Equities
Analysis on central Europe and Pakistan is published below. Highlights There are several reasons why Chinese authorities will likely allow the yuan to depreciate 6-8% from current levels in the coming months. RMB depreciation will weigh not only on emerging Asian but also on other EM currencies via several channels. We continue to recommend shorting a basket of the following currencies versus the U.S. dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. Feature Chinese authorities will likely allow the yuan to fall 6-8% vis-à-vis the U.S. dollar from current levels in the coming months. The value of the RMB holds the key to the broader trend in EM currencies. In turn, dynamics in EM exchange rates typically define the trajectory for EM asset classes: stocks, credit spreads and local currency bonds. Odds are that the RMB along with other emerging Asian currencies will continue to depreciate (Chart I-1). There are several reasons why Chinese authorities will likely allow the yuan to fall 6-8% vis-à-vis the U.S. dollar from current levels in the coming months. Chart I-1Emerging Asian Currency Index Chart I-2Deflating Export Prices Herald Currency Depreciation First, currency depreciation will help mitigate the impact of U.S. import tariffs. With global trade volumes shrinking and U.S. import prices from China deflating (Chart I-2, top panel), China will benefit from a cheaper currency. Second, RMB devaluation goes against the Trump’s administration’s preference. The U.S.-China trade talks have flopped, and both sides seem to be jockeying to better position themselves ahead of another round of discussions. From a negotiation strategy perspective, it makes sense for China to devalue the yuan before a new round of negotiations starts again. Third, China needs lower interest rates to reduce the strain on numerous debtors. However, narrowing interest rate differential with the U.S. has often coincided with periods of RMB depreciation over the past nine years (Chart I-3). Chart I-3CNY/USD And Interest Rate Differential One reason why policymakers in China were previously reluctant to explore RMB/USD depreciation beyond the 7 mark was due to the risk of rampant capital exodus and a potential spike in financial market volatility. In other words, authorities were mindful that even mild and controlled depreciation could spiral out of control. However, with Chinese nationalistic rhetoric on the rise and the nation rallying around the flag, authorities now have more room to maneuver. They will not have a problem restricting capital outflows by residents, and there will be little general public dissatisfaction with a devaluation. Finally, at around $3 trillion, the central bank’s foreign exchange reserves are equivalent to only 14% of all yuan deposits, and 11% of broad money (M2) supply. In turn, the overhang of local currency money supply will exert structural downward pressure on the renminbi’s exchange rate in the coming years. This may be a convenient time to release some proverbial air out of the balloon – namely, the lingering money bubble in China – by devaluing the yuan. Bottom Line: The path of least resistance for the RMB is down. EM Currencies Are In Danger In recent months, we have been highlighting that the Korean won has been at a critical technical juncture and has broken down (Chart I-4, top panel). The Taiwanese and Singaporean dollars seem to be the next shoes to drop (Chart I-4, middle and bottom panels). Chart I-4 Chart I-5No Recovery In Asian Exports So Far U.S. import prices from various Asian countries are deflating, as shown in the bottom panel of Chart 2 on page 2. This typically warrants currency depreciation to mitigate the impact of export price deflation on national producers. Furthermore, emerging Asian exports are still shrinking, as evidenced by the latest trade numbers. Korea’s total exports for the first 20 days of May and Taiwan’s exports of electronics parts as of April are still contracting at a rapid pace (Chart I-5). The latter leads cyclical turning points in global trade by a couple of months. Finally, the RMB is the anchor currency in emerging Asia, and its depreciation will filter through the exchange rates of other regional, export-dependent economies. Regarding other EM currencies, they are also at risk of Chinese yuan depreciation. Apart from manufacturing sector competitiveness (discussed above), China’s exchange rate affects other economies in two distinct ways: Less Chinese imports: An RMB devaluation reduces the amount of China’s U.S. dollar inflows/payments to its trade partners (Chart I-6). Many EM and some DM currencies will be negatively affected since China is a major source of demand for these economies. Less capital outflows from China: RMB depreciation will likely be accompanied with heightened controls over capital outflows from China. In fact, various proxies for capital flight out of the mainland suggest the authorities have already substantially clamped down on outflows (Chart I-7). Economies that have profited from capital flight from China over the years are already feeling pain. For example, relapsing Australian property prices can be attributed to reduced capital flows from China. Chart I-6Chinese Imports In RMB And USD Chart I-7China: Reduced Capital Flight Likewise, there will be a period of painful adjustment in many emerging economies in Asia and elsewhere that have profited from Chinese capital flows – both via official and non-official channels. Bottom Line: RMB depreciation will affect various currencies via diverse channels: (1) deteriorating export competitiveness for manufacturing-based economies; (2) diminished mainland imports from China’s trade partners; and (3) reduced capital flows from China to economies that have typically relied on Chinese capital flows. The U.S. Dollar: A Review Of The Indicators We believe that the cyclical and structural backdrops remain favorable for the dollar, and that it will likely overshoot before a major top sets in. The U.S. dollar bull market is extended, but that does not mean it is over. Odds are that the greenback will overshoot before making a major top. In our last weekly report, we revisited currency valuations and found the dollar to be only moderately (one standard deviation) expensive, according to the real effective exchange rate based on unit labor costs. The latter is our favored currency valuation metric. The greenback has been in a major structural bull market since 2011. Secular bull/bear markets do not typically end before valuations reach 1.5-2 standard deviations. We believe that the cyclical and structural backdrops remain favorable for the dollar, and that it will likely overshoot before a major top sets in. Chart I-8U.S. Equity And Economic Outperformance Warrants Dollar Appreciation U.S. stocks are outperforming the rest of the world in local currency terms, not only based on market-cap equity benchmarks but also when measured using equal-weighted equity indexes (Chart I-8). This signals that return on capital is higher in the U.S. relative to the rest of the world. The latter has historically been positively related with the primary trend in the trade-weighted dollar (Chart I-8). The U.S. dollar currently offers an attractive yield relative to many of its peers. Chart I-9 illustrates the interest rate (3-month swap rate) differentials between the dollar and various EM and DM currencies. For each individual exchange rate, the bar denotes the U.S. interest rate spread over other markets, and the dot is the mean of this spread over the past 20 years. Not only is the current interest rate differential in favor of the greenback in the case of many currencies, but the spread is well above its 20-year mean for virtually all of the currencies included in Chart I-9. The sole exception is the Mexican peso – the latter’s current interest rate differential versus the U.S. is wider than its 20-year mean. In fact, the peso is among our most preferable EM currencies. The U.S. dollar currently offers an attractive yield relative to many of its peers. Bottom Line: Odds are in favor of a U.S. dollar overshoot, especially versus cyclical currencies such as EM and commodities-based ones. We continue to recommend shorting a basket of the following currencies versus the U.S. dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. We are also structurally short the RMB versus the dollar. For investors who are looking for currencies with the least downside versus the U.S. dollar, our picks are MXN, RUB, THB, TWD, SGD and central European currencies. EM Credit Markets And Domestic Bonds: It’s All About Exchange Rates From a macro perspective, EM dollar-denominated and local currency bonds are primarily driven by exchange rates. EM sovereign spreads are very sensitive to both EM exchange rates and industrial metals prices (Chart I-10). The latter two are primarily driven by global trade cycles in general and China’s growth in particular. EM corporate spreads have been less sensitive to EM exchange rates. Yet they are unlikely to defy a major down-leg in EM currencies. The basis is as follows: when currencies depreciate, foreign-currency debt becomes more expensive to service warranting a period of wider credit spreads. Exchange rate fluctuations account for the bulk of domestic bonds’ total returns for foreign investors. We discussed this topic in our report titled Asset Allocation For EM Assets. Chart 11 shows the total return indexes in dollars and euros for the EM GBI local currency government bond index. Euro-based investors have fared much better than dollar-based ones. The euro’s depreciation versus the dollar explains this gap. However, from a technical point of view, total return in euros is facing a major resistance level (Chart I-11, bottom panel). European investors should take note. Chart I-10EM Sovereign Spreads Correlate With EM Currencies And Commodities Chart I-11Total Returns on EM Local Bonds In USD And Euros Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Continue Favoring Central Europe Within EM Equities: An overweight position in Central European (CE) equities within an EM equity portfolio is still warranted due to the following reasons: First, CE economies are the least exposed to a Chinese and global trade slowdown - the main causes of the EM selloff. Even though these economies are leveraged to German and euro area manufacturing - both of which are currently weak - they have little direct exposure to China and commodities. Second, currency trends are critical for the relative performance of equities. We expect EM currencies will depreciate versus the euro and against CE currencies. This argues in favor of CE stocks within an EM portfolio. Third, CE domestic demand remains strong and private credit growth robust (Chart II-1). Additionally, the authorities are maintaining a loose fiscal policy stance. As to European equity portfolios, we recommend underweighting CE bourses versus the core European markets. Chart II-2 illustrates that when EM equities underperform DM ones, CE share prices lag behind euro area stocks. Chart II-1Private Credit Growth Is Robust Chart II-2CE Underperforms Core Europe When EM Underperforms DM Currencies and Fixed-Income Markets: CE growth outperformance relative to EM suggests that CE exchange rates will outperform the majority of EM currencies. Critically, odds are that the euro has made a major bottom versus most EM currencies. This will facilitate CE exchange rate appreciation versus many other EM currencies. The latter warrants overweighting CE fixed-income markets against respective EM benchmarks. Currency Trades: Today we recommend closing our long CZK / short euro position. This trade has generated a 4.4% gain since September 28, 2016 with extremely low volatility. The basis for closing this position is there are signs that Czech growth and labor market tightness are peaking, warranting an end to rate hikes. Specifically, both economic activity and wage growth are slowing. This will lead the central bank to halt its rate hikes. Instead, we are opening a new trade: Go long CZK versus an equal-weighted basket of PLN and HUF. For the first time, Czech short rates have risen above those in Poland and Hungary (Chart II-3). This will be a major driver for Czech koruna appreciation against the other two currencies. The PLN and HUF will underperform the CZK because their monetary and fiscal policies are much easier than is currently warranted. Chart II-3Czech Interest Rate Differentials Versus Hungary And Poland Are Positive Chart II-4Trade Balances Favor CZK vs HUF & PLN The Hungarian central bank will launch its corporate QE program in July 2019 with a total of HUF 300 billion in corporate bond purchases. This will likely weigh on the HUF as the central bank monetizes some of the country’s outstanding corporate debt. Additionally, the Polish government has announced large fiscal stimulus ahead of this year’s elections. The fiscal deficit is projected to widen from 1% currently to 2% of GDP by 2020. Finally, trade balances in Poland and Hungary are deteriorating while the Czech Republic is running a large trade surplus (Chart II-4). Bottom Line: Continue overweighting CE within both EM equity and local currency bond portfolios. We are taking profits on our long CZK / short the euro trade and initiating a new position: Long CZK / short an equal-weighted basket of HUF and PLN. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Pakistan: No Pain, No Gain Pakistan’s economy and stock market are currently going through painful but necessary adjustments. The country has been suffering from a severe balance-of-payment crisis. Its exchange rate has already depreciated by 30% versus the U.S. dollar since December 2017. Its stock market in U.S. dollar terms has plunged 55% from its May 2017 peak. A bottom in the stock market is likely to occur when the currency stabilizes. Odds are that the Pakistani rupee is in its late phase of adjustment (Chart III-1). First, a US$ 6 billion worth IMF bailout fund is on its way. The country reached a staff-level agreement with the IMF on May 12. The IMF will release the funds in phases over a period of 39 months. Meanwhile, Pakistan will likely also receive US$ 2-3 billion from the World Bank and the Asian Development Bank (ADB) in the next three years. Altogether, multilateral financing will amount to about US$3 billion per year over the next three years. The country will also likely continue its bi-lateral borrowings from China, Saudi Arabia and the UAE. Last year, about US$10 billion of external borrowing and a nearly US$7 billion reduction in the central bank’s foreign reserves helped fund the US$18 billion current account deficit. Over the next 12 months, we expect the financing needs to be considerably smaller due to shrinking twin deficits (Chart III-2). Chart III-1Pakistan's Rupee: Close To A Bottom? Chart III-2Twin Deficits Are Likely To Shrink Both trade and current account balances have started showing improvement in U.S. dollar terms due to a steep contraction in imports. Going forward, we expect export growth to turn positive on the back of currency devaluation but import contraction will deepen. Lastly, the IMF agreement might allow Pakistan to issue some Eurobonds while higher local rates might attract some foreign portfolio capital. Second, Pakistan’s top leadership has cooperated with the IMF. Just earlier this month IMF economist Reza Baqir was appointed the new central bank governor. In addition, the Finance Minister and the Federal Bureau of Revenue chairman have been replaced. These new appointments increase the odds that the IMF program will be enforced in Pakistan. Indeed, after only two weeks on the job the new central bank governor raised the policy rate this Monday by 150 basis points to 12.25%. Meanwhile, significant fiscal consolidation is on the way, as the new policymakers will be committed to the IMF program. The budget for the next fiscal year (June 2019 – May 2020), which will be presented in Parliament on May 24, will likely show a considerable reduction in non-interest expenditures. Finally, the IMF is also pushing for increased central bank independence. In the last 17 months, the central bank purchased massive amounts of government securities – a de facto monetization of public debt. This has exacerbated domestic inflation and currency depreciation. So long as the country is under the IMF program, it is reasonable to expect no public debt monetization. In summary, the ongoing substantial monetary and fiscal tightening and accompanying reduction in the twin deficits, coupled with the increased availability of foreign funding are positive for the exchange rate. It is possible that Pakistan will follow the 2016-2017 Egyptian roadmap. Egypt experienced a severe balance-of-payment crisis and agreed to a similar IMF bailout program. In the case of Egypt, a 55% depreciation in its currency in late 2016 was followed by a 77% rally in share prices in U.S. dollar terms over the subsequent 18 months (Chart III-3). We are putting Pakistani stocks on our upgrade watch list. We are reluctant to upgrade it now because currency weakness might persist for a couple of months. Further, monetary and fiscal tightening will amplify the economic downturn weighing on corporate earnings. Banks’ NPL ratios and provisions will likely rise considerably. Chart III-3The 2016-2017 Egyptian Roadmap Chart III-4Pakistani Equities: A Long-Term Profile Bottom Line: We are putting Pakistani equities on an upgrade watch list. This bourse’s technicals are becoming interesting – it might bottom at its previous highs (Chart III-4). In addition, both absolute and relative valuations of Pakistani stocks appear attractive (Charts III-5 & Chart III-6). Chart III-5Equity Valuations Look Attractive Chart III-6Relative Equity Valuations Also Look Attractive We are waiting for share prices and the currency to stabilize before recommending an overweight position in Pakistani equities. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights In the second half of 2019, economic growth will stop accelerating… …but an underpinning of equity valuations will limit sell-off magnitudes to around 10 percent or so, rather than deeper sustained plunges. The equity market will end up in a sideways channel… …but defensives, such as healthcare, will outperform economically-sensitive sectors. Overweight Euro Stoxx 50 versus Shanghai Composite. Overweight the JPY. Bitcoin is due another technical correction. Feature The 2019 playbook for economies and markets is playing out exactly as we predicted. In our first report of this year we wrote that 2019 would be the economic and investment opposite of 2018. Opposite to 2018 because the first half of 2019 would see inflation fade, and growth accelerate. And opposite to 2018 because the second half of 2019 would see inflation stop fading, and growth stop accelerating (Chart of the Week). Chart of the WeekIn The First Half Of 2019, Inflation Faded, Growth Accelerated Inflation Faded, Growth Accelerated Back in early January, we wrote: “Inflation is set to disappoint as the recent near-halving of the crude oil price feeds into both headline and core consumer price indexes. With central banks now promising even greater ‘dependence on the incoming data’, this unfolding dynamic will force them to temper any hawkish intentions and rhetoric, limiting the extent of upside in bond yields.” This was a controversial view at the time. Yet within a month of writing, the Federal Reserve had stopped hiking interest rates, while the ECB and other major central banks had also pivoted to more dovish. We also wrote: “Germany should benefit from another support to growth. Last year, the auto sector – a major engine of the German economy – spluttered as it absorbed the new WLTP emissions testing standard. Through the middle of 2018 German motor vehicle exports suffered a €20 billion hit which shaved 0.6 percent from Germany’s €3.4 trillion economy (Chart I-2). Now, if auto exports stabilize, this drag will disappear. And if auto exports recover to the pre-WLTP level after this one-off and temporary shock, Germany will receive a 0.6% mirror-image boost to growth.” 1 2019 is the economic and investment opposite of 2018. We now know that the German economy accelerated to a close-to-trend 1.7% clip in the second quarter, up from a -0.8 percent rate of contraction in the third quarter of 2018 (Chart I-3). This is not just due to relief in the auto sector. Growth in other European economies has also rebounded, so the acceleration in growth has a broader foundation, and is now beyond doubt. Given the openness of the European economy, it is also inconceivable that this growth pick-up does not reflect a more generalized acceleration in global activity.2 Chart I-2The WTLP Drag On German Auto Exports Is Over Chart I-3German GDP Growth Accelerated To A 1.7 Percent Clip To repeat, the 2019 playbook for economies and financial markets is playing out exactly as expected; in the first half of the year, inflation faded while growth accelerated. The question is: what happens next? Growth Will Struggle To Accelerate Further Clients ask us an important theoretical question: what is the most important driver for the economy and financial markets; is it the change in the bond yield (or interest rate) or is it the level of the bond yield? The answer is that both the change and the level of the bond yield are important in their different ways. The German economy accelerated to a close-to-trend 1.7% clip in the second quarter. When it comes to accelerations and decelerations in credit creation, it is the change in the bond yield that is the most important. Remember, GDP is a flow statistic, which means that GDP growth is a change of flow statistic receiving contributions from the change of flow of credit. As changes in the flow of credit result from the change in the bond yield – all else being equal – it is the change in the bond yield that drives GDP growth. If all of this sounds somewhat confusing, then Chart I-4 should make the point crystal clear. Chart I-4The Change In The Bond Yield Drives GDP Growth Since last November, high-quality 10-year bond yields have plunged 70 bps, and this collapse in yields helped to provide a strong impulse to growth in the first half of 2019. To receive the same impulse again in the second half, bond yields would have to plunge another 70 bps. But with the German 10-year bund yield already at -0.1 percent, the same rate of decline seems highly unlikely, if not mathematically impossible. The upshot is that the growth impulse from declining bond yields can only fade in the second half of this year. However, when it comes to valuations and solvencies in the financial markets, it is the level of the bond yield that is the most important. Essentially, at a tipping point, higher bond yields can suddenly and viciously undermine the valuation support of equities, triggering a plunge in the stock market and other risk-assets which threatens a disinflationary impulse on the economy. The growth impulse from declining bond yields can only fade in the second half of this year. How can we sense this tipping point? It broadly equates to when the sum of the 10-year yields on the T-bond, German bund, and JGB is at 4 percent, the ‘rule of 4’ (Chart I-5). Conversely, when the sum is below 3 percent, the ‘rule of 3’, – as it is now – the seemingly rich valuation of equities versus bonds is broadly justified (Chart I-6).3 Chart I-5When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB Equals 4 Percent, The Global 10-Year Yield Equals 2 Percent Chart I-6The Rule Of 4, And The Rule Of 3 The upshot is that in the second half of 2019, economic growth will stop accelerating, but the support to equity valuations will limit sell-off magnitudes to around 10 percent or so, rather than deeper sustained plunges (Chart I-7). In aggregate, the equity market will end up in a sideways channel, but defensives, such as healthcare, will outperform economically-sensitive sectors. Chart I-7The Low Expected Return On Equities Is Justified When Bond Yields Are Ultra-Low How Did We Do? In our first report of the year, we also made (or reiterated) five investment recommendations. Today, we will review whether they worked or not, and what to do with them now. 1. Own a 25:75 combination of European banks relative to market, plus U.S. T-bonds. Chart I-8Banks Didn’t Outperform, But Bonds Did! Did it work? Yes. Although European banks underperformed the market, this was more than offset by the huge rally in T-bonds that resulted from the Fed going on hold (Chart I-8). Hence, the position is up 1 percent this year and 3.5 percent since its inception last November with the added advantage of negligible volatility. What to do now. Take profits. 