Economy
According to our BoJ Monitor, there is still a need for additional monetary policy easing to combat weak growth and inflation. BoJ officials have not outright dismissed the possibility that another rate cut could happen, but policymakers have learned that…
Japan remains the poster child for the global low inflation backdrop. Headline CPI inflation is now at only 0.2%, while core CPI inflation is slightly higher at 0.7%. More worrisome, however, is that services CPI inflation dipped slightly below 0% in…
Highlights Structurally overweight US T-bonds versus core European bonds. Our preferred expression is long T-bonds versus Swiss bonds. US yields can fall a lot more than European yields, and European yields can rise a lot more than US yields. Structurally underweight the overvalued dollar versus undervalued European currencies. Our preferred expression is long SEK/USD. Structurally underweight price-sensitive European export sectors. Undervalued European currencies cannot fall much further, and those European exporters that depend on price competitiveness will struggle to outperform. But structurally overweight soft luxuries. Despite President Trump’s threat to tariff French products, soft luxuries retain very strong pricing power and sustainable long term demand growth from rising female labour participation rates globally. Fractal trade: The 65-day fractal structure of global equities suggests that they are vulnerable to a near-term countertrend move. Feature Chart of the WeekLike-For-Like, Structural Inflation Is Lower In the US Than In Europe A seemingly trivial disagreement between Europeans and Americans on how to measure inflation turns out to be the culprit for three major distortions in the world right now: Deeply divergent monetary policies across the developed economies. Huge valuation anomalies in the foreign exchange markets. President Trump’s threat of a trade war to counter the huge trade surpluses that Europe and China are running against the US. The inflation measurement disagreement wouldn’t really matter if inflation were running in the mid-single digits. But when inflation is near zero, the seemingly trivial difference in inflation measurement methodologies has ended up generating massive distortions. European And American Inflation Are Not The Same European inflation excludes the maintenance and upkeep costs associated with owning your home, whereas US inflation includes these costs at a hefty 25 percent weighting, making owner occupied housing by far the largest single item in the US inflation basket. By omitting the largest item in the US inflation basket, European inflation is subtly yet crucially different to American inflation. The European statisticians argue that unlike all the other items in the inflation basket, there is no independent market price for the ongoing cost of home ownership, and therefore this cost should be excluded. The American statisticians argue that the ongoing cost of home ownership is the single largest expense for most people and, as such, it should be ‘imputed’ from a concept known as ‘owner equivalent rent’ – essentially, asking homeowners how much it would cost to rent their own home. Different definitions of inflation will trigger very different policy responses from central banks. Both the European and American approaches have their merits and drawbacks, and it is not our intention to endorse one approach over the other. Our intention is simply to point out that the two approaches can give very different results for inflation – and therefore trigger very different policy responses from inflation-targeting central banks, with their consequent economic and political repercussions. If Americans used the European definition of inflation, then headline inflation in the US today would be running at the same sub-par rate as in the euro area, 1 percent, and well below the Fed’s 2 percent target (Chart I-2 and Chart I-3). More important, the five year annualised rate of inflation – let’s call it US structural inflation – would have been stuck below 1 percent since 2016 (Chart I-1 and Chart I-4). Under these circumstances, it would have been impossible for the Fed to hike the funds rate eight times, as it did through 2017-18. Chart I-2Like-For-Like, Headline Inflation Is Identical In The US And The Euro Area... Chart I-3...And Core Inflation Is ##br##Very Similar Chart I-4Using The European Definition Of Inflation, The Fed Couldn't Have Hiked Rates Instead, what if Europeans used the American definition of inflation? European inflation does not include owner equivalent rent, but it does include housing rent for those that do rent their homes. In the US, these two items tend to move in lockstep (Chart I-5). If we assume the same for Europe, we can deduce that a US type weighting for owner equivalent rent would have boosted the headline inflation rate in the euro area by 0.3-0.4 percent through 2014-16, and by a possible 0.5 percent in Sweden through 2013-15 (Chart I-6 and Chart I-7). Under these circumstances, it would have been very difficult for the ECB and Riksbank to take and maintain policy rates deeply in negative territory, as they did