Equities
In the 60 years covered by our equilibrium fed funds rate estimate, recessions have only occurred when the funds rate has exceeded our estimate of equilibrium. S&P 500 performance across the four phases of the fed funds rate cycle reveals that it has…
One way to benefit from the global growth soft-patch is to go long global gold miners/short S&P oil & gas E&P stocks on a tactical three-to-six month basis. Since our Monday inception three days ago, this pair trade is already up 9%. The relative moves in the underlying commodities that serve as pricing power proxies are the key drivers of this share price ratio (top panel). Given the massive currency debasement potential that has gripped Central Banks the world over, such a flush liquidity backdrop will boost the allure of the shiny metal more so than crude oil. Meanwhile, global manufacturing PMIs are foreshadowing recession and our diffusion index has plummeted to the lowest level since 2011 (diffusion shown inverted, middle panel). In the U.S. specifically there is a growth-to-liquidity handoff and the ISM manufacturing survey’s new order versus prices paid subcomponents confirms that global gold miners have the upper hand compared with E&P equities (bottom panel). Bottom Line: We initiated a tactical long global gold miners/short S&P oil & gas E&P pair trade on a three-to-six month time horizon with a stop at the -10% mark. The ticker symbols for the stocks in these indexes are: GDX:US and BLBG – S5OILP – COP, EOG, APC, PXD, CXO, FANG, HES, DVN, MRO, NBL, COG, APA, XEC, respectively. Please refer to this Monday’s Weekly Report for additional details.
Highlights Analysis on Brazil is available below. If banks in China are forced by regulators to properly recognize and provision for non-performing assets, large banks would become substantially undercapitalized while many small- and medium-sized banks (SMBs) would have little equity capital left. That would hammer their ability to finance the economy. Provided on aggregate SMBs have actually outgrown larger ones in terms of balance sheet size, the precarious state of the former’s financial health has become a matter of macro significance. The principal danger to shareholders of mainland banks is equity dilution. We reiterate our long U.S. banks/short Chinese bank shares trade, and within the latter our long large/short SMB stocks position. Feature Chinese Banks: A Value Trap Chart I-1Chinese Bank Share Prices Are On Edge Banks are crucial to financing the private sector as well as all levels of government in China. Not only do banks originate a substantial share of credit, but also they account for 82% of purchases of government bonds. That is why today we revisit the fundamentals of the Chinese banking sector. Besides, their equity valuations appear very cheap, and many investors are tempted to buy their shares. Chinese banks’ financial ratios look healthy and valuations appear extremely cheap because they have not recognized and provisioned for non-performing assets. By expanding their balance sheets enormously and not provisioning for bad assets, their profits have mushroomed. Banks have retained a share of these profits, boosting their capital. Yet, their share prices have been flat over the past 10 years. Recently, investable bank stocks have been lingering around their December lows. Another gap down could be lurking around the corner (Chart I-1). We highlight their poor financial health in the section below, where we perform stress tests for both large as well as small and medium sized banks (SMB). The principal danger to shareholders is equity dilution that will continue occurring among mainland banks (Chart I-2). Our bearish view on Chinese bank stocks has not been contingent on a systematic financial crisis but on inevitable and substantial equity dilution. Investment conclusions: Absolute return investors should stay clear of Chinese bank stocks – they are the ultimate value trap. For relative value traders, we reiterate our long U.S. banks/short Chinese bank shares trade, and within the latter our long large/short SMB stocks position (Chart I-3). Chart I-2Beware Of Equity Dilution Chart I-3Our Trades On Chinese Banks Large Versus Small And Medium Banks China’s banking system consists of five large banks (Industrial and Commercial Bank of China, China Construction Bank, Bank of China, Agricultural Bank of China, and Bank of Communications) and about 3150 small- and medium-sized banks (SMBs). All five large banks are publically listed but the central government still holds about 70-80% of their equity. About 36 of the SMBs are also listed but the central authorities in Beijing have a stake in some of the medium-sized banks. Notably, the central government has no equity in any of the small banks. In recent years, SMBs have been playing a greater role in sustaining the credit boom: First, on aggregate SMBs have actually outgrown the five large banks in terms of balance sheet size. The former’s risk-weighted assets1 (RWAs) of RMB 73 trillion exceeds the RMB 65 trillion of large banks (Chart I-4). Recently, investable bank stocks have been lingering around their December lows. Another gap down could be lurking around the corner. The value of RWAs emphasizes banks’ claims on enterprises, non-bank financial institutions and households over holdings of government bonds. Hence, RWAs of banks are a more pertinent measure of non-government financing than total assets. Second, over the past 12 months large banks and SMBs have accounted for 40% and 60% of the rise in the aggregate banking system’s RWAs, respectively (Chart I-5). Therefore, further credit acceleration will be difficult to engineer if – as we discuss below – SMBs begin retrenching under regulatory pressures and amid tighter market financing in the wake of the Baoshang bank failure. Chart I-4SMBs Have Outgrown Large Ones Chart I-5SMBs Have Contributed Enormously To The Credit Boom