instances occurred in a post recessionary environment, which is similar to today. The 2009-2011 period also best aligns with the main reason for having this rule of thumb in the first place: to gauge the risk of interest rates undermining the market by weighing on forward multiples and/or via an economic slowdown because of tightening in monetary conditions. Our analysis shows that while the exact timing and size of the stock market drawdown varies from episode to episode, it is generally consistent with a roughly 10% pullback in the S&P 500 albeit with a 1-2 month lag following the trigger in our rule1 (Chart 7). Chart 7Monitoring Our 100-125bps Rule Of Thumb Keep in mind that such a pullback is consistent with historical precedents when the Fed is actively engaged in QE, with the most recent example being last September’s/October’s 10% drawdown. Our sense is that the ongoing bond market selloff will serve as a catalyst for a continuation/acceleration of the reopening/rotation/reflation trade out of highly valued tech stocks and into more compellingly valued deep and early cyclicals. Such a transition typically proves tumultuous. This week, we update our sanguine view on an early-cyclical sector, and act on the downgrade alert to a deep cyclical sector via downgrading a safe haven commodity index to a below benchmark allocation. Financials Are On Fire Within the GICS1 universe, the most levered sector to interest rates is the S&P financials sector. Given that the bond selloff has staying power, we reiterate our overweight stance on this early-cyclical sector that we fist boosted to an above benchmark allocation on November 16, 2020. Following up from the 100-125bps bond market tightening rule of thumb, adding another layer of complexity via bringing in the yield curve (YC) is instructive. This analysis corroborates our rule of thumb and suggests that not only do 10-year US Treasury yields have more room to rise, but also so does the S&P financials sector, especially given that it is hovering at an extremely depressed level relative to the S&P 500 (Chart 8). Chart 8V-Shaped Recovery? Historically the yield curve peaks at a range of 150 to 250 bps. In the past 7 cycles, this range was in place with only one exception: the first leg of the double dip recession in the early 80s. This represents a stellar track record of where the YC peters out based on empirical evidence. Even in the post GFC world, the YC steepened north of 250bp (thrice) and during the early stages of that recovery. The implication is that if history at least rhymes, then the yield curve can steepen a lot more. Were it to revisit the 250bps level, the YC could nearly double from current levels (Chart 9A). Practically, given that the Fed will pin the 2-year US Treasury yield near zero with a near-term max value of roughly 50bps, this equates to a tentative early-cycle peak 10-year Treasury yield range of 2% to 3%. Chart 9AYield Curve Can Steepen A Lot More Putting this in perspective, at current levels, the 10-year US Treasury yield is roughly where it stood right after Brexit in mid-2016, which was last cycle’s trough, and still deeply in overvalued territory according to BCA bond valuation model (Chart 9B). Importantly, back then, as now, yields have been late comers to the equity rally. As a reminder, during the manufacturing recession the SPX troughed on Feb 15, 2016 – the day the Royal Dutch Shell / BG Group merger closed – while interest rates bottomed in the first week of July 2016. One key driver of the positive impact of rising interest rates on relative financials share prices will be the end to the banking sector’s hemorrhaging net interest margins (Chart 10). Chart 9BBonds Remain Extremely Overvalued Chart 10NIM Turnaround Looms Financial services companies represent the nervous system of every economy and a vibrant economy is synonymous with firming loan growth (bottom panel, Chart 11). Beyond the recovery in the broad non-financial corporate sector, the overheating residential housing market in particular is another vital area that is propping up the financials sector (top panel, Chart 11). All of this suggests that relative profitability will pick up steam this year, a message that our macro-driven relative EPS models also corroborate (second panel, Chart 12). This stands in marked contrast to sell-side analysts’ profit expectations and represents an exploitable trading opportunity: the earnings hurdle is so low for financials that even a modest beat of suppressed EPS growth expectations will go a long way in breathing fresh life into this neglected early-cyclical sector (third & bottom panels, Chart 12). Tack on pent up financials sector buyback demand and a 40bps dividend yield carry versus the SPX and the profit outlook brightens further for this interest rate-sensitive sector. Chart 