Financial Markets
Highlights Portfolio Strategy The risk/reward tradeoff remains squarely to the downside and we are turning cyclically (3-12 month horizon) cautious on the prospects of the broad equity market. The Presidential cycle, UBER’s IPO, the SPX hitting all-time highs following the initial December 2018 yield curve inversion, and two additional yield curve inversions signal that this time is no different and a recession is likely upon us in the coming 18 months. The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P tech hardware storage & peripherals (THS&P) index. Our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Recent Changes Downgrade the S&P THS&P index to neutral, today. Put the S&P tech sector on downgrade alert. Table 1 Feature The SPX appeared to crack early in the week, but dovish Fed President statements saved the day and stocks recovered smartly to end the week on a high note. Our tactically (0-3 month) cautious equity market stance has served us well and has run its course. We are currently leaning toward a cyclically (3-12 month) cautious stance as a slew of our cyclical indicators have rolled over decisively. At the current juncture the big call to make is on the longevity of the business cycle. Crudely put, can the Fed engineer a soft landing or is the looming easing cycle a precursor of recession (Chart 1)? We side with the latter. Chart 1What’s The Opposite Of Bond Vigilantes? This is U.S. Equity Strategy service’s view. BCA’s house view remains constructive on a cyclical 3-12 month time horizon. As a reminder, the ongoing expansion is officially the longest on record and BCA’s house view also calls for recession in late-2020/early-2021. Stan Druckenmiller once famously said “…you have to visualize the situation 18 months from now, and whatever that is, that's where the price will be, not where it is today." Thus, if BCA’s recession view is accurate then we need to start preparing the portfolio for a recessionary outcome. This week we conduct a simple thought experiment on where and why the SPX will be headed as the economy flirts with recession. But first, we rely on the message from our indicators to guide us in determining if the cycle is nearing an end. Last December parts of the yield curve slope inverted (Chart 2) and our simple insight was that the market almost always peaks following the yield curve inversion and we remained bullish on the prospects of the broad equity market and called for fresh all-time highs based on the results of our research.1 On May 1, 2019 we got confirmation as the SPX vaulted to new all-time highs, so that box is now checked. Chart 2The Yield Curve... Beyond the traditional yield curve inversion that forecasts that the Fed’s next move will be a cut and eventually the cycle ends, other yield curve type indicators have inverted and also foreshadow the end of the business cycle. Charts 3A & 3B show that the unemployment gap and another labor market yield curve type indicator have both inverted signaling that the business cycle is long in the tooth. Chart 3A...Is Always Right...Chart 3B...In Predicting Fed Cuts This time is no different and the business cycle will end. Why? Because the Fed has likely raised interest rates (as we first posited on November 19, 2018 and again on December 3, 2018) by enough to trigger a default cycle in the most indebted segment of the U.S. economy where the excesses are most prominent in the current expansion: the non-financial business sector (Chart 4A). Chart 4AMind The Corporate Debt Excesses Chart 4BDefault Cycle Looming Already, junk bond market spreads are widening and the yield curve is predicting that a default cycle is around the corner (yield curve shown on inverted scale, bottom panel, Chart 4B). Another interesting indicator is the Presidential cycle. Chart 5 updates our work from last year showing years 2 & 3 of 17 Presidential cycles dating back to 1950. In the summer of year 3 the SPX typically peaks. Finally, the anecdote of the biggest unicorn, UBER, ipoing on May 10, 2019 also likely marks the ending of the cycle. Therefore if recession looms in the coming 18 months what is the typical magnitude of the SPX EPS drawdown and what multiple do investors pay for trough earnings? Chart 5Presidential Cycle Says Sell While the two most recent recessionary earnings contractions have been severe, we are conservative in estimating a garden variety recession causing a 20% EPS fall. S&P 500 2018 EPS ended near $162/share. This year $167/share is likely and we are now revising down our forecast for next year to $175/share from $181/share previously. A conservative 20% drawdown sets us back to $140/share in 2021. Dating back to the late 1970s when our IBES dataset on the forward P/E multiple commences, the trough forward P/E multiple during recessions averages out to 10x (Chart 6). Remaining on a conservative path we will use 13.5x, or the recent December 2018 trough multiple as our worst case multiple and a sideways move to 16.5x as the most optimistic case. This implies an SPX ending value of between 1890 and 2310 will be reached some time in 2020, with the former resetting the equity market back near the 2016 BREXIT lows. Chart 6Trough Recession Multiple Averages 10x As a result, we are not willing to play a 100-200 point advance for a potential 1000 point drawdown, the risk/reward tradeoff is to the downside. Can and has the Fed previously engineered soft landings that have caused big relief rallies in the equity market? Six times since the 1960s: once in each of the mid-1960s, early-1970s, mid-1970s, mid-1980s and mid-1990s and once in 1998 (top panel, Chart 7). Chart 7Six Mid-cycle Easing Attempts Three easing cycles were not forecast by a yield curve inversion, but the mid-1960s, the mid-1990s and in 1998 the yield curve cautioned investors that an easing cycle was looming (bottom panel, Chart 7). Specifically in 1998 the Fed only acted after the equity market fell by 20%. Another interesting observation is that ex-post five of these six iterations were truly mid cycle, one was very late cycle, but none took place in year 11 of an expansion as is currently the case. We are in uncharted territory. Chart 8 shows the mean profile of the S&P 500 six months prior to and one year post the initial Fed cut. Our assumption is that a cut in July may materialize, thus the vertical line in Chart 8 denotes t=0, which is in sync with the bond market that is pricing a greater than 75% chance of this occurrence. The subsequent market rallies were significant. Our insight from this research is that we already had the explosive rally as Chart 8 depicts, owing to the Fed’s completed pivot, with the stock market rallying from the 2018 Christmas Eve lows to the May 1, 2019 all-time highs by 26%. But, the jury is still out. The biggest risk to our call is indeed a continued rally in the S&P 500 on easy money. A way to mitigate this risk of missing out on a rally is by going long SPX LEAPS Calls once a greater than 10% correction takes root. Chart 8Is The Rally Already Behind Us? Keep in mind, that for the Fed to act and cut rates, stocks will likely have to breach the 2650 level, a point where a reflexive fall will further shake investor’s confidence in profit growth. In other words, the bond market is screaming that Fed cuts are looming, but it also means that stocks have ample room to fall before the Fed cuts rates, i.e. a riot point will force the Fed’s hand. Another big risk to this call is a swift positive resolution on the U.S./China trade dispute, and/or an unprecedented easing from the Chinese authorities which will put us offside as a euphoric rise will definitely ensue. Again SPX LEAPS Calls are an excellent way to position for such an outcome. Netting it all out, the risk/reward tradeoff remains squarely to the downside and we are turning cyclically (3-12 month horizon) cautious on the prospects of the broad equity market. The Presidential cycle, UBER’s IPO, the SPX hitting all-time highs following the initial December 2018 yield curve inversion, and two additional yield curve inversions signal that this time is no different and a recession is likely upon us in the coming 18 months. Thus, this week we are further de-risking the portfolio by downgrading a tech subindex to neutral, setting a tighter stop on a different long term tech subsector holding that has been the cornerstone of the equity bull market, and putting the overall tech sector on downgrade watch. Downgrade Tech Hardware Storage & Peripherals To Neutral In the context of further de-risking the portfolio we are downgrading the S&P tech hardware storage & peripherals index to a benchmark allocation and booking a small loss of 1.0% in relative terms since inception. Four reasons underpin our downgrade of this index that comprises almost 1/5 of the S&P tech market cap. First, index heavyweight Apple has 20% foreign sales exposure to the Greater China region. While we doubt the Chinese will directly retaliate to the U.S. restriction on Huawei by directly targeting Apple, it is still a risk. Moreover, recent news of the FTC and the DOJ targeting GOOGL and FB pose a risk to Apple, especially given its App Store dominance. Any negative news on either front would take a bite out of the sector’s profits. Second, capex has taken a bit hit. Chart 9 shows industry investment is almost nil and capex intentions from regional Fed surveys and from CEO confidence surveys signal more pain down the line. Third, the S&P THS&P index’s internationally sourced revenues are near the 60% mark, and computer exports are also flirting with the zero line. Worryingly, deflating EM Asian currencies are sapping consumer purchasing power and are weighing on industry exports (third panel, Chart 10). Chart 9Capex Blues Chart 10Exports... Similarly, global trade volumes have sunk into contractionary territory and to a level last seen during the Great Recession (not shown). With regard to export expectations the recently updated IFO World Economic Survey still points toward sustained global export ails (second panel, Chart 10). More specifically, tech laden Korean and Taiwanese exports are outright contracting at an accelerating pace and so are Chinese exports. Tack on the negative signal from the respective EM Asian stock market indices and the implication is that more profit pain looms for the S&P THS&P index (Chart 11). Finally, on the domestic front, new orders-to-inventories (NOI) have not only ground to a halt from the overall manufacturing sector, but also computer and electronic product NOI are not contracting on a short-term rate of change basis (bottom panel, Chart 10). Tracking domestic consumer outlays on computer and peripheral equipment reveals that they too have steeply decelerated from the cyclical peak reached in early 2018, painting a softening picture for industry sales growth prospects (Chart 12). Chart 11...Under Pressure Chart 12Soft Sales Backdrop The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P THS&P index. Nevertheless, before