Sectors
The equity volatility curve inverted on Monday for the first time since June when the SPX had suffered an 8% pullback. The election and fiscal policy related uncertainty has injected fear back into the equity market and the volatility curve inversion is contrarily positive. As a reminder, a VIX with a 33 handle implies that in the next 30 days the S&P 500 will either fall or rise by roughly 10% and vault to all-time highs or sink back to 3100. While there is a chance that the VIX will continue to roar as it did early in the year and push the vol curve deeper in backwardation, our sense is that the correction that commenced in early September is close to running its course. Historically, the chart shows that the VIX inversion is typically short-lived and more often than not serves as a launchpad for the SPX. Bottom Line: Our view remains that the SPX could glide lower into the November election before rallying into year-end courtesy of receding election and fiscal policy uncertainties.
Neutral – Downgrade Alert Sticking to the spirit of covering defensive sectors in this week’s US Equity Sector Insights, today we turn our attention to a major player by market cap weight in the healthcare sector – the S&P pharmaceuticals index. High odds of a Biden victory weigh heavily on this sector’s prospects as we outlined in the recent joined Special Report with our sister Geopolitical Strategy service (please see “Health Care Stands To Lose The Most From A Blue Sweep” section of the report). Simultaneously, the Fed’s almost overnight drop in the fed funds rate to zero in March, coupled with investors’ further rotation out of defensive and into cyclical stocks on the back of the reopening of the economy, further dampen the allure of Big Pharma (middle & bottom panels). The only reason keeping us from downgrading the sector is a potential spike in relative share prices due to a vaccine or other virus-related news. But our sense is that most of the good news is already priced in. Bottom Line: We are neutral the S&P pharmaceuticals index, but getting ready to pull the trigger on our downgrade alert and trim exposure to below benchmark. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5PHAR – JNJ, PFE, MRK, LLY, BMY, ZTS, CTLT, MYL, PRGO.
Your feedback is important to us. Please take our client survey today. Underweight In yesterday’s US Equity Sector Insight we highlighted why investors should stay on the sidelines when it comes to the defensive S&P household products index. But, with regard to the broader S&P consumer staples sector, our view remains that over the next 9-12 months this safe haven sector, which peaked in the depths of the COVID-19 recession, will continue to underperform. As the pandemic-induced recession disappears from the rear-view window, it no longer pays to favor stable cashflow growth staples companies. In fact, our relative macro earnings model paints a dark picture for this GICS1 sector (middle panel). Among other reasons, one of the factors that will drive relative earnings lower is the weaker US dollar. As a reminder, the S&P consumer staples sector derives approximately 32% of its sales from abroad, which is 10 percentage points lower than the S&P 500. As a consequence, on a relative basis staples stocks cannot benefit from positive currency tailwinds to the same extent as the overall market can. Bottom Line: We remain underweight the S&P consumer staples sector.
Neutral We remain neutral the S&P household products index. A V-shaped economic recovery following a recession has historically been synonymous with this defensive industry underperforming (top panel). However, the uniqueness of the current recession must be taken into account. The US consumer continues to binge on household products, which are currently outpacing overall retail sales growth by 13% year-over-year (middle panel, relative consumer spending shown truncated). This trend is slated to continue until a vaccine arrives as the second wave of infections emerges. The same story holds for foreign consumers who also have an incentive to keep up their spending on US household products: a softer US dollar. A weaker US dollar will boost competitiveness of US exporters, which will translate into robust top line growth (bottom panel). Bottom Line: Given the strangeness of the current recession, we remain neutral the S&P household products index. The ticker symbols for the stocks in this index are: BLBG: S5HOPR – PG, CL, KMB, CLX, CHD.
Neutral – Downgrade Alert It no longer pays to chase the S&P homebuilding index higher; it is now on our downgrade alert watch-list. The recent pandemic-induced drubbing in interest rates boosted housing affordability and caused a knee jerk reaction in the mortgage application purchase index, which in turn served as a catalyst for the recent rally (top & middle panels). However, as the economy continues to open up, interest rates will reverse course and flip from a tailwind into a headwind. Sell-side analysts are also upgrading their earnings forecasts at the highest pace since the GFC, and we would lean against this extreme bullishness (bottom panel). Bottom Line: We are neutral the S&P homebuilders index, but it is now on our downgrade watch-list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. For more details, please refer to the recent Weekly Report.