Finally, there has so far been no deleveraging among SMBs. Large banks’ RWAs-to-nominal GDP ratio has been in decline since 2014, but the same ratio for SMBs has not dropped at all (Chart I-6). This chart corroborates that the credit boom between 2015 and 2017 was driven by SMBs, rather than by large banks. In fact, SMBs along with shadow banking are what primarily drove the credit boom that occurred over the past decade. This confirms the thesis that the unprecedented credit bubble has spiraled beyond the central authorities’ control. While China’s entire banking system is in poor health, SMBs are in considerably worse shape than large ones. In particular: SMBs have much more assets classified as equity and other investments than large banks (Chart I-7). Equity and other investments stands for non-standard credit assets that are typically much riskier than loans and corporate bonds. This is the principal reason why in our stress test we use higher ratios of non-performing assets for SMBs than for large banks. Chart I-6No Deleveraging Among SMBs Chart I-7SMBs Exposure To Non-StandarD Credit Assets Is Huge Chart I-8Large Banks Versus SMBs Big banks are better capitalized than SMBs. The capital adequacy ratio among big banks is higher compared with the other banks (Chart I-8, top panel). Similarly, the ratio of non-performing loans (NPL) to total loans is considerably lower for large banks than for SMBs (Chart I-8, bottom panel). On the liquidity side, SMBs are more dependent on the wholesale funding market than their larger peers. Interbank transactions account for 10% of SMBs own liabilities. On the other hand, big banks are the main lenders in the interbank market. Bottom Line: SMBs have become more important than large ones in providing financing to companies and households. Yet these SMBs are much more vulnerable. A Stress Test We conducted separate stress tests on large banks and SMBs. Our findings are not optimistic. Some 71% of equity of SMBs will be wiped out if 14% of their RWAs turn sour (Table I-1). 43% of large banks’ equity will be impaired if 12% of their RWAs become non-performing (Table I-2). The reason we use RWAs rather than loans is because banks have been accumulating claims on enterprises, non-bank financial institutions and households beyond their loan books. Hence, RWAs better captures all credit assets. We use a higher impairment rate for SMBs than for large banks because the former have substantially more non-standard credit assets. Typically, the quality of non-standard credit assets is inferior to those of corporate bonds or loans. We used the following assumptions in our stress tests: For large banks, we assumed non-performing assets (NPAs) ratios of 10% in the optimistic scenario, 12% (baseline), and 14% (pessimistic) (Table I-2). For SMBs, we employed NPAs ratios of 12% (optimistic), 14% (baseline), and 16% (pessimistic) (Table I-1). The magnitude and duration of China’s current credit boom has considerably surpassed that of the 1990s, when Chinese banks held over 25% of non-performing loans (Chart I-9). Therefore, our stress test assumption that the NPAs ratio will rise above 10% is reasonable. Chart I-9China's Credit Booms In Perspective We applied a 30% recovery rate on NPAs. The recovery rate on Chinese banks’ NPLs from 2001 to 2005 was 20%. This occurred amid much stronger economic growth. Thus, an assumption of a 30% recovery rate today is realistic. Finally, we calculated overvaluations assuming the fair price-to-book value ratio for all banks is 1. How has it been possible for banks in China to continue expanding their balance sheets aggressively despite such moribund financial health? Banks can operate and expand their balance sheets with zero or even negative de facto equity capital, so long as they obtain liquidity from other banks or the central bank. This is how many Chinese SMBs have been operating in recent years. Barring institutional and regulatory constraints, banks theoretically can expand their balance sheets indefinitely by creating loans and deposits “out of thin air.” We have deliberated extensively in past reports that banks do not intermediate savings or deposits into loans and credit. Rather, they create deposits when they make a loan to or buy an asset from a non-bank entity. Loans and deposits are nothing other than accounting entries on banks’ books. It is regulators’ and shareholders’ forbearance – or lack of it – that allows banks to, or prevents banks from, expanding their balance sheets. Although Chinese authorities have been easing both monetary and fiscal policies, they have not completely abandoned their regulatory tightening efforts on banks and shadow banking, or their plans to curb leverage and speculation in the real estate market. For example, in April bank regulators released draft rules on how banks should classify all types of assets and provision for them. Over the past several years, many banks have transformed their bad loans into non-loan assets to disguise the true level of their non-performing loans (NPLs). The new regulation, if and when it is adopted and properly executed, will force banks to recognize NPAs and increase their provisions. Although Chinese authorities have been easing both monetary and fiscal policies, they have not completely abandoned their regulatory tightening efforts on banks and shadow banking, or their plans to curb leverage and speculation in the real estate market. Ultimately, this will substantially impair banks’ capital and dampen their ability to originate new credit – both in the form of making loans and buying securities. Consequently, the credit impulse will relapse and the business cycle recovery will be delayed. Bottom Line: If banks in China are forced by regulators to properly recognize and provision for NPAs, large banks would become substantially undercapitalized while many SMBs would have little equity capital left. That would hammer