11Financials Rising Alongside The Economy Finally, relative valuations are bombed out on any metric used (middle, fourth & bottom panels, Chart 13). Granted, relative technicals are not as alluring as last November, however our Technical Indicator is still below overbought levels that have marked prior relative performance peaks (second panel, Chart 13). Chart 12Green Light On Earnings Chart 13Financials Are Cheap No Matter How You Cut It Adding it all up, the selloff in the long end of the Treasury bond market and the associated yield curve steepening, rising loan growth and a turnaround in bank net interest margins signal that a durable re-rating phase looms for the beaten down financials sector. Bottom Line: Continue to overweight the S&P financials sector. Are Gold Miners Losing Their Luster? Last December when we penned the 2021 high-conviction calls Strategy Report, we put global gold miners in the “also rans” section as we did not have the courage to go underweight despite our view of an economic reopening and selloff in the bond market. It is never too late. Today, we use the downgrade alert we issued on the S&P materials sector to trim the sector to neutral via downgrading the global gold mining index to a below benchmark allocation. As a reminder, in mid-January we had put the materials sector on our downgrade watch list as a way to express the move of the cyclicals/defensives portfolio bent back down to even keel. The stock-to-bond (S/B) ratio has broken out to at least a three decade high because stocks are near all-time highs and bonds are selling off violently. This represents an explosive cocktail for gold stocks and is warning that there is ample downside for relative share prices (S/B ratio shown inverted, Chart 14). Chart 14Sell Gold Miners… This is largely due to the definitive reopening of the US economy in the coming quarters (bottom panel, Chart 15). It is also evident in 5-year/5-year forward real yields that have been soaring year-to-date signaling that investors should shy away from gold miners (real yields shown inverted, middle panel, Chart 15). Even nominal yields underscore that the path of least resistance for global gold mining equities points lower, especially given that the recent bond market selloff is driven by the real (i.e. growth) not inflation component. As a reminder, gold bullion and gold miners yield next to nothing thus when real rates rise, the opportunity cost to hold gold and gold miners skyrockets and investors abandon gold miners for higher yielding assets (top panel, Chart 16). The recent fall in the share of global negative yielding bonds by over $4tn also weighs on the prospects of gold miners (bottom panel, Chart 16). Importantly, while we are not calling for the Fed to raise rates any time soon, the 12-month forward fed funds rate discounter (as backed out of the OIS curve) has jumped back to the zero line, opening a wide gap with relative share prices. This is unsustainable and our sense is that this gulf will narrow via a drop in the latter in the coming months (fed funds rate discounter shown inverted and advanced, middle panel, Chart 16). Chart 15…When The Economy Is Roaring Another source of worry for gold stocks is the USD. Historically, a rising greenback pushes gold bullion and gold equities lower and vice versa. If the US economy will rebound at a faster clip than the euro area as the Fed is explicitly taking inflation risk and is allowing the economy to run hot, then at some point the US dollar may start to flex its muscles. Granted, this will likely be a countertrend rally in the context of a USD bear market that commenced last spring, especially given the still lopsided US dollar positioning (Chart 17). Chart 16Rising Rates Are bearish Bullion Chart 17Mighty USA = Countertrend Rally In The USD In addition, US and global policy uncertainties are melting as the US/Sino trade war has been in hibernation, the US elections are behind us and a “Blue Wave” sweep is certain to deliver mega fiscal easing packages, thus exerting downward pressure on the safe haven status of gold bullion and gold mining equities (Chart 18). Finally, the global equity risk premium is in freefall as not only the Fed, but also the ECB, the BoJ, and a plethora of other CB including EM ones are doing QE effectively engineering a “risk on” asset price inflation phase (Chart 18). Nevertheless, our bearish gold mining equity thesis has to contend with oversold conditions and bombed out relative valuations. We will be closely monitoring these two risks and stand ready to act and cut losses in case value oriented buyers come out of left field (Chart 19). Chart 18Mind The Catch Down Phase Chart 19Two Risks To Monitor Netting it all out, soaring real and nominal yields on the back of a US economic reopening, sinking policy uncertainty, and