Neutral – Downgrade Alert Banks hit all-time lows again this week on the back of mixed profit results. While Q3 loan loss reserves will rise albeit at a slower pace than H1/2020, net interest income ails and difficulty in growing revenues are significant offsets. This backdrop makes banks hostage to the 10-year US Treasury yield (top panel). With regard to fiscal stimulus and economic uncertainty, Jamie Dimon recently warned that “If the double-dip (recession) happens, we would be under-reserved by $20 billion.” Worrisomely, the longer the new stimulus checks take to arrive, the longer it will take banks to rebound. Banks have been semi-sheltered from the recession courtesy of eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent a fresh stimulus package, the unemployment rate will remain elevated, warning that lagging non-performing loans will skyrocket. Bottom Line: Stay neutral the S&P banks index, but keep it on the downgrade watchlist. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT. For more details, please refer to this Monday’s Weekly Report.
Following up from yesterday’s US Equity Strategy’s sector insight, today we take a closer look at VIX and e-mini futures positioning, again from a contrarian perspective. Using CFTC weekly data, VIX non-commercial speculative positions are net short. In fact, as a percentage of total open interest, net shorts are more extended than the months both prior to “Volmageddon” and to the Q4/2018 20% SPX drawdown. With regard to this year’s equity market carnage, net shorts are almost as extended as in late-2019/early 2020 (VIX net positioning shown inverted, top panel). Similarly, non-commercial speculative positions in S&P 500 e-mini futures are net long on a par with readings recorded in early 2020 (bottom panel). The implication is that speculators are betting on a dying down in volatility and fresh SPX all-time highs. While this will likely materialize post the November election, in the near-term our fear is that speculators will get caught offside, as elevated election and fiscal policy uncertainties will sustain downward pressure on stocks. Bottom Line: Our view remains that the SPX could glide lower into the November election before rallying into year-end.
Highlights Our model suggests that more rate hikes are ahead in 2021; we project a less than 50bps increase in the PBoC policy rate from the current level. Chinese stock prices positively correlate with interest rates and bond yields. The relationship has strengthened since 2015. In the next six to nine months, Chinese stock prices will likely trend up alongside a rising policy rate and an accelerating economic growth. Feature China’s policy rate and bond yields have been rising sharply since May and are breaching their pre-COVID 19 levels. Meanwhile, Chinese stock prices have moved sideways since mid-July, despite a steady recovery in the domestic economy. While some commentators view higher interest rates as a harbinger of an impending equity market weakness, our research shows that the relationship between China’s stock prices and short-term rates has been positive since 2015. A rally in Chinese stocks and outperformance of cyclical stocks relative to defensives positively correlate with rising interest rates and bond yields (Chart 1A and 1B). Chart 1ARising Bond Yields Coincide With Ascending Chinese Stock Prices... Chart 1B...And Offshore Cyclicals Chart 2Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 China’s massive stimulus this year generated some self-sustaining momentum that will likely push the nation’s output higher in 1H21(Chart 2). The PBoC may raise the policy rate by as much as 50bps in 2021 from its current level, but strong domestic fundamentals should be able to drive up Chinese stock prices, in both absolute term and relative to global equities in the next six to nine months. PBoC Policy Hikes:Still More Ahead While the PBoC’s policy rate has rebounded sharply, it remains at its lowest level since the Global Financial Crisis. Looking forward, will the central bank bring the policy rate (e.g. 3-month SHIBOR) back to its pre-COVID 19 range of 3 – 3.5% or the pre-trade war level near 5%? The acceleration in China’s economic recovery is expected to continue and would boost China’s annual output growth in 1H21 to two to three percentage points above its trend. Based on these estimates, our interest rate model implies more than 200bps in rate increases in 2021 from the current level1 (Chart 3). Chart 3Rising Odds Of PBoC Rate Hikes In 2021 Historically, our model has successfully captured the major turning points in China's policy rate cycles. This time around, however, the pandemic and the subsequent economic recovery may have complicated the model's predictive power. The model suggests that, in 1H21 the policy rate will return to its pre-trade war range of 4-5%, but we think the rate increases will be capped within 50bps. The model follows a modified version of "Taylor's Rule," in which we assume that the PBoC will target its short-term interest rate based on the deviation between actual and desired inflation rates and the