2. Overweight EM versus DM. Did it work? No. EM has underperformed DM this year, though the position is broadly flat since its inception in November. What to do now. Close this position and switch into overweight Euro Stoxx 50 versus Shanghai Composite. 3. Overweight European versus U.S. equities. Did it work? The position is flat this year, though modestly up since its inception in November. What to do now. Maintain the position for a little while longer, as an expected short-term underperformance of the tech sector should benefit the tech-lite European equity market. 4. Overweight Italian assets versus European assets. Did it work? The position is broadly flat this year for both Italian equities and bonds relative to their European benchmarks. What to do now. Close any cyclical exposure to Italy, but maintain a structural exposure to Italian BTPs either in absolute or relative terms. 5. Overweight the JPY. Chart I-9In Japan And Europe, The Expected Interest Rate Cannot Go Much Lower Did it work? Yes. The broad trade-weighted JPY has outperformed this year, and especially so the JPY/EUR cross. What to do now. Maintain the position. When the expected interest rate is at its lower bound, then it is difficult for the central bank to hurt its currency. In technical terms, the currency possesses a highly attractive payoff profile called positive skew (Chart I-9). Of course, there are plenty of currencies whose interest rates are near the technical lower bound, but we like the JPY because it has less political risk than the others. So for the moment, remain overweight the JPY. Fractal Trading System* This week we note that after a 100 percent rally in a near straight line, bitcoin’s 65-day fractal dimension is at the lower bound that has reliably signaled previous technical corrections. On that basis, this week’s recommended trade is short bitcoin, setting the profit target and symmetrical stop-loss at 27 percent. Also, we are very pleased to report that short tech versus healthcare quickly achieved its 6.5 percent profit target and is now closed. This leaves four open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: 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 Footnotes 1 German auto net exports and GDP are quoted at annualized rates. The Worldwide Harmonized Light Vehicle test Procedure (WLTP) is a new standard for auto emissions that took effect on September 1 2018. 2 Quarter-on-quarter real GDP growth at annualized rates. 3 Please see the European Investment Strategy Weekly Report “The Rule of 4 Becomes the Rule of 3” dated March 21, 2019 available at eis.bcaresearch.com. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades 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
Neutral In a report late last month, we noted that our overweight recommendation on S&P homebuilders had generated alpha in excess of 10% for our portfolio, despite being offside early. However, we further noted a softening in some housing related data that gave us pause, particularly in the context of a trade that had provided outstanding gains, and we added a downgrade alert and set a stop sell order at the 10% relative return mark. That mark was breached on Monday; accordingly, and in a continuation of our progressive derisking of the portfolio, we have lowered our recommendation on the S&P homebuilders index to neutral. We continue to fear that if a generalized risk-off phase materializes, yields will fall but homebuilders will not participate in the bond rally. That is not to say we have grown negative on U.S. housing in general; on the contrary, we continue to explore a bullish housing view via our long S&P homebuilders/short S&P home improvement retailers pair trade. Clients should look forward to next week’s Weekly Report for an update on the latter of these sectors. Bottom Line: Downgrade S&P homebuilders to neutral, crystalizing gains of 10%. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, DHI, PHM.
Highlights Portfolio Strategy Macro headwinds, deficient demand along with rising chemicals stockpiles that have dealt a blow to industry pricing power warn that chemicals stocks are on the verge of a breakdown. Downgrade to a below benchmark allocation. At the margin deteriorating domestic conditions, along with a sustained softness in global growth indicators that are prone to an additional setback given the rising trade policy uncertainty suggest that it is prudent to move to the sidelines on the long materials/short utilities pair trade. Recent Changes Downgrade the S&P chemicals index to underweight, today. This also pushes the S&P materials sector’s weight back down to neutral. Close the long S&P materials/short S&P utilities pair trade, today. Table 1 Feature The SPX suffered its first 5% pullback for the year early last week, and now that President Trump has opened Pandora’s Box, there are high odds that equities will continue to seesaw, at least, until the late-June G20 meeting when the heads of states meet again. Since early-March we have been, and remain, cautious on the short-term equity market outlook as a slew of our tactical indicators have soured. Chart 1 shows three additional non-confirming equity market breakout indicators that are exerting downward pull on the SPX. Stock correlations have increased (shown inverted, top panel, Chart 1), junk spreads have widened (shown inverted, middle panel, Chart 1) and the NYSE’s FANG+ Index has run out of steam (bottom panel, Chart 1). Now the risk is, as we first highlighted in the middle of last week, that the back half of the year global growth reacceleration phase goes on hiatus as this trade policy uncertainty further shatters CEO confidence and global exports remain downbeat (Chart 2). Chart 1Non-Confirming Indicators Chart 2Stalled Export Engine Worrisomely, a number of our cyclical indicators are also firing warning shots. Not only did the ISM’s manufacturing new orders-to-inventories ratio breach parity, but also BCA’s boom/bust indicator took a turn for the worse (Chart 3). Importantly, while a lot of ink is spent on how the U.S. economy is beyond full employment, labor markets are tight and the output gap has closed, resource utilization has petered out – interestingly at a lower high compared with the previous two peaks. This backdrop points to more stock market turmoil in the coming months, similar to the mid-2015 message (Chart 4). Chart 3Cyclical Trouble Brewing Chart 4No Tightness Here Tack on China’s cresting credit impulse and factors are falling into place for a tumultuous back half of the year (bottom panel, Chart 3). Keep in mind that the two ultimate “risk off” indicators we track remain tame and underscore that investor complacency remains elevated: the TED spread is at 16bps and the Japanese yen has barely budged of late. This is worrying and suggests that investors expect a positive U.S./China trade resolution (USD/JPY shown inverted, Chart 5). Chart 5No Real Risk Off Phase Yet Were the equity markets to spin out of control however, the “Fed put” remains in place and would save the day. While the Fed has taken down the median dots and projects no hikes for the rest of the year and a single hike next year, the message from the bond market is diametrically opposite. Thus, we are de-risking our portfolio and this week we are downgrading a deep cyclical sector to neutral and also closing an explicit cyclical/defensive pair trade. Chart 6 shows that over 40bps of cuts are priced in by May 2020, according to the OIS curve. Historically, this has been an excellent leading indicator of the annual delta in the fed funds rate. Our takeaway is that the Fed remains the only game in town and were another mini-riot point to occur, then the Fed would not hesitate to step in and put a floor under the equity market. Chart 6The Bond Market Has The Stock Market’s Back In sum, the risks are rising for a prolonged consolidation phase in equities on the back of a trade war escalation that pushes out the global growth recovery to early-2020. Thus, we are de-risking our portfolio and this week we are downgrading a deep cyclical sector to neutral and also closing an explicit cyclical/defensive pair trade. Chemical Reaction We have been on the sidelines on the heavyweight S&P chemicals index of late (it comprises 74% of the S&P materials sector), but factors have now fallen into place and warrant a below benchmark allocation. First, global macro headwinds will continue to weigh on this deep cyclical index as the risk of a full blown trade war will likely take a bite out of final demand. Chemical producers garner 60% of their revenues from abroad (a full 20 percentage points higher than the SPX) and thus are extremely sensitive to the ebbs and flows of emerging markets economic growth in general and China in particular. Adding it all up, macro headwinds, deficient demand along with rising chemicals stockpiles that have dealt a blow to industry pricing power warn that chemicals stocks are on the verge of a breakdown. Chart 7 shows that U.S. chemical products exports are contracting and if the greenback sustains its recent upward trajectory given heightened global trade policy uncertainty, further global market share losses are likely at a time when the overall chemicals market will be shrinking. With regard to China specifically, the recent drop in the credit impulse is far from reassuring (bottom panel, Chart 3) and, assuming that the Chinese authorities will await a riot point prior to really opening up the credit spigots, more pain lies ahead for U.S. chemical exports. Second, the picture is not brighter on the domestic front. Importantly, the American Chemical Council’s Chemical Activity Barometer is nil, warning that domestic end-demand is also ailing (Chart 8). Chart 7Hazard Warning Chart 8Toxic Profit Prospects Tack on a surprisingly persistent jump in industry headcount (bottom panel, Chart 9), and the implication is that waning productivity will slash chemicals profits (bottom panel, Chart 8). Finally, a number of other operating metrics are languishing. Chemicals railcar loads are outright contracting and the softening ISM manufacturing survey points to further downside in the coming months (middle panel, Chart 9). The chemicals shipments-to-inventories ratio is also in contraction territory as this downbeat demand has been met with a buildup in inventories both at the wholesale and manufacturing levels. As a result, a liquidation phase has ensued and chemicals selling prices have sunk into the deflation zone (middle & bottom panels, Chart 10). Chart 9Deficient Demand Chart 10Liquidation Phase Adding it all up, macro headwinds, deficient demand along with rising chemicals stockpiles that have dealt a blow to industry pricing power warn that chemicals stocks are on the verge of a breakdown. Bottom Line: Trim the S&P chemicals index to underweight. Given the 74% weight chemicals stock have in the S&P materials sector, this move also pushes the S&P materials sector’s (Chart 11) weight to neutral from overweight, and we crystalize modest losses of 5.2% in this niche deep cyclical sector. The ticker symbols for the stocks in the S&P chemicals index are: BLBG: S5CHEM – DWDP, ECL, SHW, PPG, IFF, CE, ALB, LIN, APD, DOW, LYB, FMC, CF, MOS, EMN. Chart 11Trim Materials Back Down To Neutral Materials/Utilities: Move To The Sidelines While we were early in identifying a reflationary impulse from the Chinese authorities and put on an explicit cyclicals/defensives pair trade to capitalize on this opportunity at the end of January, the long materials/short utilities pair trade has failed to live up to its expectations, and today we recommend moving to the sidelines. Such a move is part of our de-risking of the portfolio given the rising global macro headwinds on the horizon we identified earlier. More specifically on the domestic front, our Economic Impulse Indicator (EII) suggests that beneath the surface some cracks are appearing in the U.S. economy. The EII encapsulates six parts of the U.S. economy and on a second derivative basis, softness is apparent (top panel, Chart 12). The ISM manufacturing survey corroborates this message and is also flirting with the boom/bust 50 line, signaling that it is prudent to take some risk off the table (bottom