the specter of a countertrend USD rally, all undermine global gold mining stocks. Bottom Line: Downgrade the global gold mining index to underweight today. This move also pushes the S&P materials sector back to the neutral zone. A Few Words On The “Back-To-Work” Trade Last year we created two baskets of stocks to capture the economic reopening theme by constructing a long/short pair trade. This year, we crystallized 21.5% in gains from that pair trade and subsequently reopened it and it is already up another 21.3% since the second inception on February 3, 2021. Two weeks ago, we took a fresh look at the economic reopening theme and pitted “Back-To-Work” laggards against leaders. First, we filtered for well-behaved cyclical industries among all the sectors and sub-sectors we cover. We define a well-behaved cyclical industry as one that trailed the SPX from February 19, 2020 to March 23, 2020; and then outpaced the broad market from March 23, 2020 to today (all computations are in relative to SPX terms). Such filtering excluded all of the defensive & cyclical industries that outperformed the market during the recession, and it also excluded those industries that were too damaged by the pandemic and could not recover above the March 23 trough level (for example, airlines) always in relative terms. Chart 20 is a stylized depiction of our analysis. In total 27 industries survived the filtering. We then computed what is the minimum percentage increase required in order for each group to recover to its February 19 level, and then calculated the difference between that required increase and the one that actually materialized. A positive value signifies that the sector climbed above its February 19 level, whereas a negative value means that the sector still has not recovered. Chart 20Stylized Depiction Of “Back-To-Work” Sectors To Buy And To Avoid… Chart 21 displays the results. Our rationale is as follows: should the economic recovery and normalization themes continue unabated as we expect, then the risk/reward trade-off of owning the “laggards” is greater than the “overshooters”: the former have ample upside potential left, whereas the latter are already discounting a lot of good news. Chart 22 plots the ratio of the two baskets against the ISM manufacturing prices paid sub-component and the 10-year US Treasury yield and supports our rationale that the “laggards” have a long runway ahead versus the “overshooters”. Chart 21…Buy The Laggards / Sell The Overshooters Chart 22Inflation Impulse Beneficiaries Bottom Line: We deem there is an exploitable opportunity within the reopening theme and we reiterate our recent pair trade recommendation: long USES “Laggards” basket/short USES “Overshooters” basket (excluding the GICS1 sectors). As a proxy for this trade we include tickers for the largest stock in each sub-sector (excluding GICS1). Laggards: V, BLK, HCA, MCD, HON, AXP, JPM, COP, PSX, MAR, SLB. Overshooters: EMR, BLL, LIN, NUE, UNP, HD, DHI, CAT, MS, J, TSLA, AMAT. We are aware of some minor conflicts between the “Overshooters” and the “Back-To-Work” basket and also versus our current recommendations table, but we still recommend investors stick with this pair trade. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 A quick note on the taper tantrum and the 2016 iterations. During those periods the S&P 500 actually fell at the same time as yields rose (not after the rule was triggered), so technically we should not have counted that as a valid iteration on our chart. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views February 24, 2021 Stay neutral cyclicals over defensives January 12, 2021 Stay neutral small over large caps June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 Favor value over growth
Highlights The multiple paid for oil sector profits is collapsing because the market fears that the profits slump will not be short-lived. The fear is not just of a lasting hit to aviation and a slower recovery in road mobility, but an existential fear for fossil-fuelled road transportation in the post-pandemic world. Stay structurally underweight oil and gas. Within the cyclical and value segments of the equity market, overweight metals and miners versus oil and gas. Structurally underweight the stock markets of Norway and the UK which are oil and gas heavy. Structurally overweight the stock markets of Germany, Switzerland, and Denmark which have zero exposure to oil and gas or basic resources. Fractal trade: tin’s near-vertical rally is at high risk of correction. Feature Chart of the WeekOil Production Has Gone Nowhere The Brent crude oil price recently hit $65, not far below its pre-pandemic level of $69. Yet in the stock market, oil and gas equities remain the dogs, languishing 32 percent below their pre-pandemic price level. Relative to the