through 2015-19. Chart I-5Owner Equivalent Rent Tracks ##br##Housing Rent Chart I-6Using The American Definition Of inflation, Euro Area Inflation Would Have Been Higher... Chart I-7...And Swedish Inflation Would Have Been Much Higher The Different Definitions Of Inflation Have Created Dangerous Distortions If Europeans and Americans were using the same definition of inflation then, one way or the other, their monetary policies would not be as deeply divergent as they are now. One important implication is that European currencies would not be as undervalued as they are now. If Europeans and Americans were using the same definition of inflation then their monetary policies would not be as deeply divergent as they are now. Based on the ECB’s own analysis, the euro area is over-competitive versus its top 19 trading partners – meaning the euro is undervalued – by at least 10 percent. Moreover, the ECB admits that this sizable undervaluation only appeared after the ECB and Fed started taking their monetary policies in opposite directions in 2015 (Chart I-8). Chart I-8The Euro Is Undervalued By More Than 10 Percent Put the other way, the dollar would not be as overvalued as it is now. In turn, the stronger dollar has created its own dangerous spill-overs. As we explained last week in The Hidden Sales Recession Of 2015… And Why It Matters Now, the surging dollar in 2015 could not have come at a worse time for China. Given that the Chinese economy was already slowing sharply, and the yuan was pegged to the dollar, the resulting loss of Chinese competitiveness just exacerbated the slump. Forcing China to loosen the dollar peg in August 2015. All of which brings us neatly to the hot topic of 2019, and likely 2020 too – President Trump’s threat of a trade war to counter the huge trade imbalances that Europe and China are running against the US. As it happens, President Trump has a good point. Trade wars almost always stem from trade imbalances; and trade imbalances almost always stem from exchange rate manipulations or, at least, exchange rate distortions that advantage one economy to the detriment of another. The euro's undervaluation only happened after monetary policies diverged in 2015. Most of the euro area’s €150 billion trade surplus with the US appeared after 2015, so it cannot be a structural issue. In fact, the evolution of the trade imbalance has tracked relative monetary policy between the Fed and ECB almost tick for tick (Chart I-9), via the exchange rate channel and the over-competitiveness of the euro which the ECB fully admits. Chart I-9Excessively Divergent Monetary Policies Caused The Euro Area's Huge Trade Surplus With The US Of course, neither the ECB nor the Fed are deliberately targeting trade or the exchange rate; they are targeting inflation. But to repeat, they are targeting different definitions of inflation. Crucially, with a backdrop of near zero inflation, small definitional differences in inflation can generate huge economic and financial distortions, with dangerous political consequences. The Compelling Structural Opportunities The definitional difference between European and American inflation explain many of the economic and financial distortions we are witnessing now, as well as the dangerous political consequences. The main counterargument is that the inflation definitions are what they are; neither the ECB nor the Fed are likely to change them anytime soon. Nevertheless, there are compelling structural opportunities. Since 2015, American inflation has outperformed European inflation for one reason and one reason only: owner equivalent rents have surged by almost 20 percent relative to other prices (Chart I-10 and Chart I-11). The historic evidence suggests that such a pace of outperformance is unsustainable structurally and, absent this tailwind, US and European headline inflation rates have to converge, one way or the other. Chart I-10An Unsustainable Surge In US Owner Equivalent Rent... Chart I-11...Has Lifted US Headline ##br##Inflation In this inevitable convergence, the asymmetric starting point of bond yields favours a long US T-bonds, short core European bonds structural position. Because, if the inflation convergence is downwards, T-bond yields will fall much further than European yields; whereas if the inflation convergence is upwards, European yields will likely rise more than T-bond yields. Our preferred structural expression is: long US T-bonds, short Swiss bonds. For currencies it is the opposite message. The overvalued dollar is likely to underperform, at least versus other developed market currencies. Given that Swedish inflation has been the most understated by the exclusion of owner equivalent rents, combined with the Riksbank’s intention to exit negative interest rate policy imminently, our preferred structural expression is: long SEK/USD. American inflation has outperformed European inflation for one reason and one reason only: owner equivalent rents have surged by almost 20 percent relative to other prices. Lastly, European export growth – even in Germany – has been heavily reliant on a cheapening euro (Chart I-12). Undervalued European currencies cannot