their ability to finance the economy. Investment Ramifications Given the increased importance of SMBs in China, the precarious state of their financial health has become a matter of macro significance. Even if regulators partially reinforce recognition of provisions for NPAs, aggregate credit growth will decelerate. A simple simulation to illustrate this point: If SMBs RWAs growth were to decelerate from 11% currently to 8%, large banks’ RWA annual growth would need to surge from 8% now to 16% for all banks’ RWA growth to accelerate from the current 9.5% to 12%. The latter is probably what is required to promote an economic recovery. Such a ramp-up in large banks’ RWAs is unlikely, given they would also be facing stricter regulatory requirements. The key point is that the positive effects of monetary and fiscal easing continue to be hampered by regulatory tightening on the credit system. The latter will delay a business cycle recovery in China. For now, although the credit plus fiscal spending impulse has picked up, economic growth has not yet revived (Chart I-10, top two panels). The reason has been a declining marginal propensity to spend among households and companies (Chart I-10, bottom two panels). We have discussed this issue at great length in past reports. Consistently, nominal industrial output, car sales and smartphone sales as well as total imports are either very weak or are in outright contraction (Chart I-11). All series in Chart I-11 and I-12 include June data. Chart I-10Stimulus Versus Marginal Propensity To Spend Chart I-11Chinese Economy: No Recovery So Far Chart I-12Chinese Corporate EPS: The Outlook Is Downbeat Importantly, Chinese corporate per-share earnings in RMB are contracting for the MSCI investable universe and will soon be contracting for A-share companies as well (Chart I-12). We maintain our negative outlook for EM risk assets and China-plays globally due to our downbeat view on China’s credit cycle. This differs from BCA’s House View, which is positive on global/Chinese growth. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com Brazil: Buy The Rumor, Sell The News? Having surged on the back of Congress’s initial approval of the social security reform, Brazilian financial markets are attempting to break above important technical resistance levels both in absolute and relative terms (Chart II-1 and Chart II-2). If the Bovespa decisively breaks above these technical resistance lines, it would mean it is in a structural bull market. A failure to break out will lead to a sizable setback. Chart II-1Are Brazilian Equities Poised For A Breakout In Absolute Terms… Chart II-2…And Relative Terms? We upgraded Brazilian equity and fixed-income markets right after the first round of presidential elections on October 7, but then downgraded them in early April. In retrospect, the downgrade was a miscalculation. Presently, investor confidence in Brazil is very high, sentiment is very bullish and markets are overbought. Faced with the choice of chasing the market higher or waiting, we are opting for the latter. Pension Reform: Necessary But Not Sufficient Chart II-3Public Debt-To-GDP Ratio Will Rise Further The nation’s pension bill is a very positive and much-needed step in the structural reform process. However, in its current form, it is insufficient to make public debt dynamics sustainable – i.e., halt the rise in the government debt-to-GDP ratio (Chart II-3). Table II-1 illustrates the savings from the social security reform adopted in the lower house. As estimated by the Independent Fiscal Institute, an advisory think-tank of the Senate, the reform would bring only BRL 744 billion of savings over the next decade. Is this sufficient to stabilize the public debt-to-GDP ratio? One way these reforms could contain the rise in the public debt-to-GDP ratio is if the savings generated significantly exceed the primary fiscal deficits over the next several years – i.e., the government runs continuous robust primary fiscal surpluses. Yet, the pension bill falls short of achieving this goal. The estimated savings in the first four years will likely be around BRL 130 billion. This amounts to annual savings of BRL 33 billion. Chart II-4 demonstrates that savings from the reform are too small to flip the government’s (often optimistic) projected primary fiscal deficit into a surplus in the forecast period. One way these reforms could contain the rise in the public debt-to-GDP ratio is if the savings generated significantly exceed the primary fiscal deficits over the next several years. Another scenario for stabilizing the public debt-to-GDP ratio is for interest rates to drop meaningfully below nominal GDP growth. Having plummeted amid very benign global and domestic backdrops, local currency bond yields still remain about 100 basis points above current nominal GDP growth (Chart II-5). It remains to be seen whether local currency borrowing costs will drop and stay below nominal GDP in the years to come. Chart II-4Primary Fiscal Balance Will Remain Negative Despite Pension Reform Chart II-5Borrowing Costs Remain Above Nominal GDP Growth Overall, the pension reform in current form does not guarantee public debt sustainability in Brazil: It is simply insufficient to get the government to run recurring primary fiscal surpluses. Another prerequisite – nominal GDP growth exceeding local bond yields over next several years – is contingent on further reforms as well as on a substantial improvement in confidence among investors, companies and households. It Is All About Confidence The sustainability of public debt, economic growth and financial markets are interlinked, with the common thread being confidence. In a virtuous cycle, financial markets typically rally while the currency stays firm. Subdued inflation will allow the central bank to rapidly reduce interest rates. This will help boost confidence among businesses and consumers, buoying the