market, the oil and gas sector has underperformed by 42 percent, and the underperformance has been almost a straight line down. Moreover, since last June when the crude oil price has risen by 50 percent, oil and gas equity prices have gone nowhere. This massive divergence of a surging crude oil price from slumping oil and gas equities raises the obvious question, what can explain this dichotomy? (Chart I-2 and Chart I-3) Chart I-2Oil And Gas Equities Have Slumped In Absolute Terms... Chart I-3...And In Relative ##br##Terms One apparent puzzle is that the oil sector’s profits have underperformed their established relationship with the crude oil price. In fact, there is no puzzle. The oil sector’s profits might appear to track the oil price, but the reality is that profits track the value of oil production, meaning the product of oil production and the oil price. Clearly though, if output is flat, then profits will appear to track the oil price. But as it took a massive cut in oil output to support the oil price, the value of oil production and therefore, the oil sector’s profits, have significantly underperformed the oil price. Put another way, if you need to cut output to boost the commodity price it might help the commodity price, but it doesn’t much help the equity sector’s profits! (Chart I-4 and Chart I-5). Chart I-4Oil And Gas Profits Appear To Track The Oil Price Chart I-5In Reality, Oil And Gas Profits Track The Value Of Oil Output Will Fossil-Fuelled Road Transportation Be Driven To Extinction? We can now explain the 42 percent underperformance of oil equities, and perhaps more importantly, forecast what will happen next. When the pandemic took hold, and economic mobility ground to a halt, the oil sector’s 12-month forward profits slumped. Bear in mind that aviation accounts for 8 percent of oil consumption but, more crucially, road transportation accounts for half of all oil consumption. However, as the pandemic’s impact was expected to be short-lived, the multiple paid for those depressed 12-month forward profits rose. This partly compensated for the profit slump, but still left oil equity prices much lower. The multiple paid for oil sector profits is collapsing because the market fears that the profit slump will not be short-lived. When profits started to recover – albeit, as just discussed, by much less than the oil price rise – it should have boosted oil equity prices. The problem was that the multiple paid for those profits fell by much more than the recovery in profits, with the result that oil equities continued to underperform. Begging the question, why is the multiple paid for oil sector profits collapsing? (Chart I-6) Chart I-6Why Is The Multiple Paid For Oil Sector Profits Collapsing? The multiple paid for oil sector profits is collapsing because the market fears that the profit slump will not be short-lived. The fear is not just of a lasting hit to aviation and a slower recovery in road mobility. The fear has become existential. Governments’ plans for pandemic stimulus and recovery have put green energy at front and centre stage. Thereby the recovery has fast-tracked the ultimate nemesis of the oil industry – the extinction of fossil-fuelled road transportation. Are the fears for oil consumption justified? Yes. Aviation is not likely to reach its pre-pandemic level of oil consumption for many years, and long-haul aviation may never get there. But the much bigger threat is fossil-fuelled road transportation. From October 2021, London will extend its Ultra Low Emission Zone (ULEZ) to an 8 mile radius from the city centre.1 The effect will be to banish from London all diesel-fuelled vehicles made before 2015 as well as some older petrol-fuelled vehicles. We expect other major cities to follow London’s example. In most cases, this initiative will happen regardless of the success (or not) of electric vehicles (EVs). Combined with other green initiatives around the world, policymakers’ unashamed aim is to drive fossil-fuelled road transportation to extinction. To repeat, road transportation accounts for half of all oil consumption. The upshot is that the structural downtrend in oil consumption will persist unless the shift away from fossil-fuelled road transportation hits a brick wall, or at least a bottleneck. We do not see such a brick wall or a bottleneck in the foreseeable future. We conclude that though the sector may offer occasional countertrend tactical buying opportunities, long-term equity investors should underweight oil and gas. Structurally Prefer Metals And Miners To Oil And Gas The preceding analysis of the oil sector can be extended to other commodity equities, like the metals and miners. To reiterate, it is the total value of commodity output – the product of commodity production and the commodity price – that drives the profits of