getting too bearish there is a silver lining. This index has a net debt/EBITDA of 0.5x versus the non-financial broad market of 2x. On the valuation front this tech subindex trades at 28% discount to the non-financial broad market on an EV/EBITDA basis suggesting that most of bad news is already reflected in bombed out valuations (Chart 13). The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P THS&P index. Bottom Line: Downgrade the S&P THS&P index to neutral for a modest relative loss of 1.0% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CMPE – AAPL, HPQ, HPE, NTAP, STX, WDC, XRX. Chart 13But B/S Remains Pristine Put Tech On Downgrade Alert We are compelled to put the S&P tech sector on our downgrade watch list as President Trump’s hawkish trade talk and actions since May 5 warn that tech revenues (60% export exposure) and profits will likely remain under intense downward pressure. The way we will execute this tech sector downgrade to underweight will be via the S&P software index, the sector’s largest market cap weight. A downgrade to neutral in the S&P software index would push our S&P tech sector weight to a below benchmark allocation. Thus, we are initiating a stop near the 10% relative return mark on the S&P software high-conviction overweight call since the December 3, 2018 inception and also lift the stop to 27% from 17% relative return on the cyclical overweight we have on the S&P software index since the November 27, 2017 inception. Any near term stock market pullback will likely trigger these stops and push the tech sector to an underweight position. Stay tuned. With regard to the overall tech sector, our EPS model is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel, Chart 14). In more detail, tech capex has recaptured market share swinging from below 6% to above 13% in the past decade and now has likely hit a wall similar to the late 1990s peak (second panel, Chart 15). On a rate of change basis tech capital outlays have all peaked and national data corroborate the message from stock market reported data (bottom panel, Chart 15). Chart 14Grim EPS Model Signal Chart 15Exhausted Capex? The San Francisco Fed’s Tech Pulse Index (comprising coincident indicators of activity in the U.S. information technology sector) is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel, Chart 14). Delving deeper into operating metrics, we encounter some profit margin trouble for tech stocks. Not only do industry selling prices continue to deflate, but also our tech sector wage bill gauge is picking up steam. Taken together, all-time high profit margins – double the broad market – appear unsustainable and something has to give (Chart 16). On the export relief valve front, the sector faces twin headwinds. First the trade war re-escalation suggests that an interruption/disruption of tech supply chains is a rising risk, and the firming greenback will continue to weigh on P&Ls as negative translation effects will hit Q2, Q3 and likely Q4 profits (Chart 17). Chart 16Margin Trouble Chart 17Rising Dollar Will Weigh On Revenues & Profits Netting it all out, our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Nevertheless, there are two sizable offsets contrasting all the grim news. Tech stocks are effectively debt free with the net debt/EBITDA sitting on the zero line and valuations a far cry from the tech bubble era. Finally, the drop in interest rates via the 10-year yield and looming Fed cuts will underpin these growth stocks that thrive in a disinflationary backdrop (Chart 18). Netting it all out, our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Bottom Line: We are compelled to put the tech sector on our downgrade watch list. We will execute the S&P tech sector downgrade to underweight when the S&P software index’s stops are triggered. This would push the S&P software index to neutral from currently overweight. Stay tuned. Chart 18But There Is An Offset: Melting Yields Help Growth Stocks Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Bond yields have fallen a lot since the beginning of November, … : At the close on November 8th, the 10-year Treasury bond yielded 3.24%. By last Monday, it was yielding just 2.07%. … but the move isn’t terribly anomalous relative to history: In terms of nominal yields, the decline was just over a one-standard-deviation event; per real yields, it amounted to a -0.7 sigma move. The Fed may be preparing for a rate cut, but overweight duration positions will only pay off if several more follow: A one-and-done rate cut would stretch out the expansion and the bull markets in equities and spread product, but Treasuries are priced for an extended rate-cutting cycle. Feature Stocks are said to be the only asset that people want more of when prices rise, and less of when they fall. Lately, bonds have also seemed to have an upward-sloping demand curve, because more and more people have bought them as they’ve gotten more expensive. A BCA client who’s been shaking his head at the action got in touch with us last week to try to make some sense of it all. Experience tells him that big moves like the one that’s been unfolding since last November don’t go on forever. When they stop, mean reversion would suggest that they’re prone to retrace a good bit of territory. He came to us for some historical context to support or contradict his intuition, as summed up in something like the following statement. “Over the past 50 years, the current move equates to an x-standard-deviation event. Following similar instances, rates have risen by x basis points over the next six months, and by y basis points over the next twelve months.” The Empirical Record The sharp decline in the 10-year Treasury yield that began in early November can be viewed as three separate declines (Chart 1). In the first, the 10-year yield fell by 68 basis points (“bps”) over a span of 37 trading days. After retracing a third of the decline over the next 11 sessions, it slid by another 40 bps over 48 days. Following a one-half retracement over the ensuing 13 days, it shed 53 basis points in 32 days, capped off by a 36-bps decline across the final eight sessions (Table 1). Chart 1The Path To 2.07% Table 1A Lower 10-Year Treasury Yield In Three Steps Using the daily 10-year Treasury yield series beginning in 1962, we compared the individual yield declines for prior 37-, 48- and 32-day periods, as well as for the aggregate 141-day session spanning the entire stretch from the November 8th peak to the June 3rd trough. We also looked at the May 21st to June 3rd crescendo relative to past eight-day segments. The standardized moves range from three-quarters of a standard deviation below the mean for the 48-day middle leg to 1.5 and 1.8 for the 37- and 8-day moves, respectively (Table 2). All in all, the entire move grades out to 1.3 standard deviations below the mean – a somewhat unusual move, but nothing too special. Table 2Standardized Values Of Nominal 10-Year Treasury Yield Declines The current decline’s relative stature is undermined by the wild volatility of the late ‘70s and early ‘80s, when bond yields and annual inflation reached double-digit levels (Chart 2). To try to place the current episode on a more equal framework, we also calculated standardized moves in real (inflation-adjusted) yields. On a real basis, however, the current moves made even less of a splash. The 8-day decline (z-score = -1.2) was the only component that was more than a standard deviation from the mean, and the overall move amounted to just 0.7 standard deviations below the mean (Chart 3). Chart 2No Historical Anomaly In The Current Market Chart 3Little Impact In Terms Of Real Yields We are familiar with the electronic financial media’s increasingly popular convention of stating daily yield moves in proportion to the previous day’s closing yield.1 That convention has the advantage of fitting snugly aside stock price quotes on TV and computer screens, but it is ultimately nonsensical. The proportional change in a bond’s yield relative to its starting yield doesn’t come close to approximating the change in the value of that bond. Comparing proportional changes in bond yields across timeframes would be a way of putting today’s yield moves on a more equal footing with yield moves in the high-inflation, high-coupon era of the late seventies and early eighties, but it conveys no practical information. The margin by which long-maturity Treasuries have outperformed intermediate-maturity Treasuries is unusual, ... Our next steps were instead to compare Treasury total returns and the change in the slope of the yield curve to past flattening and steepening episodes. The moves here were also unavailing over both seven- and one-month periods, as the high-coupon ‘70s and ‘80s still dominated (Chart 4). In terms of the change in the 10-year Treasury yield, both nominal and real; Treasury index total returns; and the slope of the yield curve (3-month rate to 10-year yield), both the aggregate move since last October and its three component moves have amounted to one-standard-deviation events. They would only have had about a one-in-six chance of occurring randomly in a normally distributed population, but they do not represent unsustainable moves that cry out to be reversed. Chart 4Little Impact In Terms Of Treasury Total Returns, ... Digging a little deeper to consider total returns across different regions of the yield curve, we do find one apparent anomaly at the long end of the curve. The long Treasury index has outperformed the intermediate Treasury index by a two-standard-deviation margin over both a seven-month and a one-month timeframe (Chart 5). On a standalone basis, the long Treasury index has beaten the seven-month mean return by one-and-a-half standard deviations, and the one-month mean return by two standard deviations (Chart 6). The two-standard-deviation results would only be expected to occur one out of forty times, and thereby validate our client’s sense that something has been going on. ... and history suggests they’ll be partially unwound over the next six to twelve months. Chart 5... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... Chart 6... And Long-Maturity Returns Have Been Elevated Moving on to the second part of his inquiry, we reviewed the standalone performance of the long Treasury index, and the relative long-versus-intermediate performance, over subsequent six- and twelve-month periods. We focused our analysis on instances when historical z-scores were greater than or equal to their current levels to try to determine if we should expect current performance to reverse and, if so, how sharply. On a standalone basis, long Treasury index performance has gently reverted to the mean over the subsequent six and twelve months, posting returns over those periods within +/- 0.2 standard deviations of its long-run average (Table 3). Table 3Standardized Values Of Future Long-Maturity Treasury Index Returns Outlying relative long-versus-intermediate performance like we’ve witnessed over the last seven months has reversed more convincingly. The long Treasury index has underperformed its intermediate-maturity counterpart over six and twelve months when its z-scores were greater than or equal to their current levels over a seven- and one-month basis, falling roughly 0.5 standard deviations below the mean (Table 4). The future does not have to resemble the past, especially over small sample sizes, but relative long-end underperformance would accord with our constructive view of the U.S. economy. It would also be consistent with our anti-duration and pro-inflation biases. Table 4Standardized Values Of Future Difference Between Long- And Intermediate-Maturity Treasury Index Returns The Fed, Again The consistency of the comments from Fed officials last week would seem to suggest that they are trying to prepare the ground for a rate cut. A cut at next week’s FOMC meeting might be a little too abrupt, but it seems increasingly possible that the committee could guide markets to a cut at the next scheduled meeting at the end of July. Various officials have made it abundantly clear that they view trade tensions as a threat to the economy, and that the bank is prepared to adjust policy, if need be, to sustain the expansion. Uber-dovish St. Louis President Bullard, who said last Monday that, “a downward policy rate adjustment may be warranted soon,” no longer appears to be such an outlier. We do not think a rate cut is necessary, and we would be content to remain on the sidelines if we were on the committee, but our opinion is irrelevant. We endeavor not to be distracted by what we think should happen, devoting our focus instead to determining what’s most likely to happen. To that end, our estimate of the probability that the Fed’s next move might be a cut is rising by the speech/interview. When incorporating that probability into investment strategy, we have been thinking a lot about a question that keeps being raised within BCA: If the Fed cuts rates next week or next month, how will markets respond? Assuming the economic backdrop doesn’t deteriorate, we expect that a rate cut will keep the equity and credit bull markets going. The answer depends heavily on the context in which the Fed cuts, and we assume that if the Fed cuts after the economy has taken a dramatic turn for the worse, risk assets would decline. In that case, markets would presumably read the Fed’s decision as confirmation that things were even worse than they perceived and that a significant bout of risk aversion was right around the corner. On the other hand, if the cut came against a backdrop of decent, if unexciting, economic data, risk assets would likely rally. For an investor who cannot resist injecting his/her opinion into the mix, the market response would be supportive of risk assets if a rate cut was unnecessary, but negative if the economy couldn’t get along without it. Investment Implications We believe that the U.S. economy is doing just fine, thank you, and do not yet see the signs that the expansion requires more monetary accommodation if it is to continue. Assuming that the cast of the incoming data does not change enough to change our view, we would expect that a rate cut would defer the end of the expansion and thereby defer the end of the bull markets in risk assets. We are therefore content to stick with our recommendation that investors should remain at least equal weight equities and spread product. We are still looking for restrictive monetary policy to be the catalyst that ends the expansion, and anything that pushes restrictiveness further into the future ought to keep the market parties going. Our view has aligned with the house view over the last year, but there is no guarantee that it will continue to do so. A growing minority of managing editors has been repeatedly challenging the internal consensus in our daily meetings, and it will be debated vigorously at our monthly view meeting Monday morning in Montreal. It is possible that the house view, and the U.S. Investment Strategy view, could soon become less constructive, though our level of conviction remains fairly high. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 If a bond yielding 3% at Friday’s close ends Monday’s session with a yield of 2.94%, 6 bps lower, its yield is shown as having declined 2% on the day (-.0006/.03 = -2%).
Highlights It remains too early to put on fresh pro-cyclical trades, but the Federal Reserve’s dovish shift is a positive development at the margin. As the market fights a tug of war between weak fundamentals and easier monetary policy, bigger gains are likely to be made at the crosses rather than versus the dollar. Safe-haven currencies are also winners in the interim. Continue to hold short USD/JPY positions recommended last week. Watch the gold-to-bond ratio for cues on where the balance of forces are shifting, with a rising ratio negative for the dollar. Once investors eventually shift their focus towards the rising U.S. twin deficits, de-dollarization of the global economy and low expected returns for U.S. assets, the dollar will peak. New idea: Buy SEK/NZD for a trade. Feature Global markets have once again decided that the U.S. is due for rate cuts, and the Federal Reserve appears to be heeding their message. Both Fed Governor Lael Brainard and Fed Chair Jerome Powell have suggested that policy should be calibrated to address the downside risks posed by the trade war. The question du jour is the path of the dollar if the Fed eventually does ease monetary policy. A slowing global economy on the back of deteriorating trade is positive for the greenback, since it is a counter-cyclical currency. A Fed rate cut will just be acknowledging the gravity of the slowdown. On the other hand, a dovish Fed knocks down U.S. interest rate expectations relative to the rest of the world. This has historically been bearish for the dollar, and positive for global growth. Our bias remains that the dollar will emerge a loser in this tug of war, especially if Beijing and Washington come to a trade agreement. However, for currency strategy, it is important to revisit our indicators to see where the balance of forces for the dollar lie. We do this via the lens of interest rate differentials, global growth, liquidity trends, and positioning. Expectations Versus Reality Markets are mostly wrong about Fed interest rate expectations, but do get it right from time to time. Since the 1990s, most Fed rate-cutting cycles were initially predicted in advance by the swaps market. Moreover, the current divergence between market expectations and policy action is as wide as before the Great Recession, and among the deepest in over three decades (Chart I-1). The fact that the Fed seldom cuts interest rates only once during a mid-cycle slowdown suggests expectations could diverge even further. Outside of recessions, falling rate expectations relative to policy action have historically been bearish for the dollar, and vice versa. This makes intuitive sense. As a reserve and counter-cyclical currency, the dollar has tended to rise during times of capital flight. However, if we are not on the cusp of a recession, then easier monetary policy by the Fed should improve global liquidity, which is bullish for higher-beta currencies and negative for the dollar. On this front, our discounter suggests rate cuts of about 80 basis points are penciled in by the swaps market over the next 12 months. This will put downward pressure on the dollar. It also helps that sentiment on the greenback remains relatively bullish, and speculators are very long the currency (Chart I-2). Chart I-1Big Divergences Are Rare Chart I-2Lots of Room For The Dollar To Fall Chart I-3Relative Rates Moving Against The Dollar Relative interest rate differentials between the U.S. and the rest of the world continue to suggest that the greenback should be slightly higher. However, the Treasury market tends to be a global interest rate benchmark rather than specific to the U.S. With global growth in a downtrend and the Fed becoming relatively more dovish, U.S. interest rates are falling much faster than elsewhere and closing the interest-rate gap vis-à-vis the rest of the world. A peak in U.S. interest rates relative to its G10 peers has always been a bad omen for the greenback (Chart I-3). Market action following the Reserve Bank of Australia’s (RBA) interest rate cut this week is a case in point. The initial reaction was a knee-jerk rally in AUD/USD. Australian 10-year government bond yields are already 65 basis points below U.S. levels, the lowest since the 1980s. But the structural growth rate in Australia remains higher than in the U.S., suggesting there is a natural limit as to how low relative interest rates can go. We remain long AUD/USD, but are maintaining a tight stop at 68 cents should rising volatility nudge the market against us.1 Australian 10-year government bond yields are already 65 basis points below U.S. levels, the lowest since the 1980s. Bottom Line: Interest rate expectations between the rest of the world and the U.S. are already at very depressed levels. This suggests that unless the world economy tips into recession, rate differentials are likely to shift against the greenback. A dovish Fed could be the catalyst that triggers this convergence. Portfolio Flows The change in the U.S. tax code to allow for the repatriation of offshore cash helped the dollar in 2018, but not to the extent that might have been expected. On a rolling 12-month basis, the U.S. has repatriated about $400 billion in net assets, or close to 2% of GDP. Historically, this is a very huge sum that would have had the potential to set the greenback on fire – circa 10% higher. The issue today is that the tax break was a one-off, and net flows into the U.S. are now rolling over as the impact fades (Chart I-4). Historically, portfolio flows into the U.S. have been persistent, so it will be important to monitor how fast repatriation flows run off. The Fed’s tapering of asset purchases has been a net drain on dollar liquidity. In the meantime, foreign investors have been fleeing U.S. capital markets at one of the fastest paces in years. On a rolling 12-month total basis, the U.S. is seeing an exodus of about US$200 billion in equity from foreigners, the largest on record (Chart I-5). In aggregate, both foreign official and private long-term portfolio investment into the U.S. has been rolling over, with investor interest limited only to agency and corporate bonds. Foreigners are still net buyers of U.S. securities, but the downtrend in purchases in recent years is evident. Chart I-4Repatriation Flows Have Peaked Chart I-5Investors Stampeding Out Of U.S. Equities The one pillar of support for the dollar is falling liquidity (Chart I-6). Internationally, the Fed’s tapering of asset purchases has been a net drain on dollar liquidity, despite a widening U.S. current account deficit. The Fed’s balance sheet peaked a nudge above US$4.5 trillion in early 2015 and has been falling since. This has