deviation between real GDP growth and China’s trend GDP growth rate. The latest data shows across-the-board strengthening in the economy; most indicators have surprised to the upside, confirming our optimistic assessment.2 However, Taylor's Rule is not able to account for sudden shocks in the economy, such as a pandemic-induced global recession. Thus, the model exaggerates the magnitude of interest rate bumps, based on an economic growth acceleration following a one-off economic shock. In a report earlier this year, we noted that the PBoC has been proactive in normalizing its monetary policy following short-term shocks.3 This is contrary to economic downturns when the PBoC has been a reactive central bank and its decisions often lagged a pickup in economic activity. As such, although interest rates have swiftly rebounded after the pandemic-induced growth contraction in Q1, we expect the pace of rate hikes to be slower in 2021. Chart 4Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits External factors are accounted for in the model, though they may be underestimated. The US Federal Reserve Bank has decisively shifted its monetary policy to broadly accommodative and will stay behind the inflation curve in the next few years. The collapse in interest rate differentials between the US and China has made RMB-denominated assets attractive, boosting strong inflows of foreign capital and rapidly pushing up the value of the RMB (Chart 4, top panel). While we think Chinese policymakers have pivoted to prefer a strong RMB, the recent countermeasures by the PBoC indicate that the central bank will not allow the RMB to climb too rapidly.4 China's drastic tightening in monetary conditions and the sharp rally in the trade-weighted RMB from 2011 to 2014 led to a prolonged economic downturn (Chart 4, bottom panel). Therefore, in the absence of synchronized policy tightening from other central banks, the magnitude of rate hikes by the PBoC will be measured. Bottom Line: The PBoC will continue to push up the policy rate in 2021, but our baseline view is that the magnitude will be capped below 50bps. Interest Rates And Chinese Stocks Chart 5Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Many investors might think that stock prices tend to react negatively to monetary policy tightening because interest rate upturns and mounting bond yields lead to higher costs of funding for corporations and lower profit growth. However, Chinese stock prices started moving in the same direction with policy rates and bond yields following the burst of the 2014/15 stock market bubble (Chart 5 and Chart 1A and 1B on Page 4 and 2). In general, when China’s economic and profit growth accelerates, share prices can rise with higher interest rates. Share prices can still climb with cuts in interest rates even when economic growth slows but profit growth rate remains in positive territory. However, when profit growth is expected to drop below zero, share prices will drop even if rates are falling (Chart 6A and 6B). In this vein, the most pertinent reason for Chinese stocks to move in tandem with bond yields is that Chinese stocks are increasingly driven by economic fundamentals, which are supported by the volume of total credit creation (measured by total social financing) rather than the price of money in China. Furthermore, the reverse relationship between the volume and price of money in China broke down after 2015; China’s credit creation has become less sensitive to changes in interest rates. Chart 6AWhen Interest Rates Rise... Chart 6B...Economic Growth Holds The Key For Stock Performance Since 2015, the PBOC shifted its policy to target interest rates instead of the quantity of money supply (Chart 7). In order to effectively manage the official interbank rates (the 7-day interbank repo rate), the central bank uses tools such as reserve requirement ratio cuts and liquidity injections in the interbank system (Chart 8). In other words, the central bank has forgone its control of the volume of money. Moreover, since late 2016, rather than direct interest rate hikes, the PBoC has been taking monetary policy tightening measures through changes in its macro-prudential assessment (MPA). The changes in the MPA are evident in the 3-month / 1-week repo spread.5 As such, an increase in the 3-month interbank repo rate (and SHIBOR) is often intended to curb shadow-banking activities rather than depress aggregate credit creation and business activities (Chart 9). Chart 7Monetary Policy Regime Shifted In 2015 Chart 8More Open Market Operations Chart 9Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Another idiosyncrasy is China’s fiscal stimulus, which has become a more relevant driver of total social financing since the onset of the 2014/15 economic downcycle (Chart 10). The amount of government bond issuance is specified by the People’s Congress in March each year and is not affected by changes in interest rates or bond yields. Therefore, growth in total social financing can still accelerate despite a higher price of money (Chart 11). Chart 10Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Chart 11Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing By the same token, a rising 3-month SHIBOR can also be the result of rapid fiscal and quasi-fiscal expansions, as seen in Q3 this year. A flood of central and local government bond issuance drained liquidities from commercial banks, boosting the banks’ needs to borrow money from the interbank system. Nevertheless, the market’s appetite for risk assets increases because fiscal stimulus provides an imminent and powerful reflationary force in China’s business cycles. Chart 12Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Rising policy rates typically push up corporate bond yields. However, bond yields in China play a relatively small role in driving corporate financing costs on an aggregate level, since commercial banks are still dominant in China’s debt market. Commercial banks' average lending rates closely track the PBoC’s policy rate on a cyclical basis, but Chinese authorities periodically use window guidance to target the Loan Prime Rate (LPR), a reformed bank lending rate. Hence, the direction in both the LPR and the average lending rate can temporarily diverge from the policy rate. These measures can boost bank loan growth even in a rising interest rate environment (Chart 12). Bottom Line: The key driver of Chinese stock performance is the country’s domestic credit, business, and corporate profit growth cycles. Since the 2014/15 cycle, the policy rate has not been the determinant of China’s economic or credit growth. Investment Conclusions We expect that this year’s massive monetary and fiscal stimulus to accelerate the country’s economic recovery into 1H21. Therefore, even if interest rates and bond yields advance, Chinese stock prices can still trend upward. Chinese cyclical stocks should also continue to outperform defensives, in both the onshore and offshore markets (Chart 13A and 13B). Chart 13AStay Invested In Chinese Stocks Chart 13BCyclicals Still Have Upside Potentials Rates will begin to climb and fiscal policy will also become more restrictive if China’s output moves above trend growth through 1H21. Government bond quotas and fiscal budget will be determined at the National People’s Congress in March. If the economy is strong, odds are that fiscal stimulus will be scaled back. At that point, investors should start to look for a peak in China’s business cycle linked to monetary and fiscal policy tightening. As growth expectations start to downshift in the equity market, yields on long-dated government bonds will start to decline while yields on the short end will not drop. Additionally, the small-cap ChiNext market has been considered as a speculative segment of the domestic financial market with higher multiples and greater volatility than large-cap A shares. The bourse's trailing price-to-earnings ratio and price-to-book ratio are extremely elevated at 79 and 8.6, respectively, much higher than for broader onshore and offshore Chinese stocks. As such, this market will remain the most vulnerable to domestic liquidity tightening. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 based on our estimates for 1h21: 7.5-8.0% GDP growth, 2.5-2.8% headline CPI, 6.5-6.7 USD/CNY, and the fed holding current fund rate unchanged. 2Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 3Please see China Investment Strategy Weekly Report "Don’t Chase China’s Bond Yields Lower," dated February 19, 2020, available at cis.bcaresearch.com 4On October 12, the PBoC removed financial institutions’ Forex reserve ratio of 20%, making betting against the RMB cheaper. 5Please see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Bulls regained control of the equity market, and frenzied buying on Monday pushed the SPX and NDX indexes within striking distance of fresh all-time highs. Our sense is that the market has finally come round to BCA’s view of better-than-even chances of a “Blue Wave” as we first articulated in a joined Special Report with our Geopolitical Strategy service in mid-July “Blue Trifecta: Broad Equity Market And Sector Specific Implications”. However, market leadership is slightly perplexing. While a “Blue Wave” would make a massive fiscal package highly likely in the New Year, bulls bidding tech titans to nose bleed levels anew argues that a new closing of the economy is upon us. The “sleeping giant” 10-year US Treasury yield still hovering below the June highs also signals that something is amiss with the economy, thus boosting the allure of the longest duration equity sector: tech stocks. Finally, the VIX (volume) put/call ratio recently had a 3 handle (shown inverted as a 21-day moving average, top panel). The chart also shows the VIX (open interest) put/call ratio (PCR) that has historically behaved as a contrarian indicator: a high reading leads to a higher VIX and lower SPX and vice versa (PCR shown inverted, middle panel). In other words, as investors are foregoing downside protection the odds are high that an equity pullback would materialize. Bottom Line: Our view remains that the SPX could glide lower into the November election before rallying into year-end.