commodity equities. On this basis, the long-term prospects for the metals and miners appear somewhat brighter than for oil and gas equities (Chart I-7). Chart I-7Commodity Sector Profits Track The Value Of Commodity Output Looking at the production of copper, it has increased by around 25 percent over the past decade, albeit this is just in line with world real GDP. By comparison, the production of oil has gone nowhere (Chart of the Week). It is the total value of commodity output that drives the profits of commodity equities. Turning to price, relative to the 2011 high the copper price is around 15 percent lower, whereas the oil price is 50 percent lower (Chart I-8). Chart I-8The Copper Price Has Outperformed The Oil Price Hence, on the all-important value of output, copper has moved in a sideways channel over the past decade while oil has been in an unmistakeable structural downtrend, with lower highs and lower lows (Chart I-9). Chart I-9The Value Of Output Is Trending Sideways For Copper, But Downwards For Oil This relative trend is likely to continue as the shift from fossil-fuelled road transportation to EVs will weigh on oil demand, while supporting copper (and other metal) demand. We do not recommend an outright overweight in metals and miners given that their profits are just moving in a sideways channel. However, within the cyclical and value segments of the equity market, a good structural position is to overweight metals and miners versus oil and gas. When Oil And Gas Underperforms, So Does Norway’s OBX And The UK’s FTSE 100 Regional and country equity market performances is driven by the dominant sectors within each stock market. In relative terms, it is also driven by the sectors that are missing. If the oil and gas sector is a structural underperformer, then oil and gas heavy stock markets such as Norway and the UK will be structural underperformers too. If the oil and gas sector is a structural underperformer, it inevitably means that oil and gas heavy stock markets such as Norway and the UK will be structural underperformers too (Chart I-10 and Chart I-11). Chart I-10When Oil And Gas Underperforms, Norway's OBX Underperforms... Chart I-11...And The UK's FTSE 100 ##br##Underperforms The corollary is that stock markets which are under-exposed to the structurally underperforming sector will be at a relative advantage. This supports our structural overweighting to the stock markets of Germany, Switzerland, and Denmark, which all have zero exposure to oil and gas and basic resources. Fractal Trading System* Tin’s near-vertical rally is at high risk of correction based on fragility on all three fractal structures: 65-day, 130-day, and 260-day. A good trade is to short tin versus lead, setting a profit target and symmetrical stop-loss at 13 percent. In other trades, the underweights to China and Korea surged, but short AUD/JPY and short copper/gold reached their stop-losses. The rolling 12-month win ratio stands at 57 percent. Chart I-12Tin Vs. Lead When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 ULEZ will be the zone inside London’s North Circular and South Circular Roads. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
The paradox of reflation is that if it is successful, investors should begin to expect a better future today, and thus higher interest rates down the road. This process has begun. Since August 2020, 5-year / 5-year forward TIPS yields have been…
Precious metals have been a prime beneficiary of the reflation efforts of global central banks. Low real rates and a weak dollar are generally positive for the complex, albeit the reaction amongst each of these metals has not been uniform. Platinum has…
Highlights For the month of February, our trading model recommends shorting the US dollar versus the euro and Swiss franc. While we agree a barbell strategy makes sense, we would rather hold the yen and the Scandinavian currencies. In the near term, we recommend trades at the crosses, given the potential for the dollar rally to run further. An opportunity has opened up to short the AUD/MXN cross. We are tightening the stop on our short EUR/GBP position to protect profits. We believe EUR/CHF still has upside. While the US has been labelling Switzerland a currency manipulator, the real culprit is Europe. Precious metals remain a buy. We are placing a limit sell on the gold/silver ratio at 70, after our initial target of 65 was touched. Platinum should also outperform in 2021. Remain long AUD/NZD, as the key drivers (relative terms of trade and cheap valuation) remain intact. Feature Currency markets are at a crossroads. On the one hand, news on the vaccine front continues to progress, raising the specter that we might return to normalcy sometime in the second half of this year. On the other hand, the current lockdowns are slowing down