triggered a severe contraction in the U.S. monetary base, and has severely curtailed commercial banks’ excess reserves. However, with the Fed turning more dovish and its balance sheet runoff slated to end in September, dollar liquidity will likely improve at the margin. Chart I-6A Dollar Liquidity Squeeze Bottom Line: Currency markets continue to fight a tug of war between deteriorating global growth and easier monetary conditions. Our bias is that the dollar will emerge a loser. Falling interest rate differentials, portfolio outflows, soft relative growth and easing liquidity strains support this thesis. Another Dovish Shift By The ECB The European Central Bank (ECB) kept monetary policy unchanged following this week’s meeting, while highlighting that it will be on hold for longer – at least until mid-2020. The EUR/USD rallied on the news, suggesting the market expected a much more dovish ECB. Our bias is that with European long-term rates already at rock-bottom levels relative to the U.S., the currency market will continue to be disappointed by ECB policy actions for now. Economic surprises are rising in Sweden relative to New Zealand. Terms for the new Targeted Longer-Term Refinancing Operation (TLTRO III – in other words, cheap loans), were announced at 10 basis points above the main refinancing rate. They can fall as low as 10 basis points above the deposit rate if banks meet certain lending standards. There was no mention of a tiered system for its marginal deposit facility, which would have alleviated some cash flow pressures for euro area banks. We remain of the view that TLTROs are a better policy tool than a tiered central bank deposit system. Chart I-7A Tentative Bottom In Euro Area Data In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy, since liquidity gravitates towards the countries that need it the most. While a tiered system can allow a bank to offer higher rates and attract deposits, there is no guarantee that these deposits will find their way into new loans. It is also likely to benefit countries with the most excess liquidity. The euro’s bounce suggests that the ECB’s dovish shift is paradoxically bullish for the euro. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. Meanwhile, fiscal policy is also set to be loosened. Swedish new orders-to-inventories lead euro area growth by about five months, and the recent uptick could be a harbinger of positive euro area data surprises ahead (Chart I-7). Bottom Line: European rates are further below equilibrium compared to the U.S., and the ECB’s dovish shift will help lift the euro area’s growth potential. Meanwhile, investors are currently too pessimistic on euro area growth prospects. Our bias is that the euro is close to a floor. Buy SEK/NZD For A Trade A few market indicators suggest there is a trading opportunity for the SEK/NZD cross: Since 2015, the cross has been trading into the apex of a tight wedge formation, defined by higher lows and lower highs. From a technical standpoint, the break above the 50-day moving average is bullish, suggesting the cross could gap higher outside its tight wedge (Chart I-8). Economic surprises are rising in Sweden relative to New Zealand. Going forward, this trend is likely to persist given that investor expectations toward the Swedish economy are very bearish (on the back of depressed sentiment towards the euro area). Relative economic surprises have a good track record of capturing short-term swings in the currency (Chart I-9). Chart I-8A Breakout Seems##br## Imminent Chart I-9Sweden Could Perform Better Than New Zealand Interest rates are moving in favor of the SEK/NZD cross. For almost two decades, relative interest rate differentials between Sweden and New Zealand have been a powerful driver of the exchange rate (Chart I-10). The housing downturn appears well advanced in Sweden relative to New Zealand. Rising relative house prices have historically been supportive of the cross (Chart I-11). The undervaluation of the krona has begun to mitigate the effects of negative interest rates, mainly a buildup of household leverage and an exodus of foreign direct investment. Chart I-10Relative Rates Favor SEK/NZD Chart I-11Swedish House Prices Could Stabilize The USD/SEK and NZD/SEK cross tend to be highly correlated, since the SEK has a higher beta to global growth than the kiwi (Sweden exports 45% of its GDP versus 27% in New Zealand). On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the SEK/NZD an attractive way to play USD downside. Meanwhile, the carry cost of being short NZD is lower compared to being short the U.S. dollar. Housekeeping We recommended a short USD/JPY position last week, which is currently 1.3% in the money. Our conviction remains high that this could be the best performing trade over the next one-to-three months. For one, the cross has “underperformed” its safe-haven status. The AUD/JPY is back to its 2016 lows, suggesting the market is flirting with another riot point, but the USD/JPY is still well above 100. We expect the latter to eventually give way as currency volatility rises (Chart I-12). Chart i-12Hold Short USD/JPY Positions Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “A Contrarian View On The Australian Dollar,” dated May 24, 2019, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been negative: Headline and core PCE were both unchanged at 1.5% and 1.6% year-on-year, respectively. Personal income increased by 0.5% month-on-month in April. However, personal spending increased by only 0.3% month-on-month, lower than expected. Michigan consumer sentiment index fell to 100 in May. Markit composite PMI fell to 50.9 in May, with manufacturing and services PMIs both falling to 50.5 and 50.9, respectively. ISM manufacturing PMI fell to 52.1 in May, while non-manufacturing PMI increased to 56.9. MBA mortgage applications increased by 1.5% in May. The trade deficit fell from $51.9 billion to $50.8 billion in April. On the labor market front, initial and continuing jobless claims rose to 218 thousand and 1.682 million, respectively DXY index fell by 0.8% this week. Chairman Powell gave the opening remarks at the FedListens conference organized by the Chicago Fed this Tuesday, during which he stated that the Fed is closely monitoring trade developments, and will act to sustain the expansion. This signals the potential for rate cuts in the coming monetary policy meetings. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative with inflation well below target: Markit manufacturing PMI in the euro area fell to 47.7 in May, as expected. Markit services and composite PMI increased to 52.9 and 51.8 respectively in May. Unemployment rate fell to 7.6% in April. Preliminary headline and core CPI both fell to 1.2% and 0.8% year-on-year respectively in May, dropping to the lowest levels in more than one year. Producer price inflation fell to 2.6% year-on-year in April. Retail sales growth fell to 1.5% year-on-year in April. Employment growth was unchanged at 1.3% year-on-year in Q1. EUR/USD increased by 0.8% this week. On Thursday, the ECB decided to leave interest rates unchanged. The Governing Council also expects the key rates to remain at current levels at least through the first half of 2020. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Housing starts fell by 5.7% year-on-year in April. Construction orders fell by 19.9% year-on-year in April. Consumer confidence fell to 39.4 in May. Nikkei manufacturing PMI increased to 49.8 in May, while Markit services PMI fell to 51.7 in May. Capital spending was positive in Q1, rising 6.1% year-on-year versus expectations of 2.6%. USD/JPY fell by 0.6% this week. Our “Heads I Win, Tails I Don’t Lose Too Much” bet on a short USD/JPY position is currently 1.3% in the money since entered last Friday. Report Links: Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mixed: Nationwide house prices grew by only 0.6% year-on-year in April. Mortgage approvals increased to 66.3 thousand in April. Money supply (M4) increased by 3% year-on-year in April. Markit manufacturing PMI fell to 49.4 in May, the lowest since 2016. Construction PMI also fell to 48.6, while services PMI increased to 51. GBP/USD increased by 0.5% this week. During Trump’s visit to U.K. this week, he said that U.S. companies should have market access to every sector of the British economy as part of any deal. The pound is likely to trade higher until political uncertainty is reintroduced in July, ahead of elections for a new Conservative leader. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: Private sector credit increased by 3.7% year-on-year in April, slightly lower than expected. AiG performance of manufacturing index fell to 52.7 in May, while the services index increased to 52.5. The current account deficit narrowed to from A$6.3 billion to A$2.9 billion in Q1. Retail sales contracted by 0.1% month-on-month in April. GDP came in at 1.8% year-on-year in Q1, in line with expectations. Trade surplus fell to A$4.9 million in April. AUD/USD increased by 0.76% this week. The RBA cut interest rates by 25 bps to a record low of 1.25% on Tuesday, the first move since August 2016. Governor Philip Lowe emphasized that this decision is not due to deterioration in the Australian economy. Moreover, he believes that while the cut might reduce interest income for many, the effects will be fully passed to mortgage rates, thus lowering payments and boosting disposable income. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly negative: Consumer confidence fell to 119.3 in May. Terms of trade increased by 1% in Q1. ANZ commodity price was unchanged in May. NZD/USD increased by 1.4% this week. The New Zealand dollar is benefitting from rising soft commodity prices, on the back of a poor U.S. planting season. However, we believe terms of trade over the longer term will be more favorable for Australia, compared to New Zealand. Hold strategic long AUD/NZD positions. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mostly positive: Industrial product prices increased by 0.8% month-on-month in April. GDP growth increased by 1.4% year-on-year in Q1, above expectations. Markit manufacturing PMI fell to 49.1 in May. Labor productivity increased by 0.3% quarter-on-quarter in Q1. The trade deficit narrowed to C$0.97 billion in April. Exports increased to C$50.7 billion, while imports fell to C$51.7 billion. USD/CAD fell by 1% this week. The latest downdraft in oil prices is likely to have a negative impact on the loonie. We remain short CAD/NOK as a play on better pricing for North Sea crude, versus WTI. Norway will also benefit more from a pickup in European growth. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been neutral: Real retail sales fell by 0.7% year-on-year in April, versus the consensus of -0.8%. Headline inflation fell from 0.7% to 0.6% year-on-year in May. Manufacturing PMI increased to 48.6 in May. USD/CHF fell by 1.1% this week. The franc will benefit from rising volatility as penned in our Special Report three weeks ago. Moreover, the franc is still cheap relative to its fair value. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was little data out of Norway this week: Manufacturing PMI came in at 54.4 in May, from 54 in April. Current account surplus increased from NOK 47.3 billion to NOK 67.8 billion in Q1. USD/NOK fell by 0.6% this week. Our Commodity & Energy team continue to favor oil prices, but have revised down their forecasts from $77/bbl to $73/bbl for Brent this year and next. Despite the recent plunge in crude oil prices, rising inventories in the U.S. allow for OPEC production cuts, which will eventually be bullish. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Manufacturing PMI jumped to 53.1 in May, versus 50.9 in the previous month. Retail sales grew by 3.9% year-on-year in April. Industrial production increased by 3.3% year-on-year in April. Manufacturing new orders rose by 0.1% year-on-year in April. Lastly, the current account surplus increased to SEK 63 billion in Q1. USD/SEK fell by 0.6% this week. We like the Swedish krona as a potential reflation play and are going long SEK/NZD this week for a trade. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Crude oil price volatility surged over the past week, and likely will remain elevated. Underlying prices continue to reflect heightened policy risk ranging from continuing Sino – U.S. trade-war tensions; new tariff threats against Mexico from the Trump administration; global growth concerns, which are fuelled by rising oil inventories in the U.S.; and the continued threat of war in the Persian Gulf (Chart of the Week). These factors are exacerbating recession fears in the U.S., where the yield curve is pricing in a greater than one-in-three chance of a recession one year forward (Chart 2). Given the above-trend performance of the American economy relative to other DM economies, this is disconcerting re global growth generally, and re EM GDP prospects in particular. EM GDP drives EM commodity demand. Given EM commodity demand is the principal driver of global commodity demand, it is especially important in our modeling. Chart of the WeekVolatility Surges on Policy-Risk Concerns Reducing EM GDP growth from 4.2% and 4.5% this year and next to 3.8% and 4.1% shaves ~ $2/bbl off our 2019 Brent price expectation and $3/bbl off our 2020 expectation. Chart 2Bond Market Pricing High Odds of U.S. Recession To be conservative, our oil-demand assumptions for EM GDP have followed World Bank estimates, which means they’ve been below post-Global Financial Crisis (GFC) trend (Chart 3). Cutting right to the chase: Reducing EM GDP growth from 4.2% and 4.5% this year and next to 3.8% and 4.1% shaves ~ $2/bbl off our 2019 Brent price expectation and $3/bbl off our 2020 expectation. This brings our Brent forecast to $73/bbl and $77/bbl for this year and next.1 We continue to expect WTI to trade $7/bbl and $5/bbl below Brent this year and next. Highlights Energy: Overweight. We expect OPEC 2.0 – the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia – to extend its production cuts to year end when it meets later this month or next month. This will still allow OPEC 2.0 to raise production in 2H19 over 1H19 if needed, due to the group's current over-compliance with the agreed cuts. KSA's production is currently close to ~500k b/d below its output target. We believe Wednesday’s inventory report released by the U.S. EIA showing a 22.4mm-barrel increase in commercial crude oil and refined products inventories all but assures OPEC 2.0’s production cuts will be extended when the producer coalition meets. Base Metals: Neutral. Union members who voted to strike a Codelco copper mine over the weekend remain on the job, after Chilean government officials joined to mediate negotiations, according to Fastmarkets MB. Precious Metals: Neutral. Gold rallied above $1,340/oz – up 4% over the past week – as global trade tensions and other factors riling equity, bond and commodity markets intensified. Ags/Softs: Underweight. The USDA reported corn plantings were running at 67% this week, vs. an average of 96% percent over the 2014 – 18 period. The department surveyed 18 states, which account for 92% of all 2018 corn acreage. Feature Global oil demand concerns are manifesting themselves in the almost-relentless selling of futures seen in the past two weeks. This coincided with an increasing risk premium noted in our price decomposition, and with rising concerns over the health of the global economy generally.2 Markets are becoming increasingly concerned U.S. and Chinese trade and foreign policy will spill into the larger global economy and result in a full-blown global trade war. Already, Mexico and Canada have been drawn into this vortex once again – the former is being threatened with U.S. tariffs once more, after presumably having agreed to a revised NAFTA treaty, the latter via increased inspection of meat imports into China.3 On Wednesday, the World Bank lowered its global growth forecast, taking 0.3 percentage points off its 2019 growth estimate – lowering it to 2.6% in 2019 – and reducing its 2020 forecast to 2.7% from 2.8% earlier.4 The Bank noted, “Emerging and developing economy growth is constrained by sluggish investment, and risks are tilted to the downside. These risks include rising trade barriers, renewed financial stress, and sharper-than-expected slowdowns in several major economies.” Assessing Lower EM Growth Prospects We follow the World Bank’s GDP growth estimates closely, largely because the Bank’s forecasts tend to be lower than those of the IMF, which induces a measure of conservatism to our forecasts. We use the Bank’s EM GDP estimates (levels and growth rates) to estimate oil demand in our modelling. Prior to the Bank’s updated forecast released on June 4, we re-estimated EM oil consumption, by shaving 0.4 percentage points from our earlier EM GDP forecast. This means our simulation is 0.1 percentage point below the Bank’s most recent estimate for EM GDP this year, and 0.3 percentage points below the Bank’s 2020 estimate. Using the World Bank's revised forecasts as inputs to our fundamental model – and leaving all other assumptions unchanged – the lower EM GDP estimate for 2019 would take our average Brent expectation to $71/bbl. Averaging this with our existing expectation of $75/bbl leads us to change our 2019 forecast to $73/bbl. To hit this new estimate of $73/bbl would require 2H19 Brent prices to average ~ $79/bbl, which we believe is not unreasonable. For 2020, the slowdown in EM GDP we used gives an expectation of $73/bbl for Brent, versus our previous estimate of $80/bbl. We average these as well, and change our estimate for 2020 Brent to $77/bbl. OPEC 2.0 Remains Focused On Lower Inventories Our lower EM GDP estimates take growth rates to those roughly prevailing during the 2015 – 16 oil-price collapse. This episode was a true global shock, particularly for commodity exporters, which was not offset by higher growth in the GDPs of commodity importers (Chart 4). This go-round is different, however: The 2015 – 16 oil price collapse was a self-inflicted shock, occasioned by OPEC’s decision to launch an all-out market-share war in 2014. This had a devastating effect on EM commodity-exporting countries, particularly the oil exporting countries. We expect OPEC 2.0 to extend production cuts, even though we believe the market will need an additional 900k b/d of production from the producer coalition. This time, the global backdrop is considerably different. For one thing, the oil-price collapse laid the foundation for the formation of OPEC 2.0, which has shown remarkable production discipline since it was founded in November 2016, and took on the mission of reducing the massive unintended inventory accumulation brought on by the combination of the OPEC market-share war and surging U.S. shale production (Chart 5). The nominal target for this mission is OECD inventories. Chart 4EM Oil Demand vs. GDP Chart 5Commercial Oil Inventories Will Resume Drawing We continue to stress this founding principal of OPEC 2.0, because its leadership continues to make it a focal point when engaging with the press and guiding the market. It is for this reason we expect OPEC 2.0 to extend production cuts, even though we believe the market will need an additional 900k b/d of production from the producer coalition to keep prices below $85/bbl. KSA’s Energy Minister, Khalid al-Falih, this week said, “We will do what is needed to sustain market stability beyond June. To me, that means drawing down inventories from their currently elevated levels.”5 Fiscal, Monetary Policy Support EM Demand The other noteworthy aspect of the current market is central banks globally are more accommodative than they were during the 2015 – 16 oil-price collapse. In addition, fiscal stimulus is being deployed globally, and likely will be increased. Against this backdrop, it is difficult to see monetary or fiscal policy being the sort of headwind it has shown it can be post-GFC. As our colleague Peter Berezin noted in last week’s Global Investment Strategy, “politicians will pursue large-scale fiscal stimulus” to avoid a slide into deflation.6 U.S. – Iran Tensions High, But Ebbing Lastly, oil markets seem to have reduced their concern over U.S. – Iran tensions in the Persian Gulf. This may be due to the fact that U.S. Secretary of State Mike Pompeo said the U.S. was “prepared to engage in a conversation (with Iran) with no pre-conditions. We are ready to sit down.”7 All the same, the U.S. recently deployed an aircraft carrier strike group to the Persian Gulf, where it now is on station, and B52 bombers. From the oil market’s perspective, any thawing in the potential military standoff in the Gulf would require the U.S. to abandon its stated goal of reducing Iran’s oil exports to zero. In and of itself, a resumption of official Iranian oil exports would simply re-distribute production cuts and the make-up production OPEC 2.0 is providing markets in the wake of Venezuela’s collapse, where oil production has fallen to ~ 850k b/d from ~ 2mm b/d when OPEC 2.0 was formed. Bottom Line: Wednesday’s massive 22.4mm-barrel build in U.S. crude and refined product inventories shocked the global oil market, and pushed Brent prices toward $60/bbl as we went to press. Almost surely, this will harden KSA’s and OPEC 2.0’s resolve to maintain production cuts into 2H19 to drain oil inventories globally. The lower prices also will act as a headwind to U.S. shale producers, a topic we will take up in a two-part Special Report next week and the following week. We’ve established rig counts in the U.S. shales are closely tied to WTI price levels and curve shape: Lower prices and a flattening forward curve will restrain drilling in the shales, and the rate of growth in U.S. output. Lastly, fiscal and monetary policy globally will be supportive of commodity demand, and EM oil demand in particular, as this stimulus is deployed. We continue to expect prices to rally from here, but have lowered our forecasts slightly to $73 and $77/bbl for Brent this year and next. We continue to expect WTI to trade $7 and $5/bbl below these levels in 2019 and 2020. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1 Please note, we ran our simulations earlier this week, prior to the World Bank’s most recent forecast released June 4. This means our simulation is 0.1 percentage point below the Bank’s most recent estimate for EM GDP this year, and 0.3 percentage points below the Bank’s 2020 estimate. 2 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Policy Risk Sustains Oil’s Unstable Equilibrium,” dated May 23, 2019, available at ces.bcaresearch.com. 3 The amounts involved in the stepped up meat inspections in China are small. However, they can be read as an extension of the foreign-policy imbroglio involving the possible extradition of Huawei Technologies’ CFO from Canada to the U.S. to face trial on charges she and the company allegedly conspired to commit bank and wire fraud to avoid U.S. sanctions on Iran. Chinese officials deny there is any connection. Please see “Canada says China plans more meat import inspections, industry fears disaster,” published by reuters.com June 4, 2019. 4 Please see Global growth to Weaken to 2.6% in 2019, Substantial Risks Seen , published by the World Bank June 4, 2019. 5 This quote came from a reuters.com report that relayed what al-Falih told Arab News. Please see “Saudi’s Falih says OPEC+ consensus emerging on output deal in second half,” published June 3, 2019. 6 Please see Global Investment Strategy Weekly Report titled “MMT And Me,” dated May 31, 2019, which discusses the prospects for large-scale fiscal stimulus and accommodative monetary policy globally. It is available at gis.bcaresearch.com. Peter also expects a détente in the Sino – U.S. trade war, arguing both sides would benefit from reducing trade tensions and tariffs. 7 Please see U.S. prepared to talk to Iran with 'no preconditions', Iran sees 'word-play' published by reuters.com June 2, 2019. This followed news that Iran’s President Hassan Rouhani said his country is willing to speak with the U.S. if it shows respect. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
Highlights Chart 1Bond Rally Supports Stocks Financial markets are pricing-in an intensifying global growth slowdown, but not all assets are responding equally. U.S. Treasuries have rallied strongly, while equities and credit spreads remain resilient. Case in point, the S&P 500 is only 5.9% off its Q3 highs in absolute terms, but is down 11.3% versus bonds (Chart 1). The markets are pricing-in that the Fed will react to slower growth by cutting rates and that easier Fed policy will keep risk assets supported. But consider what will happen if, at the June FOMC meeting, the Fed doesn’t seem as eager to cut rates as the market would like. The perception of less monetary support could prompt a sharp sell-off in equities and credit spreads. That tightening of financial conditions could then be enough to force the Fed’s hand, ultimately leading to the rate cut that the market has already come to expect. The odds of the above scenario are rising by the day, especially since the President’s decision to expand the trade war to Mexico. We recommend a cautious near-term (0-3 month) stance on credit spreads as a hedge against this mounting risk. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 139 basis points in May, dragging year-to-date excess returns down to +221 bps. As we noted in last week’s report, corporate bond spreads have not responded as aggressively as some other assets – commodities and Treasuries – to the escalating trade war and the deteriorating global growth data.1 This leaves the sector vulnerable to a near-term sell-off, especially if the Fed doesn’t validate the market’s dovish expectations at this month’s FOMC meeting. We advise investors to hedge their exposure to credit spreads on a 0-3 month horizon. Beyond that, assuming that the U.S. government’s tariff announcements eventually reach a plateau, the outlook for corporate bond excess returns is positive on a 6-12 month investment horizon. Spreads are comfortably above levels typically seen at this stage of the economic cycle (Chart 2) and, tariffs aside, the U.S. economy is growing at a reasonable clip. As for balance sheets, corporate profit growth contracted in the first quarter, dragging the year-over-year growth rate down to 7%. That is roughly equivalent to the trend rate in corporate debt growth, meaning that if profit growth stabilizes near that level our measure of gross leverage will stay flat (panel 4). We are also keeping a close eye on C&I lending standards. While the most recent data showed an easing in Q1, the continued contraction in loan demand poses a risk (bottom panel). High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 250 basis points in May, dragging year-to-date excess returns down to +443 bps. As with investment grade corporates, the risk of near-term spread widening is high. We noted in last week’s report that excess junk returns versus Treasuries outpaced the CRB Raw Industrials index by 9% during the past 12 months, a historically wide divergence that is bound to fade.2 Looking further out, high-yield bonds still look like a good bet on a 6-12 month investment horizon. Spreads are comfortably above typical levels from past cycles and the excess spread available in the junk index after accounting for expected default losses has risen to 325 bps, well above its historical average (Chart 3). Assuming historically average excess compensation and a 50% recovery rate, current junk spreads discount an expected 12-month default rate of 3.1%. This is well above the Moody’s baseline projection of 1.5% and even above the 2.7% default rate seen during the past 12 months. The spread-implied default rate should be easy to beat, though a persistent increase in job cut announcements could pose a risk (bottom panel). MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 40 basis points in May, dragging year-to-date excess returns down to -13 bps. The conventional 30-year zero-volatility spread widened 6 bps on the month, the combination of a 4 bps widening in the option-adjusted spread (OAS) and a 2 bps increase in the compensation for prepayment risk (option cost). At 49 bps, the conventional 30-year OAS now looks elevated compared to recent years, though it remains slightly below its pre-crisis mean (Chart 4). Nonetheless, we see high odds that the MBS/Treasury basis will contract going forward. Falling mortgage rates and an uptick in refinancing activity led to the recent widening in MBS spreads. But with the housing activity data showing signs of improvement, we anticipate that mortgage rates are close to a trough and that refis will soon peak (panel 2). If the “risk off” sentiment in financial markets prevails in the near-term, then MBS will outperform corporate credit. But expected 6-12 month excess returns remain higher for corporate bonds than for MBS. We therefore maintain only a neutral allocation to MBS, despite increasingly attractive valuations. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 45 basis points in May, dragging year-to-date excess returns down to +107 bps. Sovereign debt underperformed duration-equivalent Treasuries by 205 bps on the month, dragging year-to-date excess returns down to +206 bps. Local Authorities outperformed the Treasury benchmark by 11 bps, bringing year-to-date excess returns up to +219 bps. Meanwhile, Foreign Agencies underperformed by 61 bps, dragging year-to-date excess returns down to +130 bps. Domestic Agencies underperformed by 1 bp in May, bringing year-to-date excess returns up to +28 bps. Supranationals outperformed by 4 bps on the month, bringing year-to-date excess returns up to +27 bps. Sovereign debt remains expensive relative to equivalently rated U.S. corporate credit (Chart 5), and the dollar’s relentless march higher presents a further headwind for the sector. We continue to recommend an underweight allocation. Previously, we made an exception for Mexican sovereign bonds, which trade cheap relative to U.S. corporates (bottom panel). However, with the U.S. government now threatening tariffs on imported Mexican goods, the peso will likely see heightened volatility in the coming months. We recommend standing aside on Mexican sovereigns for the time being. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 75 basis points in May, dragging year-to-date excess returns down to +29 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio rose 1% in May, and currently sits at 80% (Chart 6). The ratio is more than one standard deviation below its post-crisis mean, but close to the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Long-dated municipal bonds (10-year, 20-year and 30-year) have outperformed short-dated munis (2-year and 5-year) by a wide margin since the beginning of the year, but long-end yield ratios remain relatively attractive. 20-year and 30-year Aaa-rated municipal bonds are particularly alluring. Yield ratios for those bonds remain above their pre-crisis averages, whereas 10-year, 5-year and 2-year Aaa yield ratios are close to one standard deviation below their respective pre-crisis means. State & local government balance sheets are in decent shape and a material increase in ratings downgrades is unlikely (bottom panel). We therefore recommend an overweight allocation to municipal bonds, but with a preference for 20-year and 30-year Aaa-rated securities. We showed in a recent report that value declines sharply if you move into shorter maturities or lower credit tiers.3 Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in May, with yields falling by more than 30 basis points for all maturities beyond 1 year. The 2/10 Treasury slope flattened 5 bps on the month and currently sits at 19 bps. The 5/30 slope was unchanged on the month and currently sits at 65 bps (Chart 7). The belly (5-year/7-year) of the curve looks particularly expensive relative to the wings (see Appendix B) and we continue to recommend a barbell curve positioning: Investors should overweight the long and short ends of the curve and avoid the belly.4 Further, this week we recommend an additional fed funds futures calendar spread trade to take advantage of possible near-term Fed actions. Investors should buy the August 2019 contract and sell the February 2020 contract. The long position in the August contract will turn a profit if the Fed responds to market turmoil and cuts rates at the June or July meetings. Meanwhile, the short position in the February 2020 contract will only lose money if 3 or more rate cuts occur between now and then. We would expect our spread trade to return +48 bps in a scenario where the Fed keeps rates flat until next March and +23 bps in a scenario where there is one rate cut in June or July and another rate cut between September and January. The only scenarios where the trade loses money involve two or more rate cuts between September and January. TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 116 basis points in May, dragging year-to-date excess returns down to +39 bps. The 10-year TIPS breakeven inflation rate fell 21 bps on the month and currently sits at 1.74%. The 5-year/5-year forward TIPS breakeven inflation rate fell 15 bps on the month and currently sits at 1.90%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.5 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at a healthy 3% (annualized) clip in April, but has only risen 1.6% during the past year. 12-month trimmed mean PCE inflation has been higher, and actually just moved above the Fed’s target following last week’s April data release (Chart 8). In last week’s report we noted that core PCE inflation has a track record of converging toward the trimmed mean.6 As such, we recommend that investors remain overweight TIPS versus nominal Treasuries in U.S. bond portfolios. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +64 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 5 bps on the month and actually hit a new all-time low of 26 bps in mid-May, before settling at 28 bps (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are also shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in May, bringing year-to-date excess returns up to +195 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month. It currently sits at 69 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst waning demand (bottom panel) and decelerating prices (panel 3). However, CMBS still offer reasonable compensation for this risk. Especially compared to other similarly-rated fixed income sectors.7 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in May, bringing year-to-date excess returns up to +90 bps. The index option-adjusted spread widened 3 bps on the month and currently sits at 51 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread product. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 75 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of May 31, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of May 31, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +56 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 56 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 4 We have specifically been recommending a position short the 7-year bullet and long a duration-matched 2/30 barbell. 5 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
Highlights Inverted Curves & Recessions: While an inverted U.S. Treasury curve has been a reliable early indicator of past U.S. recessions, the current inversion appears “too soon” relative to the evolution of U.S. economic data today compared to past recessions. The Role Of The Term Premium: Term premia on U.S. Treasuries are negative at all maturities, much more so further out the yield curve, thanks to historically low economic and inflation volatility and, of late, greater investor risk aversion. This suggests that the economic signal from an inverted Treasury curve is somewhat distorted by unusually low bond risk premiums. The Stance Of Monetary Policy: Curve inversions that precede recessions are typically accompanied by tight monetary policy that trigger slowing growth expectations. On that front, the Fed’s current stance is roughly neutral based on measures like r* or the Taylor Rule. That does not, however, preclude the Fed from delivering rate cuts to offset the potential economic shock from escalating U.S. trade protectionism. Feature The rush into the safety of government debt accelerated rapidly last week, after another Trump Tariff Tweet targeted Mexican exports to the U.S. Investor confidence, already shaken by the escalation of the U.S.-China trade war, was further eroded by the news that the U.S. was willing to broaden the use of blunt economic tools like tariffs to deal with national security issues like illegal immigration. Global equity and credit markets sold off sharply, adjusting to both higher uncertainty and lower growth expectations. The biggest moves, however, came in the U.S. Treasury market. The 2-year Treasury yield fell -14bps to 1.92% after the Mexico tariff announcement and ended -34bps lower for the entire month of May – the largest monthly decline since November 2008 during the depths of the financial crisis. The 10-year Treasury yield fell -37bps on the month to 2.13%, below the fed funds target range of 2.25-2.5% and 22bps lower than the 3-month U.S. Treasury bill rate. This triggered the dreaded “inversion” signal that has preceded the majority of post-WWII U.S. recessions. The current Treasury curve inversion is not signaling an imminent U.S. recession – although it may signal a need for the Fed to ease policy to offset global growth uncertainties and below-target inflation. Given the well-known predictive properties of an inverted Treasury curve, investors are right to be more nervous about the outlook for U.S. economic growth and the potential for a recession. Multiple Fed rate cuts are now discounted in shorter-maturity Treasury yields. At the same time, the intense flight-to-quality bid for duration exposure has driven the term premium on longer-maturity Treasuries – and all other developed market government bonds – down to unprecedentedly negative territory (Chart of the Week). This can potentially alter the meaning of an inverted yield curve with regards to future economic growth and expected changes in monetary policy. Chart of the WeekUST Curve Inversion: A Too-Tight Fed Or A Too-Low Term Premium? In this Weekly Report, we discuss the typical drivers of yield curve inversions and conclude that the current Treasury curve inversion is not signaling an imminent U.S. recession – although it may signal a need for the Fed to ease policy to offset global growth uncertainties and below-target inflation. Could The Treasury Curve Be Wrong This Time? Chart 2This Is A GLOBAL Bond Rally The current sharp fall in government bond yields is not only occurring in the U.S. Treasury market. Yields are hitting new cyclical lows in many countries, with the 10-year German Bund yield ending May at an all-time low of -0.2%. Yield curves have bull-flattened during this move, with 10-year yields trading below 3-month Treasury bill rates not only in the U.S., but even in places like Canada and Australia (Chart 2). Global yields have been falling steadily since late in 2018, seemingly with little regard to the performance of risk assets in either direction. This suggests a more fundamental driver – like deteriorating growth expectations or perceptions of overly-tight monetary policy – rather than simple asset allocation decisions by investors. In July 2018, we published a Special Report discussing the drivers of yield curve shape in the major developed markets and the potential economic implications.1 For the U.S., we concluded that when the 10-year U.S. Treasury yield traded below the 3-month U.S. Treasury bill rate for an extended period of time (i.e. more than just a few days), the U.S. subsequently entered recession within twelve months, on average (Table 1). With the 10-year yield now trading below the 3-month rate, the clock may have already started counting down to a recession sometime in the next year. Table 1U.S. Curve Flattening, Inversions & Recessions Since 1960 Abstracting away from the yield curve, however, not all other U.S. economic data is behaving in line with past periods leading up to U.S. recessions. The New York Fed has a model that determines the probability of a U.S. recession one year ahead based on the slope of the 10-year/3-month Treasury curve.2 The current curve level translates into a 36% probability of a recession one year from now, which is in line with the probabilities seen before the three previous U.S. recessions (Chart 3). Chart 3New York Fed's Yield-Curve Based Recession Probability Model Flashing Red Abstracting away from the yield curve, however, not all other U.S. economic data is behaving in line with past periods leading up to U.S. recessions. In Chart 4, we show a “cycle-on-cycle” analysis of selected U.S. economic data series, comparing the current backdrop to past U.S. business cycles. For all panels, the solid line represents the current cycle, while the dotted line is the average of the past five U.S. business cycles. The data is lined up such that the vertical line in the chart represents the start date of past U.S. recessions as determined by the National Bureau of Economic Research. Shown this way, we can look how the data is evolving today and see how it compares to the way the data typically moves in the run-up to a recession. Based on the data, we can make the following conclusions: The current weakness in the U.S. manufacturing sector is in line with the start of past recessions, based on the depressed level of the ISM Manufacturing New Orders-to-Inventories ratio. The Conference Board’s U.S. leading economic indicator is usually contracting in the year prior to the onset of recession; today, the year-over-year growth rate is slowing but remains positive at 2.6%. The U.S. consumer is in much better shape today - initial jobless claims are not rising and consumer confidence is not falling, as typically happens in the run-up to an economic downturn. Non-financial corporate profits also typically start to contract about one year before a recession begins; today, profit growth has slowed from the tax cut fueled surge of 2018, but has not yet downshifted into negative territory on a year-over-year basis. We can apply the same cycle-on-cycle analysis to the U.S. Treasury curve to see how today compares to past pre-recessionary periods (Chart 5). Typically, the 2-year Treasury yield falls below the fed funds rate about one full year before the start of a recession, and ends up around 150bps below the funds rate when the downturn actually begins. In the current cycle, the 2-year dipped below the funds rate back in March of this year, and now sits 58bps below the funds rate. Both of those curve relationships, however, are influenced by the changing nature of the Treasury term premium. Chart 4Only A Manufacturing Recession Chart 5Mixed Messages From The Curve The New York Fed produces estimates of the Treasury term premium for all maturities, from one year up to ten years, which allows us to see how the term premium looks different today than prior to past U.S. recessions.3 As can be seen in the bottom two panels of Chart 5, the 10-year term premium has averaged between 100-150bps in the year prior to U.S. recessions, while the 2-year term premium has averaged between 25-50bps over the same period. Today, the term premia for 10-year and 2-year yields are now both deeply negative. This suggests that the current inversion of the 2-year/fed funds curve, and the 10-year/3-month curve, is likely giving too pessimistic a signal about future U.S. growth – a fact corroborated by the cycle-on-cycle analysis of U.S. economic data. Bottom Line: While an inverted Treasury curve has been a reliable early indicator of past U.S. recessions, the current inversion appears “too soon” relative to the evolution of U.S. economic data today versus past recessions. The Message From Depressed Bond Term Premia Today, the estimated term premium for 10-year Treasuries and 2-year Treasuries is -88bps and -70bps, respectively. This means that not only are bond investors willing to accept yields below the expected path of interest rates over the life of a bond (i.e. a negative term premium), they are accepting an even lower term/risk premium for bonds with longer maturities and durations – bonds that are more risky strictly in terms of price volatility. Why would that be? Typically, bond term premia are driven by the following factors: The volatility of inflation The volatility of bond yields and returns The volatility of economic growth Investor risk aversion Proxies for the first three factors are presented in Chart 6, alongside the estimate of the 10-year Treasury term premium dating back to the early 1960s. Broadly speaking, bond term premia have been higher when realized inflation is more volatile (second panel), unemployment is high (third panel) and Treasury yield volatility is elevated. Today, all of those factors are at, or very close to, the lowest levels seen over the past 50 years. No wonder term premia are so depressed. Chart 6Term Premia Are Depressed For Structural Reasons ... Today, while there has been some modest pickup in GDP volatility, the overall stability of growth and, more importantly, inflation is consistent with depressed bond term premiums. This is mildly exaggerating the pessimistic growth signal from an inverted Treasury curve. Investor risk aversion does not exhibit the same type of broad multi-decade trends as growth and inflation, but it is safe to assume that investors become more risk averse when the economic backdrop is more uncertain. Periods of stable growth, categorized by low variability of U.S. nominal GDP growth or a rising trend in the global leading economic indicator, are associated with narrow term premiums and low measures of market-implied bond volatility like the MOVE index of U.S. Treasury option prices (Chart 7). Chart 7... And Cyclical Reasons This result does seem counter-intuitive – more economic uncertainty should make bonds safer, not riskier! The key to remember here is that it is only the term premium component of yields that rises during periods of greater volatility. Actual bond yields fall during those same periods, but because of more fundamental drivers like falling inflation expectations and a lower expected path of interest rates as the Fed eases policy. Today, while there has been some modest pickup in GDP volatility, the overall stability of growth and, more importantly, inflation is consistent with depressed bond term premiums. This is mildly exaggerating the pessimistic growth signal from an inverted Treasury curve. Bottom Line: Term premia on U.S. Treasuries are negative at all maturities, much more so further out the yield curve, thanks to historically low economic and inflation volatility and, of late, greater investor risk aversion. This suggests that the economic signal from an inverted Treasury curve is somewhat distorted by unusually low bond risk premiums. So Is The Fed Actually Running A Tight Monetary Policy? As we discussed in our yield curve Special Report last July, curve inversions typically occur during periods when monetary policy is considered restrictive. For example, every time the real fed funds rate (actual fed funds minus core PCE inflation) has been above the Fed’s estimate of the neutral r* real rate, the 10-year/3-month Treasury curve has inverted (Chart 8). Currently, the real funds rate is essentially equal to the Fed’s latest r* estimate, suggesting that monetary policy is neutral and not restrictive. Chart 8Too Soon For Sustained, Policy-Induced Yield Curve Inversion Other measures like the Taylor Rule can also provide an indication of whether monetary policy is too tight relative to real interest rates and measures of economic spare capacity. If policy was too restrictive, with a fed funds rate above the Taylor Rule, this would imply a more “fundamental” Treasury curve inversion. The Atlanta Fed’s interactive Taylor Rule tool provides estimates of a variety of Taylor Rules, using differing measures of the neutral real fed funds rate and measures of spare capacity.4 We show the results of those Taylor Rules in Table 2. Only one of twenty rules shown is currently producing a fed funds rate below the current 2.25-2.5% range, with fifteen rules indicating that a higher funds rate is still required. Table 2Taylor Rule Fed Funds Prescription Heat Map For 2019: Q2 Chart 9Our Fed Monitor Is Close To Calling For Rate Cuts Yet despite the more traditional indicators suggesting that the current level of the fed funds rate is not too high, that does not mean that there are not potential pressures on the Fed to cut rates. Our own Fed Monitor remains near the zero line, suggesting that no change in the Fed’s stance is warranted (Chart 9). Yet when looking at the individual components of the Fed Monitor, there has been enough softening of U.S. growth and inflation momentum to justify Fed rate cuts. Only the Financial Conditions component is preventing the overall Monitor from moving into the “easier policy required” zone. In other words, if equity and credit markets continue to sell off and the U.S. dollar continues to rally, a Fed rate cut becomes a higher probability outcome. Investment Conclusions Summing it all up, it does not appear that the current inverted Treasury yield curve is signaling a risk of a U.S. recession within the next 6-12 months. A very flat Treasury curve is appropriate with a Fed policy stance that is appropriately neutral. On a cyclical perspective, we still think that a small below-benchmark stance on overall portfolio duration for global bond investors is warranted, along with a modest underweight in U.S. Treasuries in currency-hedged global bond portfolios. On a more tactical basis, however, there is a growing chance that the Fed delivers an “insurance” rate cut or two before year-end in response to the increasing uncertainties over global growth and intensifying trade wars. Those cuts are largely discounted in the current level of yields, though. Our 12-Month Discounter now indicates that -75bps of rate cuts over the next year are priced into the U.S. Overnight Index Swap curve. A good tactical way to play for Fed cuts in 2019 is to implement a fed funds futures calendar spread trade to take advantage of possible near-term Fed actions. Investors should buy the August 2019 contract and sell the February 2020 contract – a position we are adding to our Tactical Overlay (see the table on page 15). The long position in the August contract will turn a profit if the Fed responds to market turmoil and cuts rates at the June or July meetings. Meanwhile, the short position in the February 2020 contract will only lose money if three or more rate cuts occur between now and then. On a more tactical basis, however, there is a growing chance that the Fed delivers an “insurance” rate cut or two before year-end in response to the increasing uncertainties over global growth and intensifying trade wars. We would expect our spread trade to return +45bps (unlevered) in a scenario where the Fed keeps rates flat until next March and +19bps (unlevered) in a scenario where there is one rate cut in June or July and another rate cut between September and January. The only scenarios where the trade loses money involve two or more rate cuts between September and January. Bottom Line: Curve inversions that precede recessions are typically accompanied by tight monetary policy that trigger slowing growth expectations. On that front, the Fed’s current stance is roughly neutral based on measures like r* or the Taylor Rule. That does not, however, preclude the Fed from delivering rate cuts to offset the potential economic shock from escalating U.S. trade protectionism. Go long an August 2019/February 2020 fed funds futures calendar spread trade to profit from near-term “insurance’ Fed rate cuts. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Special Report, “Three Frequently Asked Questions About Global Yield Curves”, dated July 31, 2018, available at gfis.bcaresearch.com and usbs.bcaresearch.com. 2 Details of the NY Fed’s probit model of U.S. recession probability based on the slope of the Treasury curve can be found here: https://www.newyorkfed.org/research/capital_markets/ycfaq.html 3 There are several methodologies used to estimate term premia for government bond yields; the one used by the New York Fed is the Adrian, Crump and Moench (ACM) approach, details of which can be found here: https://www.newyorkfed.org/research/data_indicators/term_premia.html 4 The Atlanta Fed’s interactive Taylor Rule tool can be found here: https://www.frbatlanta.org/cqer/research/taylor-rule.aspx?panel=1 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Feature The GAA DM Equity Country Allocation model is updated as of May 31, 2019. The quant model has not made significant changes in the major country allocations, but has further increased Australia’s overweight after the upgrade in the previous month, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark by 17 bps in May, largely from a 17 bps of outperformance from the Level 1 model, as the Level 2 model only eked out 1 bp of outperformance. Directionally, five out of the 12 choices generated positive alpha. The largest contributions to the outperformance in May came from the overweight in Switzerland and Australia, as well as the underweight in the U.S. Since going live, the overall model has outperformed by 170 bps, with a 350 bps of outperformance by Level 2 model, and an 11bps of outperformance from Level 1. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. Chart 3GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of May 31, 2019. Chart 4Overall Model Performance Table 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations The model’s relative tilts between cyclicals and defensives have changed compared to last month. On the backdrop of weaker global growth, the model has become positive on Consumer Staples and upgraded the sector. This was driven by both the momentum and growth components. This in turn decreases the overweight allocations to Industrials and Utilities, the model’s two overweights, and increases the underweight allocation to the eight remaining sectors. The valuation component remains muted across all sectors. Our expectations are that global growth bottoms in the back end of the year. However, the hard data has not fully materialized yet. While escalated trade war tensions between the U.S. and China continue to put downward pressure on growth indicators, Chinese credit and fiscal stimulus, similar to that of 2009 and 2015, will more than likely put a floor under further downside. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model,” dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com