economy. In turn, lower policy rates could sustain the stampede into domestic bonds, pushing government borrowing costs below rising nominal GDP growth. At that point, the country’s public debt dynamics will become sustainable, the risk premium will continue to fall, and the nation’s financial markets will be in a secular bull market. On the contrary, a vicious cycle is possible if there is a negative external or internal shock that prompts the Brazilian real to depreciate by more than 10%. On the contrary, a vicious cycle is possible if there is a negative external or internal shock that prompts the Brazilian real to depreciate by more than 10%. In this case, the central bank cannot slash interest rates. On the contrary, government bond yields – which are presently at record lows – could or will likely rise (Chart II-6 and Chart II-7). These events will hurt confidence and suppress nominal GDP growth below borrowing costs. This could aggravate investors’ anxiety over Brazil’s public debt, leading them to demand a higher risk premium. As a result, a vicious cycle could unfold. Chart II-6Government Bond Yields Are At Historical Lows Chart II-7Credit Spreads Are Very Tight Chart II-8Commodity Prices And The BRL: Positive Correlation To be clear, we are not presently forecasting the onset of a vicious cycle. Nevertheless, given our negative view on EM risk assets and currencies, we expect a pullback in the Brazilian real and risk assets in the near term. The U.S. dollar is about to rally, as we discussed in detail in last week’s report. Commodities prices will tumble as China’s growth downshift persists. Given that the Brazilian real is a high-beta currency and is often positively correlated with commodities prices (Chart II-8), it could depreciate quite a bit. Patience is especially warranted in the case of Brazilian equities because share prices have decoupled from corporate profits and the business cycle. Stock prices have surged despite plummeting net EPS revisions and contracting profits of non-financial and non-resource companies (Chart II-9) and relapsing economic growth (Chart II-10). Clearly, the rally has been driven by expanding equity multiples due to progress on the social security reform. Chart II-9Stock Prices Are Diverging From Corporate Profits Chart II-10Domestic Demand Has Stalled Bottom Line: A lot of good news has been priced into Brazilian financial markets. For now, the risk-reward profile is not attractive: investors should wait for a better entry point. This is true for both absolute return investors and dedicated EM equity and fixed-income managers. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 Risk-weighted asset is a bank's assets or off-balance sheet exposures, weighted according to risk. It is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution. Usually, different classes of assets have different risk weights associated with them. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Following up from our earnings preview from the July 8thWeekly Report, the latest ZEW Indicator of Economic Sentiment made for grim reading. BCA’s global ex-U.S. ZEW took a turn for the worse and is challenging seven year lows. Given that roughly 40% of SPX revenues are internationally sourced, deteriorating global ex-U.S. sentiment will dampen sales and profit prospects. Using national accounts data, the chart shows that corporate profits sourced overseas are on the verge of contraction. While part of this reflects the income translation drag from the appreciating greenback, persistently scarce final demand abroad also weighs on earnings. Bottom Line: Stay cautious on the prospects of the broad equity market on a cyclical three-to-twelve month time horizon.
Overweight The tide has shifted and on Monday we upgraded the S&P hypermarkets index to an above benchmark allocation. While valuations are stretched, trading at a 50% premium to the overall market on a 12-month forward P/E basis (not shown), our thesis is that these Big Box retailers will grow into their pricey valuations in the coming months. The chart shows three macro variables that signal brighter times ahead for the relative share price ratio. The drubbing in the 10-year U.S. treasury yield reflects a souring macro backdrop, melting inflation and a steep fall in U.S. economic data surprises. The ISM manufacturing index that continues to decelerate and is now closing in on the boom/bust line corroborates the bond market’s grim message. Tack on the Fed’s expected four cuts in the coming 12 months, and factors are falling into place for a durable rally in relative share prices. Bottom Line: Boost the S&P hypermarkets index to overweight. Please refer to Monday’s Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG – S5HYPC – WMT, COST.
Since the Christmas Eve lows essentially all of the 26% return in equities is explained by valuation expansion. The forward P/E has recovered from 13.5 to nearly 17.2 (bottom panel), but there is limited scope for further expansion as four interest rate cuts in the coming 12 months are already priced in lofty valuations. Now profits will have to do the heavy lifting. Meanwhile, more than half of the S&P 500 GICS1 sectors are forecast to have contracted profits last quarter, and three sectors could not lift revenue versus year ago comps, according to I/B/E/S data. In our most recent Weekly Report we also highlighted that BCA’s global manufacturing PMI diffusion index has cratered to below 40%, the NY Fed’s recession probability model continues to tick higher, and that non-financial ex-tech corporate net debt-to-EBITDA has hit all-time highs. Bottom Line: Once the euphoria around the looming Fed easing cycle settles, there will be a massive clash between perception and reality that will likely propagate as a surge in volatility. We continue to remain cautious on the prospects of the broad equity market on a cyclical three-to-twelve month time horizon.