panel, Chart 12). The bond market is sniffing out this deteriorating domestic backdrop and the recent 25bs drop in the 10-year Treasury yield has breathed life into utilities and sucked the oxygen out of materials. Fixed income proxies are also benefiting from the drubbing in Citi’s Economic Surprise Index to the detriment of growth-sensitive deep cyclicals. The melting stock-to-bond ratio reflects all these domestic forces and warns against preferring materials to utilities stocks (Chart 13). Chart 12Move To The Sidelines Chart 13Mushrooming Domestic… The specter of a re-escalation in the trade war will not only continue to weigh on some domestic indicators, but gauges monitoring the health of the global economy will also suffer a setback. Already, our Global Activity Indicator has lost its spark, underscoring that global export volumes will continue to contract. King Dollar is also flexing its muscles, especially versus vulnerable twin deficit emerging market countries which saps economic growth. Tack on the derivative deflationary effect the appreciating greenback has on the commodity complex and materials stocks are at a great disadvantage versus domestic focused utilities (Chart 14). A number of additional global growth indicators are waning and signal that relative profitability will move in favor of utilities and at the expense of materials in the coming months. BCA’s global synchronicity indicator, which gauges the number of countries with a PMI above versus below 50 is sinking like a stone. In fact, the overall global manufacturing PMI is just barely above the expansion/contraction line and global industrial production is decelerating. All of this is a net negative for the deep cyclical materials sector, but a net positive for defensive utilities stocks that sport nil foreign sales exposure (Chart 15). Chart 14…And Global Growth… Chart 15…Worries But before getting outright bearish on this pair, there is a powerful offset. Likely, most of the bad news is reflected in bombed out relative valuations and oversold technicals. This actually also prevents us from fully reversing the trade and buying utilities at the expense of materials. A move to the sidelines is more appropriate (Chart 16). At the margin deteriorating domestic conditions, along with a sustained softness in global growth indicators that are prone to an additional setback given the rising trade policy uncertainty suggest that it is prudent to move to the sidelines on the long materials/short utilities pair trade. Bottom Line: Book losses of 5.3% in the long S&P materials/short S&P utilities pair trade and move to the sidelines. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Chart 16Saving Grace Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights We’ve searched in vain for imminent domestic weakness in the U.S. economy, … : Much of our work this spring has focused on trying to poke holes in our view that the equilibrium fed funds rate remains above the target fed funds rate, but we haven’t found any evidence of overheating in the real economy, or worrisome excesses in financial markets. … but an exogenous shock could well precipitate a recession if it were serious enough: The U.S. is a comparatively closed economy, but there’s no such thing as full-on decoupling. The U.S. may react more slowly than other major economies to what’s going on in the rest of the world, but it’s not immune to it. A trade war would threaten global growth, … : U.S.-China trade negotiations have taken center stage over the last couple weeks, and escalating tension between the world’s two largest standalone economies will surely cast a pall over the global outlook. … but there are other potential threats that bear monitoring: Tensions with Iran could be the catalyst for an oil price shock, while a significant rollback of globalization could crimp corporate profit margins. Either would hasten the end of the equity bull market and the expansion. Feature Tight monetary policy is a necessary, if not sufficient, condition for a recession. We deem policy to be tight if the fed funds rate exceeds our estimate of the equilibrium fed funds rate, and easy if it is below our estimate of equilibrium. Over the six decades for which we compute an estimate of the equilibrium fed funds rate, the U.S. has only ever experienced recessions when the fed funds rate has exceeded our estimate of equilibrium (Chart 1). Tight policy isn’t always tantamount to a recession – nothing came of tight settings in 1984 or 1995 – but recessions don’t occur without it. Chart 1Recessions Only Occur When Monetary Conditions Are Tight We currently estimate that the equilibrium fed funds rate, a.k.a. the neutral rate, is about 3⅛%, and we continue to project that it will be around 3⅜% by the end of the year. Those estimates leave the Fed with plenty of headroom before it materially slows the economy. If our estimate is on the money, it will take four more rate hikes to induce an inflection in the business cycle. We have not seen anything in the ongoing flow of macro data, or evidence of excesses in the financial markets, that would suggest a recession is already under way or is lurking around the corner. Internal dynamics should continue to support the expansion, but threats from outside the U.S. are growing. We therefore conclude that the next recession may well not arrive for another two years, in the absence of a significantly adverse exogenous event. This week, we extend our focus beyond the U.S. to try to uncover the external threats that could stop the U.S. economy, and the bull markets in risk assets, in their tracks. Beyond the tariff fireworks, we also contemplate the possibility that conflict with Iran could lead to an oil price shock, and the impact of a significant rollback of globalization. It is not our base case that any of the various external threats will tip the U.S. into a recession, but investors should keep tabs on the biggest ones. Tariffs The U.S.-China trade saga has unfolded in three pairs of moves and counter-moves (Diagram 1). While the aggregate $50bn worth of Chinese goods tariffed in the first two salvos mostly targeted industrial equipment and machinery, the third installment, covering $200bn worth of imports, extended the tariffs’ reach to consumer products. Major categories included not only commodities such as base metals, chemical products and mineral fuels and oils, but also a broad swath of foods, textiles, electronics, vehicles and spare parts. After a three-month cease-fire, the developments of the last two weeks arguably marked the most significant escalation of tensions on both sides. The U.S. is now threatening to levy tariffs on the remaining $325bn of Chinese goods that have so far been spared. Diagram 1Anything You Can Do Our colleagues at BCA’s Geopolitical Strategy service suggest that recent foreign policy initiatives indicate that the White House does not feel any particular pressure to minimize economic risk this far ahead of the election. The risk of market-disruptive measures has therefore increased, and they see a 50-50 chance that the U.S. and China will fail to reach an accord (Table 1). Although the administration has delayed any action on autos and auto parts for now, Europe could be the next trade partner in its cross hairs. The odds that Section 232 (national-security-threat) tariffs will be levied on European auto imports is rising (Chart 2). Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 These heightened trade tensions may delay the global growth recovery that we were expecting to bloom in the summer, and they may also allow the dollar to keep advancing. The greenback is a countercyclical currency, moving inversely with global activity (Chart 3), and a bump in the road for global growth would likely extend its upward run. Chart 3The Countercyclical Dollar Although a strong dollar would be a headwind for exporters, the U.S. economy is comparatively closed. Tariffs are likely to exert the greatest pressure on the economy via softer consumption and investment. So far, the available evidence suggests that U.S. consumers and corporations have borne the brunt of higher tariffs in the form of higher retail prices and lower profit margins.1 Iran Our geopolitical strategists contend that investors have underrated conflict with Iran as a market risk for a while. Now that the contentiousness of U.S.-Iran relations has ratcheted higher upon the administration’s decision not to extend the import waivers on Iranian oil, the issue is back in the spotlight. Our strategists caution that managing the dispute may require more delicacy than the more hawkish elements of the administration realize. In their view, the potential for a misstep increases the odds of a recession and poses a significant risk to the equity bull market. In a joint Special Report by our Commodity and Energy Strategy and Geopolitical Strategy services at the beginning of the month, our in-house experts stressed that there are multiple moving parts driving the supply-demand balance in the global oil market.2 Investors should realize that the world faces the prospect of the loss of Venezuelan production (approximately 600,000 barrels per day (b/d)) and significant outages in Libya (~600,000 to 800,000 b/d), in addition to our strategists’ base-case estimate of 700,000 b/d from Iran’s current 1.3 million b/d output. BCA does not expect that all of that output will be lost, but the key point is that Iran is not the only potential source of a supply shortfall. Our energy strategists believe that OPEC 2.0 – the producer coalition led by Saudi Arabia and Russia, and supported by Saudi Arabia’s OPEC allies – has the capacity to make up for even their larger shortfall scenarios (Chart 4). The problem is that OPEC 2.0 may not have the will to do so in a timely fashion. Saudi Arabia and the rest of the OPEC 2.0 coalition were caught completely off guard by the administration’s issuance of import waivers in November, after they had ramped up production at its request to limit the market disruptions that would have ensued when Iran’s output was taken off the market. The last-minute waiver decision caused oil prices to crater in the wake of a supply glut that OPEC 2.0 has been working to sop up ever since (Chart 5). Chart 5... But The Oil Market Is Pretty Tight OPEC 2.0’s members may feel that they were badly used last fall, and may not be inclined to move proactively now. Russia is managing its own low-grade conflict with the U.S., and all of the coalition should bear in mind that the U.S. could release over a million b/d from its Strategic Petroleum Reserve (SPR) for a solid six to nine months, according to our energy team’s estimates. If rising oil prices are often viewed as a tax on American consumers, a late summer/early fall release of holdings could be viewed as an election rebate, courtesy of the skilled economic managers in the White House. Our team expects that OPEC 2.0 will likely guard against an oversupply-driven swoon in oil prices by managing its production on something akin to a just-in-time inventory strategy. Our energy and geopolitical strategists caution that there are two other ways the administration may overplay its hand. First, it might overestimate U.S. shale drillers’ ability to export their production. While new pipeline construction will relieve the transportation bottleneck limiting the Permian Basin output that reaches the Gulf of Mexico, oil exports from the Gulf are limited by a shortage of deep-water harbor facilities. If global trade tensions do worsen, both the dollar and U.S. equities may attract safe-haven flows. There is also the possibility that Iran might strike at Iraq, putting some of its 3.5 million b/d output at risk. It could also make good on its repeated threat to close the Straits of Hormuz, through which nearly a fifth of global oil supplies travel daily. Either of these options would dramatically escalate the conflict, but a desperate Iran might pursue them if it felt cornered. The bottom line is that the probability of an oil price shock is not negligible. Brinkmanship with Iran could upset a delicate supply-demand balance in global oil markets, and a delicate geopolitical balance in the Middle East. If the Volcker double-dip is treated as a single event, a surge in oil prices has preceded every recession in the last 45 years, except for the 2001 recession precipitated by the bursting of the dot-com bubble (Chart 6). Chart 6Oil Price Spikes Often Precede Recessions Significant Rollback Of Globalization Our Geopolitical Strategy and Global Asset Allocation services have cited peak globalization as an important long-term investment theme for the last several years. The tariff tensions between the U.S. and its trading partners would seem to have borne out their predictions, especially if one views them as having been inspired by unskilled workers’ losses from globalization. Taking on foreign exporters is likely to play well in the electorally decisive Rust Belt states, where manufacturing job losses have hit especially hard. We fully subscribe to the theory of comparative advantage as formulated by David Ricardo in the early 19th century. By allowing individual countries to specialize in what they do best, free trade increases the size of the global economic pie. Empirical evidence suggests that globalization also re-slices the pie, however. In the developed world, outsourcing manufacturing has operated to the benefit of investors and the detriment of less-skilled workers. For U.S.