economic activity across the developed world, which is bullish for the dollar. With the DXY index up 1.4% this year, it appears near-term economic weakness is dominating the currency market narrative. Our long-term trade basket is centered on a dollar-bearish theme, but we have been shifting much focus in the near term to non-US dollar opportunities. Central to this has been our conviction that the dollar is due for a countertrend bounce, in an order of magnitude of 2%-4%.1 It appears we are already halfway there (Chart I-1). For the month of January, our trade recommendations outperformed the model allocation. Notable trades were being short gold versus silver and being short EUR/GBP. Silver in particular was a big winner in January (Chart I-2). Most emerging market currencies saw weakness, especially the Korean won, Russian ruble, and Brazilian real Chart I-1The Dollar Has Been Strong In 2021 Chart I-2Our FX Portfolio Did Well In January For the month of February, our trading model recommends shorting the US dollar, mostly versus the euro and Swiss franc (Chart I-3 and Chart I-4). The model gets its signal from three variables: Relative interest rates (both levels and rates of change), valuation, and sentiment.2 While some of these variables have moved in favor the dollar, the magnitude of these moves has not been sufficient to trigger a model shift. We agree a barbell strategy makes sense. That said, we would rather hold the yen (as the safe haven, compared to the CHF) and the Scandinavian currencies (compared to the EUR). These are our two strategic positions, and we made the case for yen long positions last week. Chart I-3Our FX Model Remains ##br##Short USD... Chart I-4...Especially Versus The Euro And Swiss Franc Circling back to our trades at the crosses, we maintain that they should continue to perform well in February and beyond. We revisit the rationale behind these trades, as well as introduce a new idea: Short the AUD/MXN cross. Go Short AUD/MXN A tactical opportunity has opened up to go short the AUD/MXN cross. Central to this thesis are three catalysts: relative economic activity, valuation, and sentiment. The Australian PMI has rebounded quite strongly relative to that in Mexico, driven by the performance of the Chinese economy, versus that of the US economy. Australia exports mostly to China, while Mexico is heavily tied to the US economy. With the Chinese credit impulse rolling over, the US economy has been outperforming of late. If past is prologue, this will herald a lower AUD/MXN exchange rate (Chart I-5). Correspondingly, oil prices are outperforming metals prices. China is the biggest consumer of metals, while the US is the biggest consumer of oil. A higher oil-to-metal ratio is negative for AUD/MXN. Terms of trade between Australia and Mexico have been an important driver of the exchange rate (Chart I-5). China had a massive restocking of metals last year, much more than oil and natural gas. This implies that the destocking phase (should it occur) will be most acute among metal inventories (Chart I-6), suggesting oil imports into China could fare better than metals. On a real effective exchange rate basis, the Aussie is expensive relative to the Mexican peso. Historically, this has heralded a lower exchange rate (Chart I-7). Chart I-5AUD/MXN And Terms Of Trade Chart I-6Chinese Destocking: From Crude Oil To Metals? Chart I-7AUD/MXN Is ##br##Expensive Back in 2020, when everyone was short the Aussie and long the MXN, being a contrarian paid off handsomely. Now, speculators are roughly neutral both crosses. Should the trends we are highlighting carry on into the next few months, this will be a powerful catalyst for speculators to jump on the bandwagon. We recommend opening a short AUD/MXN trade today, with a stop loss at 16.50 and an initial target of 13. Stay Short EUR/GBP Chart I-8An Asymmetry In Pricing Our short EUR/GBP position is performing well, amidst a more hawkish Bank of England this week. Technically, there remains room for much downside on the cross. Real interest rates in the UK are rising relative to those in the euro area. The Brexit discount has not been fully priced out of the EUR/GBP cross, whereas broad US dollar weakness has eroded the discount in cable (Chart I-8). From a technical perspective, speculators are still very long the EUR/GBP, even though our intermediate-term indicator is nearing bombed-out levels (Chart I-9). Chart I-9EUR/GBP Still Has Downside Finally, short EUR/GBP tends to benefit from an outperformance of oil prices. We will be revisiting the fair value of the pound in upcoming reports given the fundamental shifts that are happening in the post-EU relationship. For now, we are tightening stops on our short EUR/GBP position to 0.89, in order to protect profits. Remain Long NOK And SEK Chart I-10NOK Follows