Highlights Portfolio Strategy Recession odds continue to tick higher, according to the NY Fed’s probability of recession model, at a time when global growth is waning, U.S. profit growth is contracting and the non-financial ex-tech corporate balance sheet is degrading rapidly. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. The souring macro backdrop coupled with a firming industry demand outlook signal that more gains are in store for hypermarket stocks. The global growth slowdown, declining real bond yields, missing inflation, rising policy uncertainty and a favorable relative demand backdrop suggest that there is an exploitable tactical trading opportunity in a long global gold miners/short S&P oil & gas E&P pair trade. Recent Changes Upgrade the S&P hypermarkets index to overweight, today. Initiate a long global gold miners/short S&P oil & gas exploration & production (E&P) pair trade, today Table 1 Feature Obsession with the Fed easing continues to trump all else, with the SPX piercing through the 3,000 mark to fresh all-time highs last week. However, it is unrealistic for the Fed to do all the heavy lifting for the equity market as we have argued recently (see Chart 3 from June 24),1 at a time when profit cracks are spreading rapidly. This should be cause for some trepidation. Since the Christmas Eve lows essentially all of the 26% return in equities is explained by valuation expansion. The forward P/E has recovered from 13.5 to nearly 17.2 (Chart 1). There is limited scope for further expansion as four interest rate cuts in the coming 12 months are already priced in lofty valuations. Now profits will have to do the heavy lifting. But on the eve of earnings season, more than half of the S&P 500 GICS1 sectors are forecast to have contracted profits last quarter, and three sectors could not lift revenue versus year ago comps, according to I/B/E/S data. Looking further out, there is a plethora of indicators that we highlighted last week that suggest that a profit recession is looming.2 Our sense is that once the euphoria around the looming Fed easing cycle settles, there will be a massive clash between perception and reality (Chart 2) that will likely propagate as a surge in volatility. Chart 1Multiple Expansion Explains All Of The SPX’s Return Chart 2Unsustainable Divergence This addiction to low rates has come at a great cost to the non-financial corporate sector. As a reminder, this segment of the economy is where the excesses are in the current cycle as we have been highlighting in recent research.3 Using stock market related data for the non-financial ex-tech universe, net debt has increased by 70% to $4.2tn over the past five years, but cash flow has only grown 18% to $1.7tn. As a result, net debt-to-EBITDA has spiked from 1.7 to 2.5, an all-time high (Chart 3). While stocks are at all-time highs (top panel, Chart 3), the debt-saddled non-financials ex-tech universe will likely exert substantial downward pressure to these equities in the coming months (Chart 4). Chart 3Balance Sheet Degrading Chart 4Something’s Got To Give Moving on to the labor market, we recently noticed an interesting behavior between the unemployment rate and wage inflation since the early-1990s recession: a repulsive magnet-type property exists where like magnetic poles repel each other (middle panel, Chart 5). In other words, every time the falling unemployment rate has kissed off accelerating wage growth, a steep reversal ensued at the onset of recession during the previous three cycles. A repeat may be already taking place, as average hourly earnings (AHE) growth has been stuck in the mud since peaking in December 2018. Importantly, the AHE impulse is quickly losing steam and every time the Fed embarks on an aggressive easing cycle it typically marks the end of wage inflation (bottom panel, Chart 5). Chart 5Beware Of Repulsion Chart 6Waiting For Growth Meanwhile, BCA’s global manufacturing PMI diffusion index has cratered to below 40% (middle panel, Chart 6). Neither the G7 nor the EM aggregate PMIs are above the boom/bust line (top panel, Chart 6). Our breakdown of the Leading Economic Indicators into G7 and EM14 also signals that global growth is hard to come by, albeit EMs are showing some early signs of a trough (bottom panel, Chart 6). As the early-May announced increase in Chinese tariffs begin to take a toll, we doubt global growth can have a sustainable recovery for the rest of 2019, despite Chinese credit growth picking up. Now, even Japan and Korea are fighting it out and are erecting barriers to trade, dealing a further blow to these economically hyper-sensitive export-oriented economies. Netting it all out, the odds of recession by mid-2020 continue to tick higher according to the NY Fed’s model (NY Fed’s probability of recession shown inverted, top panel, Chart 5) at a time when global growth is waning, U.S. profit growth is contracting and the non-financial ex-tech corporate balance sheet is degrading rapidly. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. This week we are upgrading a consumer staples subgroup to overweight and initiating an intra-commodity market neutral trade. Time To Buy The Hype The tide is shifting and we are upgrading the S&P hypermarkets index to an above benchmark allocation. While valuations are stretched, trading at a 50% premium to the overall market on a 12-month forward P/E basis (not shown), our thesis is that these Big Box retailers will grow into their pricey valuations in the coming months. The macro landscape is aligned perfectly with these defensive retailers. Consumer confidence has been falling all year long and now cracks are spreading to the labor market (confidence shown inverted, top panel, Chart 7). ADP small business payrolls declined for the second month in a row. Similarly, the NFIB survey shows that small business hiring plans are cooling (hiring plans shown inverted, middle panel, Chart 7). As a reminder, 2/3 of all new hiring typically occurs in the small and medium enterprise space. In the residential real estate market, the drop in interest rates that is now in its eighth month has yet to be felt, and house price inflation has ground to a halt. Historically, Costco membership growth has been inversely correlated with house prices (house price inflation shown inverted, bottom panel, Chart 7). Chart 7Deteriorating Macro Backdrop … Chart 8…Is A Boon To Hypermarkets… Chart 8 shows three additional macro variables that signal brighter times ahead for the relative share price ratio. The drubbing in the 10-year U.S. treasury yield reflects a souring macro backdrop, melting inflation and a steep fall in U.S. economic data surprises. The ISM manufacturing index that continues to decelerate and is now closing in on the boom/bust line corroborates the bond market’s grim message. Tack on the Fed’s expected four cuts in the coming 12 months, and factors are falling into place for a durable rally in relative share prices. This disinflationary backdrop along with the Fed’s looming easing interest rate cycle have put a solid bid under gold prices. Hypermarket equities and bullion traditionally move in lockstep, and the current message is to expect more gains in the former (top panel, Chart 9). On the trade front specifically, these Big Box retailers do source consumer goods from China, but up to now these imports have been nearly immune to the U.S./China trade dispute as prices have been deflating (import prices shown inverted, bottom panel, Chart 9). However, this does pose a risk going forward and we will be closely monitoring it for two reasons: First, because downward pressures may intensify on the greenback and second, President Trump may impose additional tariffs, both of which are negative for industry pricing power. Chart 9Profit Margins… Chart 10…Will Likely Expand Meanwhile, industry demand is on the rise and will likely offset the potential trade and U.S. dollar induced margin pressures. Hypermarket retail sales are climbing at a healthy clip outpacing overall retail sales (bottom panel, Chart 10). Already non-discretionary retail sales are outshining discretionary ones, which is a precursor to recession at a time when overall consumer outlays have sunk below 1% (real PCE growth shown inverted, top panel, Chart 10). The implication is that hypermarkets will continue to garner a larger slice of consumer outlays as the going gets tough. In sum, the souring macro backdrop coupled with a firming industry demand outlook signal that more gains are in store for hypermarket stocks. Bottom Line: Boost the S&P hypermarkets index to overweight. The ticker symbols for the stocks in this index are: BLBG – S5HYPC – WMT, COST. Initiate A Long Global Gold Miners/Short S&P Oil & Gas E&P Pair Trade One way to benefit from the global growth soft-patch and looming global liquidity injection is to go long global gold miners/short S&P oil & gas E&P stocks on a tactical three-to-six month basis. While this market neutral and intra-commodity pair trade has already enjoyed an impressive run, there is more upside owing to a favorable macro backdrop. The key determinant of this share price ratio is the relative move in the underlying commodities that serve as pricing power proxies (top panel, Chart 11). Given the massive currency debasement potential that has gripped Central Banks the world over, such a flush liquidity backdrop will boost the allure of the shiny metal more so than crude oil. Global manufacturing PMIs are foreshadowing recession and our diffusion index has plummeted to the lowest level since 2011 (diffusion shown inverted, middle panel, Chart 11). In the U.S. specifically there is a growth-to-liquidity handoff and the ISM manufacturing survey’s new order versus prices paid subcomponents confirms that global gold miners have the upper hand compared with E&P equities (bottom panel, Chart 11). Chart 11Global Soft-Patch… Chart 12…Disinflation… As a result of this growth scare that can easily morph into recession especially if the U.S./China trade war continues into next year, inflation is nowhere to be found. Unit labor costs are slumping (top panel, Chart 12), the NY Fed’s Underlying Inflation Gauge has rolled over decisively (not shown),4 and the GDP deflator is slipping (middle panel, Chart 12). Parts of the yield curve first inverted in early-December and the 10-year/fed funds rate slope is still inverted, signaling that gold miners will continue to outperform oil producers (yield curve shown on inverted scale, bottom panel, Chart 13). The near 100bps dive in real interest rates since late-December ties everything together and is a boon to bullion (and gold producers) that yields nothing (TIPS yield shown inverted, top panel, Chart 13). Meanwhile, bond volatility has spiked of late and the bottom panel of Chart 14 shows that historically the MOVE index has been joined at the hip with relative share prices. Chart 13…Melting Real Yields And… Chart 14…The Spike In Bond Vol, All Favor Gold Miners Over Oil Producers On the relative demand front, we peer over to China to take a pulse of the marginal moves in these commodity markets. China (and Russia) has been aggressively shifting their currency reserves into gold, and bullion holdings are rising both in volume terms and as a percentage of total FX reserves. In marked contrast, oil demand is feeble and Chinese apparent diesel consumption that is closely correlated with infrastructure and manufacturing activity has tumbled. Taken together, the message is to expect additional gain in relative share prices (middle & bottom panels, Chart 15). Adding it all up, the global growth slowdown, declining real bond yields, missing inflation, rising policy uncertainty and a favorable relative demand backdrop suggest that there is an exploitable tactical trading opportunity in a long global gold miners/short S&P oil & gas E&P pair trade. Bottom Line: Initiate a tactical long global gold miners/short S&P oil & gas E&P pair trade on a three-to-six month time horizon with a stop at the -10% mark. The ticker symbols for the stocks in these indexes are: GDX:US and BLBG – S5OILP – COP, EOG, APC, PXD, CXO, FANG, HES, DVN, MRO, NBL, COG, APA, XEC, respectively. Chart 15Upbeat Relative Demand Backdrop Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Cracks Forming” dated June 24, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment” dated June 10, 2019, available at uses.bcaresearch.com. 4 https://www.newyorkfed.org/research/policy/underlying-inflation-gauge Current Recommendations Size And Style Views Favor value over growth Favor large over small caps
Highlights A lower fed funds rate will not necessarily boost equities, … : A chorus of Wall Street strategists has recently advised investors to curb their enthusiasm about looming rate cuts. … because stocks are more sensitive to the relative level of the fed funds rate than they are to its direction: The Street strategists’ advice is sound, even if they haven’t homed in on its true rationale. Monetary policy’s influence on equity returns is primarily a function of the fed funds rate’s relationship to the equilibrium rate, not the direction in which it’s moving. Monetary policy settings remain accommodative, in our view, … : We estimate that the equilibrium fed funds rate remains well above the target fed funds rate. One or two rate cuts will push monetary policy even further into accommodative territory. ... and investors should therefore remain at least equal weight equities: Over the last 60 years, investors would have done exceptionally well if they had simply owned stocks when monetary policy settings were easy, and avoided them when they were tight. Feature Dear Client, We are in the midst of collaborating with several of our colleagues on a roundtable Special Report outlining the view differences between BCA’s most bullish and bearish strategists, scheduled to be published on Friday, July 19th. In the absence of a major event between now and then, the July 19th roundtable report will replace the July 22nd U.S. Investment Strategy. We will return to our usual format on Monday, July 29th. Best regards, Doug Peta U.S. equities have rallied smartly since Fed officials began hinting at rate cuts in early June. The S&P 500 advanced nearly 7% last month on rate cut hopes, and tacked on close to another 2% by making new highs in each of July’s first three sessions. As the gains grew, however, so too did the admonitions from equity strategists at leading broker-dealers that they were getting out of hand. Over the last month, no less than four shops wrote reports warning that rate cuts will not necessarily boost equities. From the financial media’s summaries of the reports, the curb-your-enthusiasm conclusion stems from a straightforward analysis of rate-cut impacts over the last 35 years. According to Goldman Sachs by way of Barron’s, the S&P 500 posted double-digit returns in the year following the start of all five of the rate-cutting cycles that occurred from the mid-eighties to the end of the nineties, before performing terribly following the cuts that began in 2001 and 2007.1 The Street-wide takeaway was that rate cuts worked wonders for stocks when the Greenspan put was still a fresh concept, but the inverse relationship between interest rates and equity multiples that initially prevailed has since been supplanted by a direct relationship. It is surely true that rate cuts are not a magic bullet for equities, but we find the flipped-correlation hypothesis wanting. There is more to the question of how monetary policy impacts equities than just the direction of rates. The state of monetary policy – accommodative or restrictive – matters, too. Even though assessments of the state of policy are necessarily uncertain, they allow for a much more sophisticated analysis of policy impacts. Without estimating the equilibrium fed funds rate, an investor cannot go beyond simple observations of the correlation between policy rates and equity returns to the causal interactions that drive the observed correlations. Numerators And Denominators When an investor buys a stock, s/he is buying a pro rata claim on the future earnings of the company that issued it. The value of that claim is a function of the company’s estimated future earnings and the interest rate used to discount them. Expressed as an equation, the fundamental value of a share of stock is as follows, where r is the reference interest rate: Year 1 Earnings + Year 2 Earnings + Year 3 Earnings + … + Year n Earnings (1+r) (1+r)2 (1+r)3 (1+r)n That equation can be simplified and rewritten as: Fundamental Value = ∑nt=1(Year t Earnings) (1+r)t It’s a stretch to think that equities’ reaction to rate cuts reversed after the year 2000. The final form of the equation shows that the underlying value of a share of stock is directly related to its future earnings and inversely related to interest rates. When the broker-dealer analyses conclude that the ‘80s-‘90s inverse relationship between stock prices and rate cuts has flipped since the turn of the millennium, they’re asserting that the relative sensitivities of stock prices to changes in the numerator (earnings) and the denominator (interest rates) have changed. That’s a mouthful, but the effect can be seen clearly by holding the numerator constant: if earnings don’t change, stock prices are inversely related to changes in interest rates. Relaxing the constant earnings assumption, the inverse relationship between rate cuts and stock prices in the ‘80s and ‘90s could only have occurred if earnings rose when the Fed cut, or if earnings fell when the Fed cut rates, but not so much that they offset the beneficial impact of the reduction in the discount rate. An Empirical Curveball When investors think about the impact of changes in interest rates on stock prices, they tend to assume that earnings remain constant. They therefore conclude that lower rates are good for stocks and higher rates are bad for them. The underlying assumption is flawed, however, because it ignores the fact that earnings are themselves a function of the macro backdrop that influences interest rates. Rising real interest rates are most often a sign of gathering economic momentum; since the end of World War II, U.S. equities have performed markedly better when real long-term Treasury yields were rising than they have when they were falling (Chart 1). Chart 1Stocks Do Better When Real Rates Rise Investors’ appetite for equities reinforces the direct relationship between earnings and rates, as long as rates are not at extremes. Trailing P/E multiples have risen with real interest rates except when rates are negative or above 4% (Chart 2). When real rates are negative, deflation is a real possibility and fearful investors value future earnings streams conservatively. When they’re above zero, investors have been willing to let multiples rise with real rates, until rates get high enough to squeeze profitability. The key, then, is what is going to happen with real yields if the Fed does indeed cut rates. Will 50 basis points (“bps”) of incremental accommodation (we expect 25-bps cuts in July and September) help to extend the expansion, or will it be too little, too late to impede the course of a recession that’s already begun? In the former case, economic growth will get a boost, and real yields and corporate earnings will go along for the ride. In the latter, the economy will contract, drawing real yields and corporate earnings into its vortex. We believe monetary policy is still squarely accommodative, and therefore have both feet planted firmly in the bullish camp. The Fed Funds Rate Cycle Our fed funds rate cycle framework helps us to assess the line of demarcation between accommodative and restrictive policy settings and thereby project the direction of corporate earnings following rate cuts. To refresh, we decompose the fed funds rate cycle into four phases based on the interaction between the level of rates and their direction (Diagram 1), as follows: Diagram 1The Fed Funds Rate Cycle Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first rate hike of a new tightening cycle and ends when the fed funds rate crosses above our estimate of the equilibrium rate. Phase II represents the latter stages of the tightening cycle, when the Fed hikes its target rate above equilibrium in a deliberate effort to cool an overheating economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate falls from below its equilibrium level to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Plotting the course of the fed funds rate is a simple matter; the challenge in Diagram 1 comes in deciding where to draw the dashed line. That decision requires estimating the policy rate that neither encourages nor discourages economic activity. Our equilibrium estimate, which uses potential GDP growth to adjust a smoothed and filtered long-run series of the actual fed funds rate, can be viewed as a line in the sand separating the point where monetary policy goes from encouraging activity to discouraging it. When the funds rate is above our estimate of equilibrium, we consider policy to be tight; when it’s below our estimate of equilibrium, we consider policy to be easy. Since equilibrium is a concept, rather than an observable objective data point, we have to look at the broad sweep of economic activity to infer whether or not our equilibrium estimate is accurate. As we’ve repeatedly written, we interpret the economic data received so far this year as indicating that the U.S. economy is decelerating from its stimulus-fueled 2018 surge, but is on track to meet or exceed its long-term potential growth pace of 2 - 2.25%. We therefore do not believe that policy is tight, and that a recession has already begun, or is in the offing. Recession? What About Stock Prices? We didn’t forget about stock prices. Markets are always our primary focus, and we study the economy for insight into how it might impact their direction. The business cycle is a robust link connecting the state of monetary policy with equity performance. In the 60 years covered by our equilibrium fed funds rate estimate, recessions have only occurred when the funds rate has exceeded our estimate of equilibrium (Chart 3). Equity bear markets typically coincide with recessions – Black Monday in October 1987 is the only instance of a bear market occurring independently of a recession in the last half-century. Chart 3Recessions Only Occur When Policy Is Tight For 60 years, stocks have thrived when monetary policy is easy and staggered when it is tight. S&P 500 performance across the four phases of the fed funds rate cycle reveals that it has been the level of rates vis-à-vis the equilibrium rate that has mattered for equity returns, not the direction. Annualized nominal S&P 500 price returns have been nine percentage points higher when policy is easy than when it is tight (Table 1), and the disparity widens to ten-and-a-half percentage points after adjusting for inflation (Table 2). The disparity is even more pronounced when the Fed is cutting rates – annualized Phase IV price returns beat Phase III by eleven percentage points on a nominal basis, and by thirteen-and-a-half percentage points on a real basis. Table 1Stocks Love Easy Policy, ... Table 2… Especially After Adjusting For Inflation Our base case is that the FOMC will cut the fed funds rate by 25 bps at its July and September meetings. The investment strategy question arising from our base-case scenario is what will that mean for equities? With reference to the dot-com bust and the financial crisis, the broker-dealers say, “nothing much.” We posit that a more sophisticated answer would consider the monetary-policy climate in which the cuts occur. Reduce equity exposure if you believe the Fed went too far hiking rates last year, but maintain/increase it if you think monetary policy has always remained accommodative. 60 years of history say that incremental accommodation will boost equities if it occurs against a backdrop of already easy policy. The S&P 500 will decline, on the other hand, if the monetary policy starting point is restrictive.2 In terms of our fed funds rate cycle framework, the equity market outcome turns on whether the cuts occur in Phase III or Phase IV. We estimate that the equilibrium rate is currently in the neighborhood of 3¼%, so we have a high level of conviction that equities will spend the rest of the year in Phase IV, the rate cycle phase that has been most conducive to equity outperformance. Investment Implications From the perspective of our monetary policy cycle framework, positioning a balanced portfolio for impending rate cuts boils down to one’s take on current monetary policy settings. If one thinks the Fed’s already tightened policy enough to squeeze the economy, s/he should sell stocks. (Some of our BCA colleagues advocate that course, and we will share the stage with them in next week’s roundtable Special Report). If one thinks, like we and the overall BCA consensus do, that the Fed hasn’t yet crossed the easy/tight Rubicon and is on a course to push the date when it will out to 2021 or beyond, one should maintain his/her equity positions and consider adding to them. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Hough, Jack, “The ‘Fed Put’ Is Kaput and Interest Rate Cuts Might Hurt Stocks,” Barron’s, July 1, 2019. 2 Remember that monetary policy impacts the economy with a lag. Cuts ameliorating too-tight policy don’t have an effect until after the initial overtightening makes its way through the system.
Internal equity dynamics are sending a powerful signal for the broad equity market. Not only are defensives outshining cyclicals and mega caps trouncing small and micro caps, but also transports are warning that the broad equity market is skating on thin ice (top panel). Importantly, drilling deeper into the highly cyclical trucking industry is instructive. Heavy-duty trucks new orders have plunged (middle panel). While this is likely a consequence of the U.S./China trade war that commenced in the spring of 2018, there are also elements of domestic demand ills that have pushed “class 8 trucks” orders to the lowest point since the late-2015/early-2016 manufacturing recession. In addition, the American Trucking Association’s trucking tonnage index has fallen recently and is contracting at an accelerating pace on a six-month rate of change basis (third panel). Bottom Line: We heed the signal from the highly sensitive transportation sector and remain cautious on the broad equity market.