-based multinationals, tariffs are a minor irritant compared to the prospect of having to reroute supply chains around China. The modest headwinds to globalization observed before the U.S. began engaging in serial bilateral trade conflicts did not undermine corporate profit margins in any material way. A bigger anti-globalization push that forced global supply chains to be rerouted or partially unwound would have much more negative effects. The U.S. is a comparatively closed economy, but the multinationals that dominate equity market capitalization rely heavily on interactions with the rest of the world. Unwinding the global supply chains that have been carefully constructed over the last 30 years would be disruptive and costly. The worst-case scenario envisioned by our geopolitical strategists, in which U.S.-China relations dramatically worsen and the tariff back-and-forth escalates in a major way, would hit equities hard, especially if supply chains had to be rebuilt. As a proxy for what globalization has meant for investors’ and blue-collar workers’ share of the pie, we consider the path of real wages relative to productivity over the last 50 years. From 1970 through 2001, U.S. wages generally kept pace with productivity gains, observing a fairly narrow, well-defined range (Chart 7). Once China entered the WTO (as denoted by the vertical line on the chart), productivity-adjusted wages fell precipitously, and even their periodic bounces have fallen well short of the level that marked the lower end of the previous range. Chart 7The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk Bottom Line: Temporary barriers to free trade, implemented as a negotiating tactic, are not a big deal for equities. A significant rollback of globalization would be, however, and a need to divert global supply chains away from China could stop the bull market in its tracks. Investment Implications Along with our Global Investment Strategy colleagues, we are somewhat more sanguine than our Geopolitical Strategy service that a worst-case outcome between the U.S. and China can be averted. We therefore continue to believe that the U.S. expansion, and the bull markets in risk assets, will persist until the Fed tightens monetary conditions enough to spark the next recession. We reiterate our recommendations that investors should maintain at least an equal weight position in equities and spread product. Enough is at stake in the conflicts with China and Iran, however, that a worsening of either could cause us to change our view, and we will be watching developments on each front closely. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Senior Analyst, Global ETF Strategy jenniferl@bcaresearch.com Footnotes 1 Mary Amiti, Stephen J. Redding, and David E. Weinstein, “The Impact of the 2018 Trade War on U.S. Prices and Welfare,” NBER Working Paper No. 25672, (March 2019). 2 Please see Commodity & Energy Strategy/Geopolitical Strategy Special Report, “U.S.-Iran: This Means War?,”dated May 3, 2019, available at ces.bcaresearch.com.
In late-January we put on a market, sector and subindustry neutral trade preferring homebuilders to home improvement retailers (HIR) as a way to benefit from the increase in residential construction at the expense of residential investment. This trade moved in the black from the get-go and is now generating alpha to the tune of 10% since inception, but more gains are in store in the coming months. President Trump’s hawkish tariff rhetoric should keep interest rates at bay, at least for a short while, and bond market nervousness is more of a boon to homebuilders than to HIR (top panel). The drop in the price of mortgage credit along with minor price concessions from homebuilders are causing sales of new homes to take off versus existing home sales (middle panel). Granted, bankers remain willing extenders of residential loans and the latest Fed Senior Loan Officer Opinion Survey revealed that demand for residential credit is making a comeback following a near yearlong decline (not shown). As a result, relative loan growth metrics also underpin the relative share price ratio (bottom panel). Bottom Line: Stick with a long S&P homebuilders/short S&P HIR pair trade and please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in the S&P homebuilding and S&P HIR indexes are: BLBG: S5HOME – PHM, DHI, LEN and BLBG: S5HOMI – HD, LOW, respectively.
Highlights So What? Odds of a total breakdown in U.S.-China relations are highly underrated. Why? The key market-relevant geopolitical event is Trump’s large risk appetite. Inflationary pressures resulting from the trade tariffs are not prohibitive for Trump’s trade war. Chinese stimulus will surprise to the upside, but a massive stimulus package will depend on talks collapsing and maximum tariffs. Markets will sell before they recover. We will maintain our current portfolio hedge of Swiss bonds and gold. Feature Chart 1Equities Sell, Safe Havens Rally Global equities have sold off and safe-haven assets caught a bid since the near-breakdown in U.S.-China trade negotiations on May 5 (Chart 1). Yet financial markets are still complacent, as the 2.8% drawdown to date on global equities and the S&P 500 does not yet reflect the depth of the geopolitical risk to sentiment and corporate earnings. To understand this risk we need to step away from the ups and downs of the trade negotiations and ask, What have we learned about U.S. policy over the past month and what does it mean for global markets on a cyclical and structural horizon? We have learned that in the lead-up to the 2020 election, President Trump is not seeking to protect his greatest asset – namely, a strong American economy – but rather to solidify his support through new ventures. By imposing the full brunt of sanctions on Iran and hiking the tariff rate on Chinese imports, Trump has made two highly significant decisions that could jeopardize the American voter’s pocketbook, with a full 18 months to go before November 3, 2020. Why has he done this? Because he believes the American economy can take the pain and he will achieve resounding foreign policy successes. These, he hopes, will make his reelection more likely. President Trump’s aggressive posture is a direct threat to the global equity bull market due to (1) higher odds of a negative shock to global trade when global growth is already weak, and (2) higher odds of an oil price shock due to a potential vicious spiral of Middle East conflict. Wreaking Havoc Historically, the United States thrives when the rest of the world is in chaos. This was obviously the case during World War I and II (Chart 2). But it also proved true in the chaotic aftermaths of the Soviet Union’s collapse and the global financial crisis, though the U.S. did suffer along with everyone else during the 2008-09 downturn. American equities have generally outperformed during periods of global chaos (Chart 3). Chart 2America Thrives Amid Global Chaos Chart 3U.S. Equities Outperform During Global Crises The reasons for U.S. immunity are well known: the U.S. has a large, insulated, consumer-driven economy; it has immense economic advantages enhanced by its dominance of North America; it has vast and liquid financial markets; and it is the world’s preponderant technological and military power. This position enables Washington to act more aggressively than other capitals in pursuit of the national interest – and to recover more quickly from mistakes. Chart 4U.S. Preponderance Declining It follows that there is an influential idea or myth that the country can or should exploit this advantage, when necessary or desirable, by “wreaking havoc” abroad. The prime example is the preemptive invasion of Iraq. In this way Washington can turn the tables on its opponents and keep them off balance. The Trump administration, regardless of Trump’s intentions, could soon become the epitome of this school of thought. First, it is true that, structurally, American preponderance has been decreasing: despite various crises, there has been sufficient peace and prosperity in the twenty-first century to see the rest of the world’s wealth, trade, and arms grow relative to the United States (Chart 4). With the rise of China and resurgence of Russia, U.S. global leadership is at risk and the Trump administration has adopted unorthodox policies to confront its rivals and try to reverse this process. Second, cyclically, President Trump is stymied at home after his Republican Party lost the House of Representatives in the 2018 midterm election. Scandals and investigations plague his inner circle. Unable to secure funding for his signature campaign promise – the southern border wall – Trump faces the risk of irrelevance. Foreign policy, especially trade policy, thus becomes the clearest avenue for him to try to notch up victories. Trump faces the risk of irrelevance. Foreign policy thus becomes the clearest avenue for him to try to notch up victories. Bottom Line: The key market-relevant event over the past month has been the Trump administration’s demonstration of voracious risk appetite. This is fundamentally a cyclical not tactical risk to the bull market due to tit-for-tat tariffs, sanctions, and provocations with rivals like China and Iran. Pocketbooks Versus Patriotism Trump’s vulnerability becomes clear by looking at our electoral Map 1, which highlights his excruciatingly thin margins of victory in the critical “swing states” in the 2016 election. We emphasize the margin of victory among white voters – which are slightly higher than the margins overall – because the Trump campaign courted the white working class specifically in a calculated strategy to swing the Midwest “Rustbelt” states and win the election. The problem for Trump is that while whites remain the majority of the eligible voting population, it is a declining majority due to demographic change. Demographics is not near-term destiny, but the vanishingly thin margins ensure that Trump cannot assume that he will win reelection without generating even more turnout and support among blue-collar whites in the key states. Job creation and rising incomes are the chief hope. The problem is that Trump’s tax cuts and the red-hot economy in 2018 did not prevent Republicans from getting hit hard in the midterm elections, especially in the Midwest. Moreover today’s resilient economy is not preventing the top two Democratic candidates, former Vice President Joe Biden and independent Vermont Senator Bernie Sanders, from beating Trump in head-to-head polling in the key swing states (Chart 5). Trump’s national approval rating, at about 44%, is nearly as good as it gets, but the indications from the Midwest are worrisome, especially because the economy has slowed. If the economy is not winning the argument on the campaign trail in 2020, Trump will need to have another leg to stand on. In addition to hammering home his attempts to build a wall on the border, Trump will highlight his economic nationalism. Protectionism has won the Rustbelt over the past three elections. As we have since 2016 argued, this now boils down to pressure on China. If Trump’s policies provoke China (or Iran) to take aggressive actions, he will have a pretext to exercise American power in a way that will likely create a rally-around-the-flag effect, at least in the short term. Elections do not normally hinge on foreign policy, but they certainly can. While President Trump may not actually want a war with Iran, he knows that George W. Bush cruised to victory amid the Afghan and Iraqi wars. Or he may have in mind 1964, when Lyndon B. Johnson crushed Barry Goldwater, an offbeat, ideological “movement candidate” (can anyone say Bernie Sanders?) in the face of a hulking communist menace, the Soviet Union. A conflict with China (or Iran) could serve similar purposes in 2020, either distracting the populace from a weakening economy or adding to an election bid centered on a reaccelerating economy. The problem is that a patriotic conflict with China or Iran is an insurance policy that threatens to undermine the health and safety of the very thing being insured: the U.S. economy. Indeed, U.S. stocks did not outperform after the September 11th attacks or during the Bush administration’s wars abroad. In essence, Trump is a gambler and is now going for broke. This constitutes a huge risk to the global economy and financial markets – a risk that was subdued just a month ago due to oil sanction waivers and tariff-free trade talks. Bottom Line: President Trump is courting international chaos because his policy priorities are tied down with gridlock and scandal at home. Aggressive foreign policy is a strategy to rack up policy victories and potentially expand his voter base, but it comes at the risk of higher policy uncertainty and negative economic impacts that could derail this year’s fledgling economic rebound and the long-running bull market. “No Deal” Is More Likely Than A Weak Deal It wasn’t just a tweet that sent volatility higher over the past two weeks. Most likely, President Trump decided to raise tariffs on China at the advice of his trade negotiators, who had become convinced that China was not offering deep enough concessions (“structural changes”) and was playing for time. This was always the greatest risk in the trade talks. China is indeed playing for time, as it has no security guarantee from the United States and therefore cannot embrace structural changes in the way that Japan did during the U.S.-Japanese trade war in the 1980s. Originally, the talks were set to last 90 days with the tariff hike by March 1. Trump was apparently determined not to lose credibility on this threat as China drew out the negotiations. Hence, he piled on the pressure to try to force a conclusion by the June 28-29 G20 summit in Japan, which has been the target date for our trade war probabilities over the past several months (Table 1). We have now adjusted those probabilities to upgrade the risk that talks collapse (50%) and downgrade the odds of a deal to 40% by that date. Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 The underlying calculation from the Trump administration is that a cosmetic, short-term deal – along the lines of the NAFTA renegotiation – will be difficult to defend on the campaign trail and hence politically risky. We upgraded the risk that talks collapse (50%) and downgraded the odds of a deal to 40% by end of June. If China agreed arbitrarily to increase imports from the U.S. by 10% by 2020, it would only increase the level of imports above the pre-trade war 2015-18 trend by $23 billion dollars in 2029 (Chart 6, panel 1). It would also have a minimal impact on the trade deficit. The deficit has increased so much in recent years that the impact of a 10% increase in exports by 2020 would merely offset the high point we reached during the trade war, leaving Trump with a mere $800 million per year by 2029 (Chart 6, panel 2). For commodities in particular – where China offered the largest purchases – the negative impact of the trade war has been so great that a 10% increase by 2020 over the status quo would fail to offset the recent damages over a ten-year period. China would have to increase imports by at least 17% to offset the trade war-induced decreases. If commodity imports were 30% higher in 2020 than otherwise, the impact 10 years down the line would amount to a mere $11 billion per year. These gains are smaller, as Chinese negotiators have long argued, than what could be made if the U.S. increased exports of advanced technology products to China. If the U.S. exported as many of these products to China as it does to the EU, as a share of EU GDP, it would amount to a $48 billion increase in exports. For Japan, the equivalent would be an $85 billion increase. Increasing the growth of these exports to China to match the recent trend of such exports globally would nearly double the amount sent to China by 2029, earning the U.S. an additional $60 billion that year (Chart 6, panel 3). The problem, of course, is that the confrontation with China is specifically focused on the latter’s technological acquisition and competition with the United States – it is precisely not about making reductions to the trade deficit at the expense of technological superiority. The tech war is more likely to derail the trade talks than the trade talks are likely to resolve the tech war. It is hugely significant that, at the moment of decision, President Trump sided with U.S. Trade Representative Robert Lighthizer and did not accept a deal focused on marginal improvements to the trade deficit. There was always a strong possibility – we previously put it at a 50% chance – that Trump would accept a short-term deal in order to get a “quick win” and minimize tariff pains ahead of the election, while punting the longer-term structural grievances until his second term when he would be less constrained by the economy. But this possibility has clearly fallen. We now put it at 35%, as shown in Table 1 above. Trump sees a shallow deal as a political liability. The most important takeaway from Table 1, however, is that the odds of a “Grand Compromise” have dropped to a mere 5%. Trump still may settle for a deal to reduce economic risks ahead of the election, but a grand compromise is very hard to get. Bottom Line: Our adjusted trade war probabilities suggest that global equities can fall further on a tactical horizon and that downside risks are grave, given a 50% chance that talks utterly collapse by the end of June. This would include a 30% chance of igniting an intense period of saber-rattling, sanctions, and Cold War-esque tensions that would cause a global flight to quality. Won’t The Trade War Turn Voters Against Trump? No. While geopolitical and political constraints push against a weak deal, the economic constraints of a failure to conclude a deal are not prohibitive. The latest tariff hike doubles the dollar magnitude of the tariffs, and an additional 25% tariff on the remaining $300 billion of imports would more than quadruple the magnitude of the tariffs from the April 2019 level (Chart 7). With all U.S. imports from China affected, price rises will percolate upward through all tradable industries and consumer goods. A few points are worth noting: The domestic value-add of Chinese exports to the U.S. is not as low as consensus holds. China’s manufacturing sector is highly competitive, comparable to the EU and Germany in the degree to which its exports to the U.S. incorporate foreign value (Chart 8). This means that Americans cannot substitute other goods for Chinese goods as easily as one might think. There remains a massive gulf between the nominal output of China’s manufacturing sector and the rest of Asia (Chart 9). Strategically it makes sense for the U.S. to want to decrease China’s share of American imports from Asia and reduce China’s centrality to the production process. But Asia cannot yet substitute for China. In practical terms this requires spreading China’s concentrated production system across the Indonesian archipelago. It is inefficient and will raise costs and import prices. Even in areas where China is lacking – such as technology, institutions, and governance – it still has a productivity advantage over the rest of Asia, pointing yet again to the cost-push inflationary consequences of an abrupt transition forced by tariffs (Chart 10). Chart 9Asia Cannot Replace China ... Yet Chart 10China's Productivity Beats Rest Of Asia Nevertheless, these cost factors are not so great as to force Trump into a weak deal. While the new and proposed tariff expansions will impact consumer goods more than the earlier batches that attempted to spare the consumer, the truth is that Chinese imports do not comprise a large share of the U.S. consumer basket (Chart 11). Chart 11American Shoppers Not Too Exposed To China Chart 12Goods Price Inflation Not An Immediate Risk Goods prices have been flat in the U.S., albeit in great part because of China, and they have fallen while the consumer price index and the real wage component of the CPI have risen by more than 20% since 2001 (Chart 12). Moreover, it is precisely in consumer goods where the American shopper does have considerable ability to substitute away from China – as opposed to the American corporation, which will have a harder time replacing Chinese-made capital goods quickly (Table 2). Thus, the risk impacts Wall Street differently than Main Street. Table 2Capital Goods Harder To Substitute Further, the median American household’s real income growth is still elevated (Chart 13). This comes on top of the fact that net household worth and the saving rate are both in good shape. President Trump has some leeway in waging his trade war. The risk, of course, is that this income growth is decelerating and Trump has given the tariffs 18 months to cause negative impacts for consumers prior to the election. He is also simultaneously wagering that the U.S.’s newfound energy independence – and his own ability to tap the strategic petroleum reserve – will prevent gasoline prices from spiking (Chart 14). This would occur as a result of any Iranian-backed attacks on oil production and export facilities across the Middle East. Chart 13American Household Still In Good Shape Chart 14Fuel Prices Already Rising Bottom Line: Inflationary pressures will result from trade tariffs (and Iranian sanctions) but they are not prohibitive for Trump thus far. This is not a recipe for cost-push inflation significant enough to trigger a recession or derail Trump’s reelection odds at present, but it is a risk that will need to be monitored. How Will China Respond? More Stimulus! The immediate ramification of a heightened trade war is deteriorating global trade and sentiment and hence slower global growth that pushes down prices. Indeed, the escalation of the trade war brings sharply into focus two long-running Geopolitical Strategy themes: Sino-American Conflict: U.S. and Chinese exports to each other have already sharply fallen off (Chart 15). Trade is interconnected so this will further depress global and Asia-ex-China exports. Chart 15Trade War Hurts Bilateral Trade ... And All Trade Chart 16Global Trade Already Rolling Over Apex of Globalization: Global trade as a whole is contracting as a result of the global slowdown, which the trade war has exacerbated (Chart 16). The negative impact on China is acute and threatens something akin to the global manufacturing recession of 2015 (Chart 17). Given that the trade war is now piling onto a merely fledgling rebound in Chinese and global growth this year, it is possible that the manufacturing slowdown could even get worse than 2015 and culminate in a global recession in our worst case scenario of a major strategic escalation. Preventing this outcome, China will increase fiscal-and-credit stimulus, which we have argued is likely to overshoot expectations this year due to trade war and the country’s desire to meet 2020 urban income goals (Chart 18). The magnitude should be comparable to the 2015-16 stimulus, unless a global recession is immediately in view, in which case it will be larger. Chart 17A Relapse Would Point Toward 2015-Sized Crisis It was the Xi administration that undertook the huge 2015-16 expansion of credit, so this magnitude is not out of the question. While Xi has attempted to contain leverage and reduce systemic financial risk, he is ultimately like his predecessors, most notably Jiang Zemin, in the sense that he will aim for social stability above all. Chart 18China Will Keep Stimulating The pain threshold of today’s policymakers has already been discovered, seeing how President Xi and the Politburo began easing policy in July 2018 after the U.S. implemented the initial Section 301 tariffs. The Chinese leaders were willing to tighten credit controls until this external risk materialized. The fact that the trade war is the proximate cause of heightened stimulus was confirmed in the wake of the Buenos Aires summit, where Xi chose to stimulate the economy further – resulting in a surge of credit in Q1 – as a way of improving China’s leverage vis-à-vis the United States in the 90-day talks. China will increase fiscal-and-credit stimulus … The magnitude should be comparable to the 2015-16 stimulus. In short, Xi and his government will stimulate first and ask questions later. Both fiscal and credit stimulus will be utilized, including traditional fiscal infrastructure spending and permissiveness toward shadow banking. A dramatic renminbi depreciation could occur but would be evidence that talks will fail (Chart 19). Chart 19Currency Agreement: Far From A Plaza Accord Stimulus will continue to be tactical, rolled out in piecemeal announcements, at least as long as the trade talks continue and there is a prospect of China’s economy rebounding without drastic measures. Only a total breakdown in negotiations – and collapse into outright Cold War – will prompt a massive stimulus package. Bottom Line: Chinese stimulus will surprise to the upside while talks are going, and it will increase dramatically if talks collapse. This will ultimately support global growth but it will not prevent market riots between a negative policy shock and the point at which markets are totally reassured about the magnitude of stimulus. How Will The Negotiations Proceed? Precariously. The risk of a strategic conflict is much higher than the markets are currently pricing. This is highlighted in Table 1 above, but there are additional reasons to have a high conviction on this point. We can demonstrate this by constructing a simple decision tree that outlines the step-by-step process by which the U.S. and China will proceed in their negotiations after the May 10 tariff rate hike (Diagram 1). To these we attach subjective probabilities that we believe are fair and slightly conservative. The result shows that it is not difficult to conclude that the conditional probability of a long-term, durable trade agreement is a mere 4%, whereas the conditional probability of an uncontained escalation in strategic tensions is as high as 59%! This is a much worse outcome than our actual view as expressed in Table 1. Diagram 1A Simple Decision Tree Says Geopolitical Risks Are Huge A similar exercise – an analysis of competing hypotheses conducted according to analytical techniques used by the U.S. intelligence community – reinforces the point that the most likely scenario is a major escalation in tensions, while the least likely is a “grand compromise” (Appendix). While our final trade war probabilities in Table 1 are not as pessimistic as these exercises suggest, the latter reinforce the point that the market is too sanguine. An increase in tariffs after five months of negotiations, with a threat to impose even more sweeping tariffs with a one-month deadline, is not conducive to Chinese concessions and therefore increases the odds of talks failing and an escalation in strategic conflict unprecedented in U.S.-China relations since the rupture from 1989-91. And this rupture would be considerably worse for the global economy. The Trump administration’s political logic is willing to accept such a conflict on the basis that a foreign policy confrontation can produce a rally-around-the-flag effect whereas a short-term deal that does not address significant technological and national security concerns is a political liability on the campaign trail. Yes, it is important that Presidents Trump and Xi are making verifiable preparations to attend the G20 summit in Japan. But they could cancel their attendance or snub each other at the event. In our view investors should wait for something more substantial to become more optimistic about political risk – such as public commitments to structural changes by China and a complementary tariff rollback schedule by the United States. Bottom Line: The odds of a total breakdown in U.S.-China relations and a Cold War-style escalation of strategic conflict are highly underrated. Markets will sell before they recover. Investment Implications Chart 20China's Nuclear Option Might Fizzle Equity markets are exposed to further downside in the short run. Even a minor escalation is not fully priced according to our Global Investment Strategy’s equity market forecasts based on our own geopolitical scenario probabilities (see Table 1 above). Our Chief Global Strategist Peter Berezin would recommend increasing exposure to risk if the S&P 500 falls 5% from current levels, other factors being equal. Cyclically, any trade agreement will fail to bring substantial benefits to the U.S.-China trade and investment outlook over a horizon beyond 12-24 months. The tech industries of the two countries will not benefit greatly from the deal. While multinational corporations exposed to the Asian manufacturing supply chain could suffer earnings downgrades from trade war, China’s stimulus will be a countervailing factor, particularly for commodities and commodity-oriented EMs. Therefore, we will keep our China Play Index and long Indonesia trades in place despite near-term risks. Ironically, U.S. treasuries can rally even when China is reducing its holdings, as global demand rises amid crisis (Chart 20). However, given that bonds have already rallied and we expect Chinese stimulus to come sooner rather than later, we will maintain our current portfolio hedge of Swiss bonds and gold, which is up 2%. We are closing our long small caps trade for a loss of 11.9%. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix
Feature In what has become a tradition, I met with Ms. Mea following client meetings in Europe last week. Ms. Mea is a long-term BCA client who has been following our Emerging Markets Strategy very closely over the years. It was our fourth meet-up in the past 18 months. Ms. Mea keeps our meetings interesting by always challenging our views and questioning the nuances of our analysis. The timing of our most recent meeting was particularly notable, as we had just received news that the latest U.S.-China trade talks had not produced an agreement. In light of this, Ms. Mea started our conversation with a question on the link between geopolitics and financial markets: Ms. Mea: Why have the U.S. and China failed to reach a trade accord when it is clear that without one, both global financial markets and business sentiment will be hurt? Answer: The U.S. and China are intertwined in a geopolitical confrontation that will endure for decades. Their strategic national interests are not aligned at all. Therefore, any accord on trade and other geopolitical disputes will not be lasting. It is impossible to accurately forecast and time all turns of the negotiation process and the associated event risks. Therefore, an investment process should be informed and guided by a thematic approach. The U.S. and China are intertwined in a geopolitical confrontation that will endure for decades. Our theme has been, and remains, that China and the U.S. are in a long-term geopolitical confrontation that epitomizes a rivalry between an existing and a rising superpower. This suggests that the demands of one side will be unacceptable to the other. That makes any agreement unsustainable over the long run. In brief, there was a structural regime shift in the U.S.-China relationship last year. Yet global equity markets rallied this year on rising expectations of a major trade deal. Notably, most of the gains in EM equities since late December occurred on days when there was positive news on the progress of trade talks. Hence, the EM rally can largely be attributed to expectations of a trade deal. Not surprisingly, the failure to conclude a trade accord has quickly pushed EM share prices back down to their mid-January levels (Chart I-1). As such, the majority of investors who have bought the EM equity index since early this year lost a substantial part of their gains in the recent selloff. Chart I-1EM Equity Index: Between Support And Resistance Given that these two nations are embroiled in a long-term geopolitical rivalry, it will be difficult to find solutions on trade and geopolitical disputes that can simultaneously satisfy both sides. Even so, this does not imply that global risk assets will be in freefall forever. Financial markets currently need to price in both (1) a geopolitical risk premium on a structural basis; and (2) the impact of trade tariffs on global business activity on a cyclical basis. Once these two components have been priced in, markets will become less sensitive to the ebbs and flows of tensions between the U.S. and China. Finally, China’s exports to the U.S. constitute only 3.5% of mainland GDP (Chart I-2). This is considerably smaller than capital spending, which makes up 42% of China’s GDP. Further, most of the investment outlays over the past 10 years have not been in productive capacity to supply goods to the American market. On the contrary, the overwhelming share of capital expenditures since 2008 have occurred in domestic segments of the economy rather than export industries. Certainly, the trade confrontation will weigh on consumer and business sentiment in China as well as reduce the flow of U.S. dollars to the Middle Kingdom, warranting RMB depreciation. Still, there are other predicaments unrelated to the U.S. import tariffs that Chinese policymakers are facing. These include the credit, money and property bubbles that we have written about extensively. China’s exports to the U.S. constitute only 3.5% of mainland GDP. Ms. Mea: With no trade deal, the odds appear to be rising that the Chinese authorities will ramp up both credit and fiscal stimulus. Should investors not be looking through the near-term volatility and be buying EM risk assets and China-plays – because this stimulus will produce a cyclical recovery in the mainland economy? Answer: It is a safe bet that the Chinese authorities will encourage more credit creation and ramp up fiscal spending. The difficulty for investors is in gauging two unknowns: What is the lead time between the stimulus and economic growth, and what will be the multiplier effect of these stimuli. Lead time: Chart I-3 portends our aggregate credit and fiscal spending impulse. Based on the past relationship between turning points in this indicator and the business cycle in China, the latter is likely to bottom around August. Chart I-2Structure Of Chinese Economy Chart I-3China: Stimulus Works With A Time Lag Chart I-4China's Stimulus And Financial Markets: 2012 Versus 2016 Multiplier effect: The impact of stimulus on the economy also depends on the multiplier effect. The latter is contingent on households’ and companies’ willingness to spend. If households and companies hasten the pace of spending, the economy can recover with little stimulus. If they reduce their expenditure growth, the economy may require much more stimulus. The majority of investors and commentators are comparing China’s current stimulus efforts with what occurred in 2016. However, our hunch is that the current Chinese business cycle might actually resemble the 2012-‘13 episode due to similarities in the multiplier effect. The size of credit and fiscal stimulus in 2012 was as large as in 2016. Nevertheless, the business cycle recovery in 2012-‘13 was very muted, as illustrated in Chart I-3 on page 3. Consistently, EM share prices and commodities did not stage a cyclical rally in 2012 as they did in 2016-‘17 (Chart I-4). Ms. Mea: It seems you are implying that differences between the 2012 and 2016 economic and financial markets outcomes are due to the multiplier. How does one appraise the multiplier effect? Answer: In a word, yes. Unfortunately, there is no easy way to forecast consumers’ and businesses’ willingness to spend – particularly in the midst of a clash between the positive effects of stimulus and the negative sentiment stemming from the ongoing U.S.-China confrontation. We have constructed indicators that measure the willingness to spend among households and companies in China. Our proxies for their marginal propensity to spend (MPS) are currently in decline (Chart I-5A and I-5B). Chart I-5AChina: Households' Marginal Propensity To Spend Chart I-5BChina: Enterprises’ Marginal Propensity To Spend MPS does not affect day-to-day expenditures, but rather captures consumer spending on large-ticket items such as housing, cars and durable goods, as well as investment expenditures by companies. Consistently, mainland companies’ MPS leads industrial metal prices by several months (Chart I-5B). Chart I-6 illustrates the critical difference between 2012 and 2016 in terms of the impact of credit and fiscal stimulus. In both episodes, the size of the stimulus was roughly the same, but the manufacturing PMI did not really recover in 2012-’13, gyrating in the 49-51 range. In contrast, it did stage a cyclical recovery in 2016-‘17 (Chart I-6, second panel). In brief, the difference between the 2012 and 2016 episodes was the MPS by companies and households (Chart I-6, third and fourth panels). There are other predicaments unrelated to the U.S. import tariffs that Chinese policymakers are facing. These include the credit, money and property bubbles that we have written about extensively. Provided the not-so-upbeat sentiment among Chinese households and businesses due to their high debt levels and the ongoing trade conflict, the odds are that their MPS will remain weak for now. As a result, the impact of credit and fiscal stimulus on China’s business cycle will be muted for now. As such, more stimulus and longer lead time may be required to engineer a cyclical recovery. Interestingly, the current profiles of both EM and developed equity markets closely resemble their 2012 trajectories – both in terms of direction and magnitude (Chart I-7). Chart I-6China's Stimulus In 2012 And 2016: Beware Of Multiplier Effect Chart I-7Is 2018-2019 Akin ##br##2011-2012? Ms. Mea: So, you are suggesting risks to China-related plays and EM financial markets are skewed to the downside. How should one assess how much downside there is, and what should investors look for to gauge turnings points in financial markets? Answer: We continuously assess the investment landscape, not only based on our fundamental analysis of the global/EM/China business cycles but also on various financial market valuations, positioning and technicals. Let’s review where we stand with respect to these metrics. Equity Valuations: EM stocks are not cheap. Our favored measure of equity valuations is the composite indicator-based 20% trimmed means of the following multiples: trailing and forward P/E, price-to-cash earnings, price-to-book value and price-to-dividend ratios (Chart I-8). On these metrics, EM stocks appear fairly valued. Nevertheless, these valuations should be viewed in the context of structural decline in EM corporate profitability. The measures of return on equity and assets for non-financial companies in EM are on par with their 2008 lows (Chart I-8, middle and bottom panels). When valuations are neutral, the equity market’s direction is dictated by the profit outlook. The latter currently remains negative for EM and Chinese companies (Chart I-9). Chart I-8EM Equities Are Not Cheap Chart I-9Downside Profit Surprises In EM And China Currency Valuations: The U.S. dollar is only moderately (one standard deviation) expensive, according to the real effective exchange rate based on unit labor costs (Chart I-10). The latter is our most favored currency valuation measure. The greenback has been in a major structural bull market since 2011. Secular bull/bear markets do not typically end before valuations reach 1.5-2 standard deviations. We reckon that the cyclical and structural backdrop remains favorable for the dollar, and odds are it will overshoot before a major top sets in. Going forward, most of the dollar’s additional gains will not occur versus the euro or the Japanese yen – which are already modestly undervalued (Chart I-10, middle and bottom panels) – but against other currencies. In particular, commodity currencies of developed economies have not yet cheapened enough (Chart I-11). Typically, a structural bear market in commodities does not end until these commodity currencies become cheap. Hence, the current valuation profile of these commodity currencies is consistent with the notion that the secular bear markets in commodities prices and EM are not yet over. Chart I-10The Euro Is Fairly Valued, The Yen Is Cheap G3 Currency Valuations Chart I-11Commodities Currencies ##br##Are Not Cheap Yet Unfortunately, there are no data for unit labor cost-based real effective exchange rates for the majority of EMs. However, it is a safe bet to infer that long- and medium-term cycles in EM currencies coincide with those of DM commodity currencies because they are all pro-cyclical. If DM commodity currencies have not yet bottomed, EM currencies remain vulnerable. Relative to the global equity benchmark, global materials have broken down to new cyclical lows. This could be a harbinger of EM relative equity performance making new lows. Ms. Mea: But the positioning in the U.S. dollar is long. How consistent is this with your view of further dollar strength? Positioning: While investors are long the U.S. dollar versus several DM currencies, they are short the greenback versus EM currencies. Chart I-12 illustrates the aggregate net long positions of both leveraged funds and asset managers in the BRL, MXN, RUB and ZAR. As of May 10 (the last datapoint available), investors were as long these EM high-beta currencies as they were at their cyclical peak in early 2018. As to emerging Asian currencies, ongoing RMB depreciation will drag emerging Asian currencies down. Notably, the Korean won has already broken down from its tapering wedge pattern. Concerning EM equities, investor positioning and sentiment was still very elevated before last week’s market turmoil. Chart I-13 demonstrates the number of net long positions in EM ETFs (EEM) by leveraged funds and asset managers. The last datapoint is also as of May 10. Chart I-12Investors Have Been Long EM Currencies Chart I-13Investors Have Been Bullish On EM Stocks In short, investor sentiment on EM was bullish and long positions in EM were extended before the U.S.-China trade confrontation escalated again. Tell-tale signs and technicals: Market profiles can sometimes help us gauge whether an asset class is in a bull or bear market, and what the next move is likely to be. We have the following observations: U.S. dollar volatility is close to its record lows (Chart I-14). Following the previous three low-volatility episodes, EM shares prices in dollar terms dropped substantially over the ensuing 18 months – 60% in 1997-1998, 65% in 2007-2008 and 30% in 2014-2015. The rationale is that very low global currency volatility indicates that investors do not foresee a major tectonic macro shift. When this does inevitably occur, currency markets move violently. The RMB depreciation could be a tectonic macro shift that global markets are not prepared for. The absolute and relative performances of EM stocks resemble that of global materials stocks. Global materials are breaking below their long-term moving averages (technical support lines) in absolute terms, raising the odds that the EM equity index will do the same. Relative to the global equity benchmark, global materials have broken down to new cyclical lows. This could be a harbinger of EM relative equity performance making new lows (Chart I-15). Chart I-14U.S. Dollar Volatility And ##br##EM Equity Returns Chart I-15EM And Global Materials: Relative To Global Index Consistently, industrial metals prices as well as our Risk-on/Safe-Haven Currency Index have potentially formed a head-and-shoulders pattern and may be entering a major down leg (Chart I-16). Further weakness in these variables would be consistent with a risk-off phase in EM financial markets. Finally, the relative performance of the MSCI China All-Share Index – which includes all onshore- and offshore-listed stocks – has relapsed relative to the global equity benchmark, failing to break above its long-term moving average (Chart I-17). This is a negative tell-tale sign, and often warrants considerable downside. Chart I-16A Head-And-Shoulder Pattern In Global Cyclical Markets? Chart I-17China All-Share Index: Absolute And Relative Performance Ms. Mea: It seems to me that the RMB holds the key. What are your thoughts on the Chinese currency? Answer: There are several reasons why the RMB will likely depreciate. First, yuan depreciation is needed to mitigate the impact of U.S. import tariffs on Chinese exporters’ profitability. Authorities could use the RMB depreciation to fight back against U.S. import tariffs – a response that U.S. President Donald Trump will certainly not like. Second, the ongoing cyclical downturn in China and rising deflationary pressures also warrant a cheaper currency. Third, there is a vast overhang of money supply in China: The broad money supply is equivalent to US$30 trillion. More stimulus will only make this oversupply of yuans larger. This, along with the desire of mainland households and businesses to diversify their deposits into foreign currencies/assets, is like “the sword of Damocles” on the yuan’s exchange rate. Finally, the sources of foreign currency that previously offset capital outflows in China are no longer available. The current account surplus has largely evaporated. In addition, the central bank seems to be reluctant to reduce its foreign exchange reserves to fund capital outflows. In fact, at US$3 trillion, its foreign currency reserves are equivalent to only 10% of local currency broad money supply. All in all, we are structurally short the RMB versus the dollar. Chart I-18China, Commodities, & EM: Identical Cycles Ms. Mea: What are the investment implications? Where are we in the EM/China investment cycle? Answer: Our investment themes since early this decade have been that EM share prices and currencies are in a bear market, the U.S. dollar is in a structural bull market, and commodities are in a structural downtrend (Chart I-18). With the exception of 2016-‘17, these themes have played out quite well. These structural moves have not yet been exhausted. At the moment, we do not foresee a 2016-’17-type cyclical rally either. The failure of EM equities to outperform DM stocks and the resilience of the U.S. dollar during the risk-on period since early this year, give us comfort in maintaining a negative stance on EM risk assets. Importantly, a decade-long poor EM performance is likely to end with a bang rather than a whimper, especially when investors by and large remain bullish on EM. On the whole, we recommend trading EM stocks on the short side and underweighting EM equities in a global equity portfolio. Within the EM equity universe, our overweights are Russia, central Europe, Thailand, non-tech Korean stocks, Mexico, Chile, the UAE and Vietnam. Our underweights are Brazil, South Africa, Turkey, Peru, Indonesia, India, and the Philippines. Fixed-income investors should also position for higher volatility and weaker EM currencies, favoring low-beta versus high-beta markets. Russian and Mexican markets are our favored local currency and U.S. dollar bonds. Finally, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, IDR, MYR, PHP and KRW. Our currency overweights are MXN, RUB, SGD and the THB as well as central European currencies. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
While we remain bullish on global equities and other risk assets over 12 months, we went tactically short the S&P 500 last Friday following the market’s complacent reaction to the Trump Administration’s further tariffs increases on Chinese imports. While a moderate trade war would still produce more economic damage than standard economic models imply, this would be greatly mitigated by significant Chinese economic stimulus and a Fed that is in no hurry to raise rates and could even cut rates. Barring any further major developments, we recommend investors start increasing risk exposure if the S&P 500 falls to 2711. A dip in global bourses would also create an opportunity to go overweight EM/European equities. Favor gold over government bonds as a low-cost hedge against trade war risks for now.