fall much further, and those European exporters that depend on price competitiveness will struggle to outperform. Even those multinationals that sell their products in dollars will lose out in the accounting translation back into a strengthening domestic currency. Hence, structurally underweight price-sensitive European export sectors. Chart I-12Without A Weaker Euro, Most European Exporters Will Struggle To Outperform The one exception to this is the soft luxuries sector. Despite President Trump’s threat to tariff French products, soft luxuries retain very strong pricing power and sustainable long term demand growth from rising female labour participation rates globally. Stay structurally overweight soft luxuries. Fractal Trading System* The 65-day fractal structure of global equities suggests that they are vulnerable to a near-term countertrend move. Accordingly, this week’s recommended trade is to short the MSCI All Country World versus the global 10-year bond (simple average of US, euro area, and China), setting a profit target and symmetrical stop-loss at 2.5 percent. In other trades, long NZD/JPY and long SEK/JPY both achieved their profit targets of 3 percent and 1.5 percent respectively. Against this, long Poland versus World reached its 4 percent stop-loss. The rolling 1-year win ratio now stands at 65 percent. Chart I-13MSCI All-Country World Vs. Global 10-Year Bond When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights China’s PMIs continue to flash a positive signal, but the hard data trend remains negative. There has been a notable improvement in China’s cyclical sectors (versus defensives) over the past month, but broad equity market performance has been flat-to-down. China’s lackluster equity index performance in the face of rising PMIs suggests that investors can afford to wait for an improvement in the hard economic data before tactically upgrading to overweight. Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets versus the global benchmark, favoring the former over the latter. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, China’s November PMIs were clearly positive, and the rise in the official manufacturing PMI above the 50 mark is notable. However, the odds continue to favor a bottoming in the economy in Q1 rather than Q4, in large part because China’s “hard” economic data has continued to deteriorate during the time that the Caixin PMI has been signaling an expansion in manufacturing activity. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, China’s cyclical sectors have outperformed defensives, which is consistent with the positive message from China’s PMIs. But China’s broad equity markets have been flat-to-down versus the global index over the past month, suggesting that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight (from neutral). Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets, but favor the former over the latter in a trade truce scenario. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Both measures of the Li Keqiang index (LKI) that we track indicated no obvious improvement in Chinese economy activity in October. The BCA China Activity indicator, a broader coincident measure of China’s economy, also moved sideways in October and (for now) remains in a downtrend. Thus, based on the “hard data”, Chinese economic activity has not yet bottomed. Chart 1A Moderate Strength Economic Recovery Will Begin In Q1 The components of our LKI leading indicator continue to tell a story of easy monetary conditions and sluggish money & credit growth (Chart 1). The indicator itself remains in an uptrend, but it is a shallow one that does not match the intensity of previous credit cycles. While the uptrend in the indicator suggests that China’s economy will soon bottom, the shallow pace suggests that the coming rebound in growth will be less forceful than during previous economic recoveries. The uptrend in headline CPI is a notable macro development, with prices having risen 3.8% year-over-year in Oct (the fastest pace in almost eight years). This rise has been driven almost entirely by a surge in pork prices, which have risen over 60% relative to last year (panel 1 of Chart 2). While some investors have questioned whether the rise in headline inflation will cause the PBoC to tighten its stance at the margin, we argued with high conviction in our November 20 Weekly Report that this will not occur.1 Panel 2 of Chart 2 shows that periods of easy monetary policy line up strongly with periods of deflating producer prices, arguing that the PBoC will see through transient shocks to headline inflation. China’s October housing market data highlighted three points: housing sales are modestly improving, the pace of housing construction has again deviated from the trend in sales, and housing price appreciation is slowing in Tier 2 and Tier 3 markets. For now, we are inclined to discount the surge in floor space started, given previous divergences that proved to be unsustainable. The bigger question is whether investors should be concerned about slowing housing prices. Chart 3 shows that floor space sold and property prices have been negatively correlated over the past three years, in contrast to a previously positive relationship. Deteriorating affordability and tight housing regulations have contributed to this shift in correlation, which helps explain why the PBoC’s Pledged Supplementary Lending (PSL) program has been so closely related to housing sales over the past few years. While the growth in PSL injections is becoming less negative, it has not risen to the point that it would be associated with a strong trend in sales. As such, we continue to see poor affordability as a threat to further housing price appreciation, absent stronger funding assistance. Poor affordability will continue to be a headwind for China’s housing market. Chart 2The PBoC Will See Through Transient Shocks To Headline Inflation Chart 3Poor Affordability Will Continue To Weigh On Housing Demand Chart 4Investors Need To See Concrete Signs Of A Hard Data Improvement China’s November PMIs were quite positive, which legitimately increases the odds that China’s economy is beginning the process of recovery. However, we see two reasons to believe that the odds continue to favor a bottoming in the economy in Q1 rather than Q4. First, while they improved in November, several important elements of the official PMI remain in contractionary territory, particularly the new export orders subcomponent. Second, while the Caixin PMI has now been above the 50 mark for 4 consecutive months, China’s hard data has continued to deteriorate since the summer (Chart 4). Given the historical volatility of the Caixin PMI, we advise investors to wait for concrete signs of a hard data improvement before firmly concluding that China’s economy is recovering. Over the last month, China’s investable stock market has rallied roughly 1% in absolute terms, while domestic stocks have fallen about 3%. In relative terms, A-shares underperformed the global benchmark, while the investable market moved sideways. In our view, the underperformance of China’s domestic market reflects increased sensitivity to monetary conditions and credit growth compared with the investable market,2 and a weaker credit impulse in October appears to have been the catalyst for A-share underperformance. Over the cyclical horizon, earnings will improve in both the onshore and offshore markets in response to a modest improvement in economic activity, suggesting that an overweight stance is justified for both markets. But we think the investable market has more upside potential in a trade truce scenario. The outperformance of cyclical versus defensive sectors is sending a positive signal, but investors can afford to wait for better economic data before tactically upgrading. Chart 5A Positive Sign From Cyclicals Versus Defensives Within China’s investable stock market, it is quite notable that cyclicals have outperformed defensives over the past month on an equally-weighted basis (Chart 5). Interestingly, key defensive sectors such as investable health care and utilities have sold off significantly, and equally-weighted cyclicals have also outperformed defensives in the domestic market. The outperformance of cyclicals and underperformance of defensives is consistent with the positive message from China’s PMIs, but the fact that this improvement is occurring against the backdrop of flat-to-down relative performance for China’s equity market suggests that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. China’s government bond yields fell slightly in November, potentially reflecting expectations of further modest easing. Our view that monetary policy will likely remain easy over the coming year even in a modest recovery scenario suggests that Chinese interbank rates and government bond yields are likely to range-trade over the coming 6-12 months. We expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. Chinese onshore corporate bond spreads eased modestly over the past month. Despite continued concerns about onshore corporate defaults, the yield advantage offered by onshore corporate bonds have helped the asset class generate a 5.4% year-to-date return in local currency terms. Barring a substantial intensification of the pace of defaults, we expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. The RMB has moved sideways versus the US dollar over the last month. USD-CNY had fallen below 7 in October following the announcement of the intention to sign a “phase one” trade deal, but the move ultimately proved temporary given the deferral of an agreement. We would expect the RMB to appreciate following a deal of any kind (a truce or something more), and it is also likely to be supported next year by improving economic activity. Still, it would not be in the PBoC’s best interests to let the RMB appreciate too rapidly, because an appreciating Chinese currency would act as a deflationary force on China’s export and manufacturing sectors. As such, we expect a modest downtrend in USD-CNY over the coming year. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report "A Guide To Chinese Investable Equity Sector Performance," dated November 27, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
The global trade slowdown has dealt a small blow to Japan’s current account balance. The trade deficit widened further in 2019, reaching -0.5% of GDP in Q3. Exports have been falling for a 10th consecutive month, weighed down in part by lower sales of auto…
Highlights Chart 1Manufacturing PMIs Track Bond Yields November’s manufacturing PMI data were released yesterday, giving us an update for two of our preferred global growth indicators: the Global Manufacturing PMI and the US ISM Manufacturing PMI (Chart 1). Unfortunately, the two indicators sent conflicting signals, providing us with very little clarity on the global growth outlook. On the positive side, the Global Manufacturing PMI jumped back above 50 for the first time since April. China is the largest weighting in the global index, and its PMI rose for the fifth consecutive month. Conversely, the US ISM Manufacturing PMI dipped further into contractionary territory in November – from 48.3 to 48.1. Optimistically, the index’s inventory component contracted by more than the new orders component, meaning that the difference between new orders and inventories rose to its highest level since May. The difference between new orders and inventories often leads the overall ISM index by several months. All in all, we continue to see tentative signs of stabilization in our preferred global growth indicators. But a more significant rebound will be necessary to push bond yields higher in the first half of next year, as we expect. Stay tuned. Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 63 basis points in November, bringing year-to-date excess returns up to +494 bps. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions and (iii) valuation.1 On balance sheets, our top-down measure of gross leverage is high and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. The third quarter’s tightening of C&I lending standards is a concern, because it suggests that monetary conditions may not be sufficiently stimulative for banks to keep the credit taps running (bottom panel). But the yield curve, another indicator of monetary conditions, has steepened significantly since Q3, suggesting that lending standards will soon move back into “net easing” territory. For now, we see valuation as the main headwind for investment grade credit spreads. Spreads for all credit tiers are below our targets, with the Baa tier looking less expensive than the others (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds, with a preference for the Baa credit tier. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher (see page 7). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 47 basis points in November, bringing year-to-date excess returns up to +671 bps. The index option-adjusted spread tightened 22 bps on the month and currently sits at 370 bps, 131 bps above our target (Chart 3). Ba and B rated junk bonds outperformed the Treasury benchmark by 79 bps and 76 bps, respectively, in November. But Caa-rated credit underperformed Treasuries by 89 bps. This continues the trend of Caa underperformance that has been in place since late last year (panel 3). We analyzed the divergence between Caa and the rest of the junk bond universe in last week’s report and came to two conclusions.3 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for this year’s Caa underperformance that make us inclined to downplay any potential negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of this year’s underperformance (bottom panel). With elevated spreads, accommodative monetary conditions and a looming recovery in global economic growth, we expect junk spreads to tighten during the next 6-12 months. MBS: Overweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in November, bringing year-to-date excess returns up to +22 bps. The conventional 30-year zero-volatility spread tightened 3 bps on the month, as a 5 bps tightening of the option-adjusted spread (OAS) was offset by a 2 bps increase in expected prepayment losses (aka option cost). We recommend an overweight allocation to Agency MBS, particularly relative to corporate bonds rated A or higher, for three reasons.4 First, expected compensation is competitive. The conventional 30-year MBS OAS is now 50 bps (Chart 4). This is very close to its pre-crisis average and only 3 bps below the spread offered by Aa-rated corporate bonds (panel 4). Also, spreads for all investment grade corporate bond credit tiers trade below our targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most homeowners have already had at least one opportunity to refinance their mortgages. This burnout will keep refi activity low, and MBS spreads tight (panel 2). Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 14 basis points in November, bringing year-to-date excess returns up to +197 bps. Sovereign debt outperformed duration-equivalent Treasuries by 36 bps on the month, bringing year-to-date excess returns up to +513 bps. Local Authorities outperformed the Treasury benchmark by 24 bps, bringing year-to-date excess returns up to +245 bps. Meanwhile, Foreign Agencies outperformed by 4 bps, bringing year-to-date excess returns up to +266 bps. Domestic Agencies outperformed by 11 bps in November, bringing year-to-date excess returns up to +51 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +36 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Foreign Agencies and Local Authorities, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 70 basis points in November, bringing year-to-date excess returns up to +6bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell 4% in November, and currently sits at 83% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Specifically, 2-year and 5-year M/T yield ratios are somewhat below average pre-crisis levels at 68% and 72%, respectively. However, M/T yield ratios for longer maturities (10 years and higher) are all above average pre-crisis levels. M/T yield ratios for 10-year, 20-year and 30-year maturities are 84%, 93% and 97%, respectively. Fundamentally, state & local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve shifted higher in November, steepening out to the 7-year maturity and flattening beyond that. The 2/10 Treasury slope was unchanged on the month. It currently sits at 17 bps. The 5/30 slope flattened 7 bps to end the month at 59 bps (Chart 7). In a recent report we discussed the 6-12 month outlook for the 2/10 Treasury slope.8 We considered the main macro factors that influence the slope of the yield curve: Fed policy, wage growth, inflation expectations and the neutral fed funds rate. We concluded that the 2/10 slope has room to steepen during the next few months, as the Fed holds down the front-end of the curve in an effort to re-anchor inflation expectations. However, we see the 2/10 slope remaining in a range between 0 bps and 50 bps, owing to strong wage growth and downbeat neutral rate expectations. Despite the outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers strong positive carry (bottom panel), due to the extreme overvaluation of the 5-year note, and looks attractive on our yield curve models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 47 basis points in November, bringing year-to-date excess returns up to -70 bps.The 10-year TIPS breakeven inflation rate rose 8 bps on the month and currently sits at 1.62%. The 5-year/5-year forward TIPS breakeven inflation rate rose 9 bps on the month and currently sits at 1.73%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.9 That being said, the 10-year TIPS breakeven inflation rate is currently 29 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +74 bps. Chart 9ABS Market Overview The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month. It currently sits at 34 bps; its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS rank among the most defensive US spread products and also offer more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate is still low, but has put in a clear bottom. The is true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating ABS credit metrics are also a cause for concern. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in November, dragging year-to-date excess returns down to +221 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month. It currently sits at 72 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer Survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). CRE prices are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +107 bps. The index option-adjusted spread tightened 2 bps on the month, and currently sits at 54 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 26 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of November 29 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 29, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 45 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 45 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of November 29, 2019) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 For details on how we arrive at our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
Feature Recommended Allocation In late November, BCA Research published its 2020 Outlook titled Heading Into The End Game, an annual discussion between BCA’s managing editors and the firm’s longstanding clients Mr. and Ms X.1 We recommend GAA clients read that document for a full analysis of the macro and investment environment we expect in 2020. In this Monthly Portfolio Outlook, we focus on portfolio construction: how we would recommend positioning a global multi-asset portfolio for the 12-month investment horizon in light of that analysis. First, a brief summary of the BCA macro outlook. We believe the global manufacturing cycle is starting to bottom out, partly because of its usual periodicity of 18 months from peak to trough, and also because of easier financial conditions, and some moderate fiscal and credit stimulus from China (Chart 1). Central banks will remain dovish next year despite accelerating growth. The Fed, in particular, worries that inflation expectations have become unanchored (Chart 2) and, moreover, will be reluctant to raise rates ahead of the US presidential election. This environment implies a moderate rise in long-term interest rates, with the US 10-year Treasury yield rising to 2.2-2.5%. Chart 1Reasons To Expect A Rebound Chart 2Unanchored Inflation Expectations Worry The Fed For an asset allocator, this combination of an improving manufacturing cycle and easy monetary policy looks like a very positive environment for risk assets (Chart 3). We, therefore, remain overweight equities and underweight fixed income. We have discussed over the past few months the timing to turn more risk-on and pro-cyclical in our recommendations.2 Since we are increasingly confident about the probability of the manufacturing cycle turning up, this is the time to make that change. Consequently, the shifts we are recommending in our global portfolio, shown in the Recommended Allocation table and discussed in detail below, add to its beta (Chart 4). Chart 3A Positive Environment For Risk Assets Chart 4Raising The Beta Of Our Portfolio Chart 5Some Signs Of Risk-On Still Missing Nonetheless, we still have some concerns. China’s stimulus (particularly credit growth) remains half-hearted compared to previous cyclical rebounds in 2012 and 2016. We expect a “phase one” ceasefire in the trade war. But even that is not certain, and it would not anyway solve the long-term structural disputes. To turn fully risk-on, we would want to see signs of a clear rebound in commodity prices and a depreciation of the US dollar, which have not yet happened (Chart 5). The 2020 Outlook proposed some milestones to monitor whether our scenario is playing out and whether we should turn more or less risk-on. We summarize these milestones in Table 1. Given these uncertainties, to hedge our pro-cyclical positioning we continue to recommend an overweight in cash, and we are instituting an overweight position in gold. Table 1Milestones For 2020 Chart 6Recessions Are Caused By Inflation Or Debt How will this cycle end? All recessions in modern history have been caused either by a sharp rise in inflation, or by a debt-fueled asset bubble (Chart 6). The Fed will likely fall behind the curve at some point as, after further tightening in the labor market, inflation starts to pick up. How the Fed reacts to that will determine what triggers the recession. If – as is most likely – it lets inflation run, that could blow up an asset bubble (and it was the bursting of such bubbles which caused the 2000 and 2007 recessions); if it decides to tighten monetary policy to kill inflation, the recession would look more like those of the 1970s and 1980s. But it is hard to see either happening over the next 12-18 months. Equities: As part of our shift to a more pro-risk, pro-cyclical stance, we are cutting US equities to underweight, and raising the euro zone to overweight, and Emerging Markets and the UK to neutral. US equities have outperformed fairly consistently since the Global Financial Crisis (Chart 7) – except during the two periods of accelerating global growth, in 2012-13 (when Europe did better) and 2016-17 (when EM particularly outperformed). The US today is expensive, particularly in terms of price/sales, which looks more expensive than the P/E ratio because the profit margin is at a record high level (Chart 8). The upside for US stocks in 2020 is likely to be limited. In 2019 so far, US equities have risen by 29% despite earnings growth close to zero. Multiples expanded because the Fed turned dovish, but investors should not assume further multiple expansion in 2020. Our rough model for US EPS growth points to around 8% next year (sales in line with nominal GDP growth of 4%, margins expanding by a couple of points, plus 2% in share buybacks). Add a dividend yield of 2%, and US stocks might give a total return of 10% or so. Chart 7US Doesn't Always Outperform Chart 8US Equities Are Expensive To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Euro zone stocks have a higher weighting in sectors we like such as Financials and Industrials (Table 2). European banks, in particular, look attractively valued (Chart 9) and offer a dividend yield of 6%, something investors should find appealing in this low-yield world. EM is more closely linked to China and commodities prices, which are not yet sending strong positive signals. We worry about the excess of debt in EM (Chart 10), which remains a structural headwind: the IMF and World Bank put total external EM debt at $6.8 trillion (Chart 11). Table 2Equity Sector Composition Chart 9Euro Zone Banks Are Especially Cheap Chart 10EM Debt Remains A Headwind Japan is another likely beneficiary of a cyclical recovery. But, before we turn positive, we want to see (1) signs of a stabilization of consumption after the recent tax rise (retail sales fell by 7% year-on-year in October), and (2) clarification of a worrying new investment law (which will require any investor which intends to “influence management” to get prior government approval before buying as little as a 1% stake in many sectors). For an asset allocator this combination of an improving manufacturing cycle and easy monetary policy looks very positive for risk assets. We raise the UK to neutral. The market has been a serial underperformer over the past few years, but this has been due to the weak pound and derating, rather than poor earnings growth (Chart 12). It now looks very cheap and, with the risk of a no-deal Brexit off the table, sterling should rebound further. The UK is notably overweight the sectors we like (Table 2). However, political risk makes us limit our recommendation to neutral. Although the Conservatives look likely to win a majority in this month’s general election, which will allow them to push through the negotiated Brexit deal, subsequent arguments over the future trade relationship with the EU will be divisive. Chart 116.8 Trillion In EM External Debt Chart 12The UK Has Been Derated Since 2016 Fixed Income: We remain underweight government bonds. Stronger economic growth is likely to push up long-term rates (Chart 13). Nonetheless, the rise in yields should be limited. The Fed looks to be on hold for the next 12 months, but the futures market is not far away from that view: it has priced in only a 60% probability of one rate cut over that time. The gap between market expectations and what the Fed actually does is what our bond strategists call the “golden rule of bond investing”. US inflation is also likely to soften over the next few months due to the lagged effect of this year’s weaker growth and appreciating dollar. We do not expect the 10-year US Treasury to rise above 2.5% – the current FOMC estimate of the long-run equilibrium level of short-term rates (Chart 14). Chart 13Growth Will Push Up Rates... Chart 14...But Only As Far As 2.5% Within the fixed-income universe, we remain positive on corporate credit. But US investment-grade bond spreads are no longer attractive and so we downgrade them to neutral (Chart 15). Investors looking for high-quality bond exposure should prefer Agency MBS, which trade on an attractive spread relative to Aa- and A-rated corporate bonds. European IG should do better since spreads are not so close to historical lows, risk-free rates should rise less than in the US, and because the ECB is increasing its purchases of corporate bonds. Chart 15US IG Spreads Are Close To Historical Lows Chart 16US Caa Bonds Have Some Catching Up To Do We continue to like high-yield bonds, both in the US and Europe. But we would suggest moving down the credit curve and increasing the weight in Caa-rated bonds. These have underperformed this year (Chart 16), mainly because of technical factors such as their overweight in the energy sector and relatively smaller decline in duration.3 With a stronger economy and rising oil prices, they should catch up to their higher-rated HY peers in 2020. To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Currencies: Since the US dollar is a counter-cyclical currency (Chart 17), we would expect it to weaken against more cyclical currencies such as the euro, and commodity currencies such as the Australian dollar and Canadian dollar. But it should appreciate relative to the yen and Swiss franc, which are the most defensive major currencies. We expect EM currencies to continue to depreciate. Most emerging markets are experiencing disinflation (Chart 18), which will push central banks to cut rates and inject liquidity into the banking system. This will tend to weaken their currencies. Overall, we are neutral on the US dollar. Chart 17The Dollar Is A Counter-Cyclical Currency Chart 18Disinflation Will Push EM Currencies Down Further Commodities: Industrials metals prices are closely linked to Chinese stimulus (Chart 19). A moderate recovery in Chinese growth should be a positive, and so we raise our recommendation to neutral. But with question-marks still lingering over the strength of the rebound in the Chinese economy, we would not be more positive than that. Oil prices should see moderate upside over the next 12 months, with supply tight and demand growth recovering in line with the global economy. Our energy strategists forecast Brent crude to average $67 a barrel in 2020 (compared to a little over $60 today). Chart 19Metals Prices Depend On China Chart 20Gold: Short-Term Negatives, But Remains A Good Hedge Gold looks a little overbought in the short term, and less monetary stimulus and a rise in rates next year would be negative factors (Chart 20). Nonetheless, we see it as a good hedge against our positive economic view going awry, and against geopolitical risks. If central banks do decide to let economies run hot next year and ignore rising inflation, gold could do particularly well. We, therefore, raise our recommendation to overweight on a 12-month horizon. Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1 Please see "Outlook 2020," dated November 22 2019, available at bcaresearch.com 2 Please see, for example, last month’s GAA Monthly Portfolio Update, “Looking For The Turning-Point,” dated November 1, 2019, available at gaa.bcaresearch.com 3 For a more detailed explanation, please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Signs Or Buying Opportunity,” dated 26 November 2019, available at usbs.bcaresearch.com GAA Asset Allocation
Germany is wading deeper into a period of political risk surrounding Chancellor Angela Merkel’s “lame duck” phase. The federal election of 2021 already looms large. Our indicator is only beginning to price this trend which can last for the next two years. …