Oil Prices The Scandinavian currencies are extremely cheap and an attractive bet for 2021. As such, we believe the recent relapse in their performance provides an opportunity for fresh long positions. For the NOK, a rising oil price is bullish, both against the EUR and USD (Chart I-10). Meanwhile, superior handling of the pandemic has buoyed domestic economic data in Norway. Both retail sales and domestic inflation have been perking up, pushing the Norges Bank to dial forward expectations of a rate lift-off. Sweden is also holding up relatively well this year. Part of the reason for this is that over the years, the drop in the Swedish krona, both against the US dollar and euro, has made Sweden very competitive. With our models showing the Swedish krona as undervalued by 13% versus the USD, there is much room for currency appreciation before financial conditions tighten significantly. The bottom line is that both Norway and Sweden are well positioned to benefit from a global economic recovery, with much undervalued currencies that will bolster their basic balances. We expect both the SEK and NOK to remain the best performers versus the USD in the coming year. Stay Long EUR/CHF While the US has been labelling Switzerland a currency manipulator, the real culprit is the euro area. To be clear, the SNB has been actively intervening in the currency markets. However, when one looks at relative monetary policy, the expansion in the ECB’s balance sheet far outpaces that of the SNB (Chart I-11). With the correlation between balance sheet policy and the exchange rate shifting, it may embolden Switzerland to intervene even more strongly in currency markets. Historically, the Swiss franc was buffeted by the global environment (improving global trade) and rising productivity in Switzerland. As a result, the SNB had no alternative but to try to recycle those excess savings abroad by lifting its FX reserves, or see even stronger appreciation of its currency. With global trade much more muted, intervention in the FX market could be a more potent headwind for the franc. Chart I-11The SNB Is More Hawkish Than The ECB Chart I-12EUR/CHF And The Global Cycle In the near-term, the risk to this trade is that safe-haven flows reaccelerate, as investors re-price risk. However, this will be a short-term hiccup. EUR/CHF is a procyclical cross and will benefit from improvement in the Eurozone economy relative to the rest of the world (Chart I-12). Meanwhile, by many measures, the Swiss franc remains expensive versus the euro. Stay Long AUD/NZD Chart I-13RBA QE Will Hurt AUD/NZD The rally in the kiwi has provided an exploitable opportunity to lean against it. We remain long the AUD/NZD cross, despite the RBA stepping up the pace of QE at its latest meeting. The rationale is as follows: The balance sheet of the RBA was already lagging that of the RBNZ, so the latest move is simply catch up (Chart I-13). It has no doubt been negative for the cross, as Australia-New Zealand rates have compressed. However, when the program expires, the AUD will be subject to external forces once again. The Australian bourse is heavy in cyclical stocks, notably banks and commodity plays, while the New Zealand stock market is the most defensive in the G10. Should value outperform growth, this will favor the AUD/NZD cross. The kiwi has benefited from rising terms of trade, as agricultural prices have catapulted higher. Should a correction ensue, as we expect, this will favor NZD short positions. Our conviction on long AUD/NZD has clearly been hit with the RBA’s latest move. As such, we are tightening stops to 1.05 for risk management purposes. Stay Long Precious Metals, Especially Silver And Platinum We are placing a limit sell on the gold/silver ratio at 70, after our initial 65 target was hit. The rationale for the trade remains intact: In a world of ample liquidity and a falling US dollar, gold and precious metals are bound to benefit. However, silver has underperformed the rise in gold. The long-term mean for the gold/silver ratio is 50, providing ample alpha for this trade (Chart I-14). Chart I-14The Case For Short Gold Versus Silver Silver is heavily used in the electronics and renewable energy industries, which are capturing the new manufacturing landscape. Silver faced resistance near $30/oz. However, this will be a temporary hiccup. The next important level for silver will be the 2012 highs near $35/oz. After this, silver could take out its 2011 highs that were close to $50/oz, just as gold did. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see our Foreign Exchange Strategy report, "Sizing A Potential Dollar Bounce," dated January 15, 2021. 2 Please see our Foreign Exchange Strategy report, "Introducing An FX Trading Model," dated April 24, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades