Sectors
Highlights Chart 1Making New Lows While the number of daily new COVID-19 cases is falling in China, the virus is spreading rapidly to the rest of the world. It is now clear that the outbreak will not be contained, though much uncertainty remains about the magnitude and duration of the global economic fallout. US bond yields have dropped dramatically, with the 10-year yield threatening to break below 1% for the first time ever (Chart 1). Interest rate markets are also pricing-in a rapid Fed response, with more than 100 bps of rate cuts priced for the next year and a 50 bps rate cut discounted for March. On Friday, BCA released a Special Alert making the case that stock prices have fallen enough to buy the market, even on a tactical (3-month) horizon. It is too early to make a similar call looking for higher bond yields. While risk assets will get near-term support from a dovish monetary policy shift, bond yields will stay low (and could even fall further) until global economic recovery appears likely. On a 12-month horizon, our base case scenario is that the Fed will not have to deliver the 110 bps of cuts that are currently priced. We therefore expect bond yields to be higher one year from now. But investors with shorter time horizons should wait before calling the bottom in yields. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 176 basis points in February, dragging year-to-date excess returns down to -255 bps. Coronavirus fears pushed spreads wider in February, and the average spread for the overall investment grade index moved back above our cyclical target (Chart 2).1 As for specific credit tiers, Baa spreads are 9 bps above target and Aa spreads are 3 bps cheap. A-rated spreads are sitting right on our target, and Aaa debt remains 5 bps expensive. Looking beyond the economic fallout from the coronavirus, accommodative monetary conditions remain the key support for corporate bonds. Notably, both the 2-year/10-year and 3-year/10-year Treasury slopes steepened in February, and both remain firmly above zero. This suggests that the market believes that the Fed will keep policy easy. As we discussed two weeks ago, restrictive Fed policy – as evidenced by an inverted 3-year/10-year Treasury curve and elevated TIPS breakeven inflation rates – is required before banks choke off the supply of credit, causing defaults and a bear market in corporate spreads.2 Bottom Line: Corporate spreads will keep widening until coronavirus fears abate, but COVID-19 will not cause the end of the credit cycle. Once the dust settles, a buying opportunity will emerge in investment grade corporates, with spreads back above our cyclical targets. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 271 basis points in February, dragging year-to-date excess returns down to -379 bps. The junk index spread widened 110 bps on the month and is currently 37 bps below its early-2019 peak. Ex-energy, the average index spread widened 93 bps in February. It is 71 bps below its 2019 peak. High-yield spreads were well above our cyclical targets prior to the COVID-19 outbreak and have only cheapened further during the past month. More spread widening is likely in the near-term, but an exceptional buying opportunity will emerge once virus-related fears fade. This is especially true relative to investment grade corporate bonds. To illustrate the valuation disparity between investment grade and high-yield, we calculated the average monthly spread widening for each credit tier during this cycle’s three major “risk off” phases (2011, 2015 and 2018). We then used each credit tier’s average option-adjusted spread and duration to estimate monthly excess returns for that amount of spread widening (Chart 3, bottom panel). The results show that, in past years, Baa-rated corporates behaved much more defensively than Ba or B-rated bonds. But now, because of the greater spread cushion and lower duration in the junk space, estimated downside risk is similar. In other words, the valuation disparity between investment grade and junk means that investment grade corporates offer much less downside protection than usual compared to high-yield. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 7 basis points in February, dragging year-to-date excess returns down to -60 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, driven by a 7 bps widening of the option-adjusted spread that was partially offset by a 6 bps reduction in expected prepayment losses (aka option cost). The 10-year Treasury yield has made a new all-time low, and the 30-year mortgage rate – at 3.45% – is only 14 bps above its own (Chart 4). At these levels, an increase in mortgage refinancing activity is inevitable, and indeed, the MBA Refi index has bounced sharply in recent weeks. MBS spreads, however, have not yet reacted to the higher refi index (panel 3). The nominal spread on 30-year conventional MBS is only 9 bps above where it started the year, and expected prepayment losses are 5 bps lower.3 Some widening is likely during the next few months, and we recommend that investors reduce exposure to Agency MBS. Even on a 12-month horizon, MBS spreads offer good value relative to investment grade corporate bonds for now (bottom panel), but investment grade corporates will cheapen on a relative basis if the current risk-off environment continues. This is probably a good time to start paring exposure to MBS, with the intention of re-deploying into corporate credit when spreads peak. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 86 basis points in February, dragging year-to-date excess returns down to -99 bps. Sovereign debt underperformed duration-equivalent Treasuries by 270 bps in February, dragging year-to-date excess returns down to -367 bps. Foreign Agencies underperformed the Treasury benchmark by 162 bps on the month, dragging year-to-date excess returns down to -189 bps. Local Authority debt underperformed Treasuries by 14 bps in February, dragging year-to-date excess returns down to +47 bps. Domestic Agency bonds underperformed by 5 bps in February, dragging year-to-date excess returns down to -7 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. We continue to see little value in USD-denominated Sovereign debt, outside of Mexico and Saudi Arabia where spreads look attractive compared to similarly-rated US corporate bonds (Chart 5). The Local Authority and Foreign Agency sectors, however, offer attractive combinations of risk and reward according to our Excess Return Bond Map (see Appendix C). Our Global Asset Allocation service just released a Special Report on emerging market debt that argues for favoring USD-denominated EM sovereign debt over both USD-denominated EM corporate debt and local-currency EM sovereign bonds.4 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 80 basis points in February, dragging year-to-date excess returns down to -114 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 11% on the month to 88%, remaining below its post-crisis mean (Chart 6). For some time we have been advising clients to focus municipal bond exposure at the long-end of the Aaa curve, where yield ratios were above average pre-crisis levels. But last month’s sell-off brought some value back to the front end (panel 2). Specifically, the 2-year, 5-year and 10-year M/T yield ratios are all back above their average pre-crisis levels at 85%, 83% and 86%, respectively. 20-year and 30-year maturities are still cheapest, at yield ratios of 93% and 94%, respectively. Investors should adopt a laddered allocation across the municipal bond curve, as opposed to focusing exposure at the long-end. Fundamentally, state and local government balance sheets remain solid. Our Municipal Health Monitor is in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both trends are consistent with muni ratings upgrades continuing to outpace downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-steepened dramatically in February, with yields down at least 30 bps across the board. The 2/10 Treasury slope steepened 9 bps on the month, reaching 27 bps. The 5/30 slope also steepened 9 bps to reach 76 bps. February’s plunge in yields was massive, but the fact that it occurred without 2/10 or 5/30 flattening signals that the market expects the Fed to respond quickly and that any economic pain will be relatively short lived. In fact, the front-end of the curve is now priced for 110 bps of rate cuts during the next 12 months (Chart 7). That amount of easing would bring the fed funds rate back to 0.48%, less than two 25 basis point increments off the zero lower bound. Though the drop in 12-month rate expectations didn’t move the duration-matched 2/5/10 or 2/5/30 butterfly spreads very much, the 5-year note remains very expensive relative to both the 2/10 and 2/30 barbells (bottom 2 panels). The richness in the 5-year note will reverse if the Fed delivers less than the 110 bps of rate cuts that are currently priced for the next year. At present, we view less than 110 bps of easing as the most likely scenario, and therefore maintain our position long the 2/30 barbell and short the 5-year bullet. TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 159 basis points in February, dragging year-to-date excess returns down to -232 bps. The 10-year TIPS breakeven inflation rate fell 24 bps to 1.42%. The 5-year/5-year forward TIPS breakeven inflation rate fell 21 bps to 1.50%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s inflation target. We have been recommending that investors own TIPS breakeven curve flatteners on the view that inflationary pressures will first show up in the realized inflation data and the short-end of the breakeven curve, before infecting the long-end.5 However, recent risk-off market behavior has caused long-end inflation expectations to fall dramatically, while sticky near-term inflation prints have supported short-dated expectations. Case in point, the 2-year TIPS breakeven inflation rate declined 16 bps in February, compared to a 24 bps drop for the 10-year (Chart 8). Inflation curve flattening could continue in the near-term but will reverse when risk assets recover. As a result, we recommend taking profits on TIPS breakeven curve flatteners and waiting for a period of re-steepening before putting the trade back on. Fundamentally, we note that the 10-year TIPS breakeven inflation rate is 38 bps cheap according to our re-vamped Adaptive Expectations Model (bottom panel).6 Investors should remain overweight TIPS versus nominal Treasuries on a 12-month horizon. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in February, dragging year-to-date excess returns down to +26 bps. The index option-adjusted spread for Aaa-rated ABS widened 7 bps on the month. It currently sits at 33 bps, right on top of its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS ranks among the most defensive US spread products. This explains why the sector has weathered the recent storm so well, and why it is actually up versus Treasuries so far this year. ABS also offer higher expected returns than other low-risk spread sectors such as Domestic Agency bonds and Supranationals. For as long as the current risk-off phase continues, consumer ABS are a more attractive place to hide than Domestic Agencies or Supranationals. However, once risk-on market behavior re-asserts itself, consumer ABS will once again lag other riskier spread products. In the long-run, we also remain concerned about deteriorating consumer credit fundamentals, as evidenced by tightening lending standards for both credit cards and auto loans, and a rising household interest expense ratio (bottom 2 panels). Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 42 basis points in February, dragging year-to-date excess returns down to +1 bp. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 9 bps on the month. It currently sits at 76 bps, below its average pre-crisis level (Chart 10). In a recent Special Report, we explored how low interest rates have boosted commercial real estate (CRE) prices this cycle and concluded that a sharp drawdown in CRE prices is likely only when inflation starts to pick up steam.7 In that report we also mentioned that non-agency Aaa-rated CMBS spreads look attractive relative to US corporate bonds in risk-adjusted terms (Appendix C), and that the macro environment is close to neutral for CMBS spreads. Both CRE lending standards and loan demand were close to unchanged during the past quarter, as per the Fed’s Senior Loan Officer Survey (bottom 2 panels). Agency CMBS: Overweight Agency CMBS performed in line with the duration-equivalent Treasury index in February, leaving year-to-date excess returns unchanged at +35 bps. The index option-adjusted spread widened 2 bps on the month to reach 56 bps. Agency CMBS offer greater expected return than Aaa-rated consumer ABS, while also carrying agency backing (Appendix C). An overweight allocation to this sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 110 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of February 28, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of February 28, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 50 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 50 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of February 28, 2020) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more information on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “The Credit Cycle Is Far From Over”, dated February 18, 2020, available at usbs.bcaresearch.com 3 Expected prepayment losses (or option cost) are calculated as the difference between the index’s zero-volatility spread and its option-adjusted spread. 4 Please see Global Asset Allocation Special Report, “Understanding Emerging Markets Debt”, dated February 27, 2020, available at gaa.bcaresearch.com 5 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 7 Please see US Investment Strategy / US Bond Strategy Special Report, “Commercial Real Estate And US Financial Stability”, dated January 27, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
Yesterday, BCA Research's US Equity Strategy service downgraded the S&P tech sector to underweight. Tech stocks are stretched, trading near two standard deviations above the historical time trend, a level that has marked three previous peaks since…
Highlights Portfolio Strategy It is still early to bottom fish, and trying to catch the proverbial falling knife does not interest us for cyclically oriented capital. Uncertainty surrounding the coronavirus epidemic and its effects on economic and profit growth, and uncertainty with regard to US elections both signal that it still pays to be cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. Lofty valuations, stretched technicals, souring macro and cresting capex, underscore that the time is ripe to take profits in software stocks and move to the sidelines. Faltering operating metrics, stretched relative valuations, a firming greenback, looming fed funds rate cuts and a contracting capex backdrop, all suggest that an underweight stance is now warranted in tech stocks. Recent Changes Book gains of 51% in the S&P software index and downgrade to neutral, today. Downgrade the S&P tech sector to underweight, today. We got stopped out and booked gains of 10% in the Global Gold Mining index. It is now neutral, from previously overweight. Table 1 Feature The SPX convulsed last week, as investors grappled with the risk of the coronavirus epidemic becoming a true pandemic (Chart 1A), and with Bernie Sanders likely clinching the Democratic nomination (Chart 1B). While a technical reflex rebound is in order as indiscriminate selling took center stage and we are looking to deploy short term oriented capital from current SPX levels all the way down to 2714 (or 20% SPX correction from recent peak), the cyclical outlook for the broad equity market remains grim. Chart 1ABlame The Virus…. Chart 1B…And Bernie We have been cautioning investors all year long in our reports, warning that the stock market’s advance has been precarious on a number of fronts and have been recommending investors sell the market’s strength. First, the extreme concentration of returns in a handful of teflon-tech stocks has been disconcerting, heralding an equity market wobble.1 Likely, a mania has taken root in certain tech stocks and the inevitable bursting of the “ATLAS” mania (Apple, Tesla, Lam Research, AMD and Salesforce) would end in tears.2 As an update, as we went to press these five stocks were down 21% from their all-time highs. Second, on January 13 we highlighted that gold has been trumping the SPX and sniffing out two-to-three fed funds rate cuts, leading the fed fund futures market, similar to last spring (top & middle panels, Chart 2).3 Third, we highlighted that the recent positive correlation between the VIX and the SPX was disquieting and signaling that a pullback was nearing.4 Now the jump in the VIX along with the vol curve inversion and the collapse in the stock-to-bond ratio all warn that the path of least resistance for the market and the forward multiple remains lower (Chart 3). Chart 2Gold Sniffed Out Fed Cuts First Chart 3Financial Conditions Are … This has already tightened financial conditions according to the soaring junk spread (top panel, Chart 4), and we deem that unless the Fed relents and eases monetary policy, the stock market will remain in melt down mode. Fourth, market internals have been screaming “get out” of the broad equity market for some time now (bottom panel, Chart 4) and the epitome was when semi stocks stalled versus the NASDAQ 100 (middle panel, Chart 4).5 Fifth, the “tenuous trio” as we have coined it (stock prices, bond prices and the US dollar) cannot all rise simultaneously. Typically we cautioned, this gets resolved with an equity market pullback as a rising greenback is deflationary for US profits (bottom panel, Chart 2). Finally, in our “Sell The Rip” report, we worried about extreme investor complacency and showed that the economic backdrop was soft owing to the collapse in imports in Q4 2019, predating the coronavirus epidemic.6 Tying everything together, ultimately what matters most to equity investors is profit growth. On that front we have heavily relied on the message of our four-factor EPS growth model, which has consistently delivered. Chart 4…Tightening Rapidly In mid-January, our SPX profit growth model continued to have no pulse, warning that the Street’s 10% profit growth estimate for calendar 2020 was unattainable. Our analysis of three EPS scenarios showed that at the time the SPX was overvalued by 8% according to the SPX 3,049 expected value for end-2020 that was actually hit last week.7 Recently, we have been inundated with client requests to update our analysis and incorporate the coronavirus epidemic to our adverse EPS scenario. Chart 5 shows that in our worst case scenario, EPS will contract by 2.41% in calendar 2020. Assuming final 2019 EPS comes in at 162.95, using I/B/E/S’ latest estimate, then the 2020 EPS level falls to 159.02. Assigning a trough multiple of 16x results in a 2,544 SPX ending value as a worst case outcome. Chart 5Our EPS Model Has Delivered Importantly, our newly weighted expected 2020 EPS falls to 164.48 versus 169.40 previously as we penciled in a 60% and 50% probability that our worst case scenario materializes in EPS and multiple assumptions, respectively (Chart 6). As a result our expected end-2020 SPX value falls to 2,755 which makes the S&P 500 still 4% overvalued (please find the assumptions on the four factor model along with the updated table of expected outcomes in the Appendix below). While no one really knows how this virus outbreak will evolve, there are two predominant market narratives that can serve as positive catalysts: a.) China will massively ease both on the monetary and fiscal policy fronts (Chart 7) and b.) the Fed (and likely other CBs) will be forced to cut interest rates despite the fact that lower fed funds rates will likely not fix the supply side global problems owing to the corona virus. In other words, liquidity injections will remain upbeat. However, if these measures – especially on the Fed’s side – prove ineffective to generate GDP growth, then the risk of a recession will skyrocket for 2020, a presidential election year. Chart 6Updated Three EPS Scenarios Chart 7How Much Will China Stimulate? As a reminder, parts of the US yield curve (YC) first inverted in December 2018 and currently the 2-year/fed funds rate slope is inverted, implying that the bond market deems the Fed will ease monetary policy. In fact, the latest CME probability of a 50bps cut on March 18 last stood at 100%. Importantly, the YC inversions did not predict the oil embargoes of the 70s, or the 9/11 attacks or the sub-prime crisis or the coronavirus outbreak. Typically, the YC inverts at the point of maximum economic strength and signals that the cycle is long in the tooth, i.e. in the current episode, 2018 registered roughly 3% real GDP growth and 25% SPX EPS growth. Put differently, the YC inversion suggests that the economy is, at the margin, vulnerable to an external shock as economic growth settles down to a lower rate trajectory. While the YC inversion does not predict recession, it forewarns recession and we continue to heed this message (Chart 8). It will not be different this time. In sum, it is still early to bottom fish, and trying to catch the proverbial falling knife does not interest us for cyclically oriented capital. Uncertainty surrounding the coronavirus epidemic and its effects on economic and profit growth, and uncertainty with regard to US elections both signal that it still pays to be cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. This week we are making some tech sector adjustments. Chart 8The Yield Curve is ALWAYS Right! Crystalize Software Gains And Downgrade To Neutral… Market events last week compel us to take profits of 51% in the S&P software index above and beyond the S&P 500’s return since the late-2017 inception and downgrade exposure to neutral. The multiyear juggernaut in software stocks is primed for a much needed pause. Its appeal is well known as within the tech space software is considered a defensive holding owing to the productivity enhancing properties it enjoys in both good and bad times. Anecdotally, it was disquieting that the Standard & Poor’s decided to add two additional cloud stocks to the S&P 500 recently, further boosting the software group’s weight in the tech sector and in the SPX. Likely, the reason was the flurry of M&A deals that has been ongoing for years. Most recently however, this M&A frenzy hit a wall (top panel, Chart 9). Meanwhile, last Monday we wrote that AAPL’s profit warning was the tip of the iceberg and an avalanche of warnings would ensue.8 MSFT followed suit and issued their own profit warning and this negative backdrop is not yet reflected in the sell side’s S&P software profit and revenue forecasts. Tack on the message from the contracting software sector deflator and odds are high that sales will underwhelm in the coming quarters (middle panel, Chart 9). The latest GDP report also revealed that, up to recently bulletproof, software capex growth sunk to nil in Q4 (bottom panel, Chart 9). Not only in absolute, but also in relative terms software outlays have petered out and have been decreasing in intensity as measured by the decelerating contribution to GDP growth (Chart 10). Chart 9Softening… Chart 10…Software Capex Beyond investment, the recent plunge in the Markit services PMI that really ignited the recent selling in equities, warns that the time is ripe to cement software gains and move to the sidelines (Chart 11). Moreover, there is a high chance that IPOs peaked last year and will dry up in 2020, which is slightly negative for overall market sentiment in general and for market darlings software stocks in particular (Chart 11). From a technical perspective, software equities went ballistic. Relative momentum surged north of 25%/annum, a nineteen-year high (middle panel, Chart 12). Similarly, relative valuations went parabolic. The S&P software index trades at a 60% premium to the broad market on a forward P/E basis (bottom panel, Chart 12). Such overvaluation was last seen in 2003. Chart 11Do Not Overstay… Chart 12…Your Welcome Finally, we refrain from getting bearish this heavyweight tech subindex. Our long-held belief is that SaaS, the broader push to the cloud, augmented reality, AI and autonomous driving, which are all software dependent, are not fads, but are here to stay. Netting it all out, we do not want to overstay our welcome in the S&P software index and are cementing gains and moving to the sidelines, for now. Bottom Line: Take profits of 51% since inception in the S&P software index and downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK. …Which Pushes Tech To Underweight Our intra-sector positioning shifts with the recent S&P tech hardware storage & peripherals downgrade to underweight9 and today’s trimming of the S&P software index to neutral, reduce the S&P tech sector to a below benchmark allocation. Tech stocks are stretched, trading near two standard deviations above the historical time trend, a level that has marked three previous peaks since 1960 (top panel, Chart 13). From a macro perspective, when the Fed cuts rates as the end of the cycle is nearing it has been a treacherous time to own tech stocks. If we are entering a recession owing to the coronavirus epidemic, underweighting tech stocks is the right portfolio strategy to generate alpha (Chart 13). Chart 13End Of Cycle Dynamics Business investment in tech has been losing market share for the better part of the last year and according to the national accounts tech capex is contracting. Excluding the software industry, capital outlays are in dire straits (top & second panels, Chart 14). Meanwhile, lofty valuations, with the tech forward P/E trading at a 20% premium to the overall market, signal that there is no cushion for this deep cyclical sector that has 60% of sales originating abroad, the largest among its GICS1 peers (third panel, Chart 14). While the Fed will likely cut interest rates soon, the stampede in the US dollar, the reserve currency of the world, is unwelcome news for the heavily export-dependent US technology sector (trade-weighted US dollar shown inverted, middle panel, Chart 15). Chart 14Red Flag: Crumbling Tech Capex Chart 15Large Foreign Sales Exposure Is Problematic Turning over to tech-heavy Korean and Taiwanese exports, they peaked in 2017, and the coronavirus epidemic guarantees that they will suffer a steep decline in the coming months, dealing a blow to the tech sector’s top line growth prospects (bottom panel, Chart 15). If supply chain breakdowns increase over the course of the next few weeks as the coronavirus related shut downs accelerate, then more tech profit warnings are looming and the resulting hit to still ultra-wide relative profit margins and EPS will likely be severe (bottom panel, Chart 14). In more detail on the operating front, the coincident San Francisco Fed Tech Pulse Index is sinking like a stone and this weakness predates the coronavirus epidemic. The implication is that highly inflated relative share prices are vulnerable to a sizable pullback (second panel, Chart 16). Worrisomely, the industry’s new orders-to-inventories ratio is contracting at the fastest pace in eight years and bodes ill for still accelerating relative forward profit growth estimates (bottom panel, Chart 16). Finally, given the severity of recent market moves, when investors typically get margin calls they tend to sell their high flying stocks that currently are mostly concentrated in the tech space. Tack on the proliferation of passive investment, and as everyone is headed for the exit doors simultaneously, tech stocks that dominate hundreds of popular and large capitalization exchange traded funds are at risk of liquidation. Adding it all up, faltering operating metrics, stretched relative valuations, a firming greenback, looming fed funds rate cuts and a contracting capex backdrop, all signal that an underweight stance is now warranted in tech stocks. Bottom Line: Trim the S&P tech sector to underweight, today. Chart 16Weakening Operating Metrics Housekeeping Our long GDX:US / short ACWI:US portfolio position got stopped out at a 10% gain. The global gold mining index is now back to neutral, from previously overweight. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Appendix Table A1 Table A2 Table A3 Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Weekly Report, “When The Music Stops…” dated January 27, 2020, available at uses.bcaresearch.com 3 Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 4 Please see BCA US Equity Strategy Weekly Report, “Will The Fed Save The Day, Again?” dated February 18, 2020, available at uses.bcaresearch.com. 5 Please see BCA US Equity Strategy Weekly Report, “Crosscurrents” dated February 3, 2020, available at uses.bcaresearch.com. 6 Please see BCA US Equity Strategy Weekly Report, “Sell The Rip” dated February 10, 2020, available at uses.bcaresearch.com. 7 Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available at uses.bcaresearch.com. 8 Please see BCA US Equity Strategy Weekly Report, “Vertigo” dated February 24, 2020, available at uses.bcaresearch.com. 9 Please see BCA US Equity Strategy Weekly Report, “Crosscurrents” dated February 3, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Highlights Supply constraints and unstoppable demand growth – the result of stricter regulations requiring higher loadings in autocatalysts to treat toxic pollution in automobile-engine emissions – will continue to push palladium’s price higher, despite a near-vertical move higher that began in 2H19. South Africa’s power grid is in a state of near-collapse, which will add volatility to mining operations focused on platinum-group metals – chiefly palladium, platinum and rhodium. South Africa accounts for 36% of global palladium production and 73% of platinum production, which makes it difficult to make the case that platinum could be substituted for palladium as its price rises. Palladium stocks are at risk of being further depleted globally as demand from automobile manufacturers in China, the US and Europe remains robust. This will keep palladium forward curves backwardated for the foreseeable future. While pressure to find alternatives for palladium will grow as prices rise, in absolute terms the additional cost resulting from higher prices for the metal – ~ $400 per vehicle – is not yet enough to draw significant investment to this effort. Feature Palladium markets are fundamentally tight and unresponsive to macroeconomic uncertainty. Table 1Top 5 Best Performing Commodities In 2019, for the third year in a row, palladium prices outperformed other major commodities, returning an impressive 54% over the year (Table 1). This is the result of a massive 13% increase in demand for the metal – powered by strong autocatalyst demand for gasoline-powered cars in China and Europe, even as collapsing auto production globally and elevated trade uncertainty continue to dog automobile sales (Chart 1). This apparent contradiction is explained by stricter vehicle emissions regulations in major consuming markets – chiefly the Euro 6d, China 6 and US Tier 3 regimes – and power shortages in South Africa, which are introducing considerable volatility on the supply side in the second-largest producing country for the metal. Chart of the WeekSurging Autocatalyst Palladium Demand Again this year, palladium markets are fundamentally tight and unresponsive to macroeconomic uncertainty. Palladium prices soared 39% YTD, its fastest 40-day increase since 2010. Unlike other commodity markets, palladium is completely disregarding the COVID-19 outbreak that originated in China late last year. Favorable supply-side fundamentals continue to drive the palladium rally: The metal’s decade-long physical supply deficit intensified in 2019 and we expect it to widen this year (Chart 2, panel 1). On the demand side, Chinese consumption is at risk. China is the world’s largest auto manufacturing market. Hubei Province – COVID-19’s epicenter – is a large car manufacturing hub, accounting for ~ 10% of the country’s annual automobile output. In the wake of COVID-19, the country’s car production is expected to fall 10% in 1Q20. In addition, the virus had infected more than 80,000 people globally, and has spread rapidly outside Hubei into Asia, Europe, the Middle East, Africa, and North America, raising the odds of a pandemic. Interestingly, speculative positioning and ETF investment demand is subdued, and is not inflating prices (Chart 2, panel 2). Chart 2Palladium Deficit To Widen This Year Palladium Demand Soars As Auto Production Collapses Strong global automobile catalyst demand drove the rally in palladium prices last year. This occurred as car production fell by 9%, 8%, and 15% in US, China, and India – an unusual divergence in fundamentals. The culprit: Technical changes to autocatalysts from stricter emissions regulations. In China, the latest phase of car emissions regulations – China 6 – was gradually introduced in high-population centers, which also suffer from high levels of pollution. These centers accounted for ~ 60% of annual Chinese car sales in 2019. China 6 represents a major shift in emissions regulations and will make the Chinese auto fleet compliant with Europe’s best practices. As a result, palladium loadings in conforming light-duty gasoline vehicles reportedly increased by ~20% in 2019. This pushed China’s autocatalyst consumption up by 570k oz despite the drop in annual car sales, which created the rare dislocation between the country’s car production and palladium prices (Chart 3). We expect this trend to continue this year: China 6 is on track to be enforced countrywide – i.e., the remaining 40% of car sales – by mid-year, providing an additional ~ 10% boost in loadings of the metal. Chart 3Stricter Regulations Support Prices Amid Falling Car Production In Europe, the introduction of Euro 6c legislation in September 2018 and the extension to all new vehicles of Euro 6d-TEMP regulations in September 2019 – mainly the real driving emissions (RDE) testing procedure adopted in the wake of the Volkswagen “dieselgate” scandal in 2015 – pushed palladium loading in autocatalysts up by ~ 25% from 2017 to 2019.1 The regulations became stricter in January 2020, putting additional stress on manufacturers to comply with the new standards, which will continue to support higher palladium loadings. We expect the COVID-19 outbreak to delay the recovery in global gasoline-powered vehicle production and consumption to 2H20. Lastly, in the US – which remains an important market for autocatalyst palladium demand (Chart 4) – the ongoing implementation of the Tier 3 legislation will continue to gradually increase palladium content in autocatalysts until 2025. For 2020, we do not expect this to significantly boost loadings per vehicle and are factoring in 2% growth. These legislative changes in major automotive markets produced a structural break in our palladium demand model (Chart 5). After adjusting our estimates for greater palladium content in gasoline aftertreatment systems, our model suggests that demand provides strong support to palladium prices, but also suggests other factors – i.e. supply and inventory – are at play. Chart 4North America's Auto Sector Remains A Large Share Of Palladium Demand Chart 5Higher Palladium Loadings Largely Explains Last Year's Price Surge In the US and Europe, consumers can absorb higher vehicle sales despite being close to saturated in terms of vehicle ownership. We expect the COVID-19 outbreak to delay the recovery in global gasoline-powered vehicle production and consumption to 2H20. In China, we expect the government will overstimulate its economy to meet its long-term goal of doubling its GDP and per capita income by 2020.2 Automobile ownership and vehicle sales there are low vs. DM economies, suggesting more upside for sales in China (Chart 6). In the US and Europe, consumers can absorb higher vehicle sales despite being close to saturated in terms of vehicle ownership. Car sales move in cycles around long-term demographic trends: The longer the current economic expansion, the further above-trend car sales can rise (Chart 7). Chart 6China: Structural Outlook For Autos Is Bright China Car Consumption Will Rebound In 2H20... Chart 7... Likewise For Europe And US Bottom Line: The combination of stricter environmental regulations in key gasoline-powered automobile markets and the post-coronavirus rebound in global auto consumption will push the palladium market further in deficit this year as it faces an inelastic supply, critically low inventories and low substitutability over the short-term (more on this below). Palladium Supply In 2020: Weak growth And Low Price-Elasticity Palladium supply is highly constrained. The largest supplies are concentrated in Russia (42%), South Africa (36%) and North America (14%). From 2015 to 2019, supply and capex grew by a very subdued 7% and 15.2% respectively, completely disregarding the 200% rise in prices (Chart 8, panel 1). This illustrates palladium supply’s extremely low price-elasticity.3 Palladium supply growth will remain muted for the foreseeable future, as Eskom begins long-delayed maintenance to refurbish its derelict generation fleet. Primary supplies declined by close to 2% last year on falling shipments from Russia and record electricity load-shedding – i.e. blackouts – in South Africa (Chart 8, panel 2).4 As tight as palladium markets are fundamentally, South Africa’s crippled power grid – long in need of upgrading and repair – has been, and remains, a key driver of short-term platinum-group metals (PGM) prices.5 Following the breakdown of close to 25% of the country’s generating capacity, Eskom – the nation’s utility monopoly responsible for ~ 90% of its electricity generation – has been forced to implement rolling blackouts to balance power supply and demand and prevent permanent damage to the country’s power grid. Palladium supply growth will remain muted for the foreseeable future, as Eskom begins long-delayed maintenance to refurbish its derelict generation fleet. Consequently, Stage 6 load-shedding events likely will become more frequent. These efforts are complicated by massive debt – ~ $30 billion – which has required government bailouts and forced the company to take loans from a Chinese industrial bank. Chart 8Top Palladium Producers' Capex Price-Elasticity Is Low This is playing havoc with PGM supplies. During the unmatched Stage 6 load-shedding in December 2019 – cutting power to 37% of grid users – PGM supplies were reduced by 50%. Stockpiles covered the loss, but persistent blackouts lasting years could push markets into an actual shortage of palladium as inventories would rapidly be depleted. This is a significant risk: Eskom itself warned rolling blackouts will persist for the next 18 months.6 Elevated local currency PGM prices are postponing announced shafts closures, as miners seek to profit from the favorable pricing environment (Chart 9). But insufficient electricity capacity will weigh on mine supply growth over the next few years as companies hold-back on much-needed long-term investments. The final units of Eskom’s Medupi and Kusile projects are expected to be completed over the next two years – adding 4800MW to its installed capacity. This can partially alleviate South Africa’s electricity difficulties, but these units are not enough to support a rebound in economic and mine production growth. South Africa is in profound need of large-scale investments in its power sector. Close to 5000MW of power capacity is scheduled to shut down over the next five years (Chart 10). Chart 9Favorable Domestic Metal Prices For South African Miners Chart 10South Africa Needs Additional Power Generation Capacity After years of pressure from mining companies, South Africa’s minister of Mineral Resources and Energy announced it would allow companies to generate unlimited electricity for their own activities. The current political and economic climate is not constructive for meeting this challenge. The World Bank recently slashed South Africa’s 2020 GDP growth forecast to 0.9% from 1.5% previously on the back of electricity and infrastructure constraints impeding domestic growth and weak external demand. Likewise, rating agency Moody's signaled – ahead of its review of South Africa’s Baa3 credit rating in March – it could downgrade the country to speculative grade, citing the detrimental impact of recurring power outages on manufacturing and mining output. After years of pressure from mining companies, South Africa’s minister of Mineral Resources and Energy announced it would allow companies to generate unlimited electricity for their own activities. This will provide much-needed help to the country’s power sector. According to the Minerals Council South Africa, mining companies could bring an additional ~ 1500MW capacity online in the next 9 to 36 months. But doubts remain with regard to the timeline for companies to obtain the necessary licenses and if these can easily be acquired. Johnson Matthey expects supply growth in Russia – the largest producer – will be capped this year as Nornickel’s processing of old mines' copper concentrate – which boosted the company’s palladium supply over the past few years – is finalized. Still, a paltry 1% gain is possible from expected efficiency gains at existing mines, according to Nornickel. The company also announced it will increase production at its Talnakh and South Cluster mines, but this additional supply will only reach markets gradually as processing capacity constraints won’t be resolved until 2023, according to Johnson Matthey. Bottom Line: Growth prospects in the top two palladium-producing countries are weak in 2020. This will not suffice to meet the soaring autocatalyst demand. Higher recycling and inventory releases – both incentivized by higher prices – will be needed to balance the market. Palladium Stockpiles Are Dangerously Low We expect palladium prices will move higher on the expanding deficit, and backwardation in the forward curve will persist to incentivize the release of inventories to market (Chart 11). Yet, global palladium stockpiles have been declining since 2014 and are now at critically low levels, raising the risk of a disrupting shortage of the metal:7 ETF and exchange inventories now stand at a paltry 600k oz (Chart 12). These are the most price-elastic stocks and will get close to zero as prices increase. Chart 10Expect Backwardation To Persist Chart 12Price-Sensitive Stockpiles Are Dangerously Low Exhaustion of inventory would spike prices until demand destruction or additional supply – both inelastic in the short-run – are able to balance the market. The Russian Ministry of Finance’s reserves – a state secret – are now almost exhausted, according to Russia’s Norilsk Nickel, the largest supplier of physical palladium in the world. Last year, Norilsk Nickel held an estimated 1mm oz of the metal in its Global Palladium Fund, and signaled it is increasingly using its reserves to balance markets and provide needed liquidity. Earlier this year, the company released 3 MT of palladium to the market from stocks. Complete exhaustion of inventory would spike prices until demand destruction or additional supply – both inelastic in the short-run – are able to balance the market. Don’t Count On Substitution, Yet Switching to platinum requires significant capital- and resource-intensive R&D and appears to be beyond the current capabilities of automakers. We expect platinum prices to rise in 2020 supported by improving fundamentals, growing safe-haven demand, and markets pricing in increasing anticipation of substitution from palladium to platinum. Unlike palladium, platinum is also affected by safe-haven demand and gets bid up with gold and silver prices in periods of high uncertainty (Chart 13). With gold prices now above $1,600/oz, platinum will benefit from safe-haven flows due to its relative price advantage (Chart 14). Chart 13Safe-Haven Flows Support Platinum Prices Chart 14Platinum Is Cheap Relative To Gold We believe substitution will commence over the coming years, but this is a gradual process. Substitution from expensive palladium to low-priced platinum in industrial applications is the largest risk to our positive view on the palladium-to-platinum (Pd-to-Pt) ratio (Chart 15). This started in smaller and more price-elastic segments (e.g. dental, jewelry and diesel autocatalyst). However, to have a real impact on overall demand and thus the price ratio, substitution needs to take place in gasoline autocatalyst technology. The discount has been at a level consistent with substitution for more than a year, but the urgency to upgrade current designs to meet new environmental legislation and RDE regulations in China, Europe, and the US is the main focus of automakers this year. Switching to platinum requires significant capital- and resource-intensive R&D and appears to be beyond the current capabilities of automakers scrambling to meet the latest anti-pollution regulations globally. Moreover, large-scale substitution will take place only if automakers’ cost-benefit analysis points to significant long-term profits from switching. That said, platinum’s supply security remains a risk in the long-term: South Africa accounts for 73% of global production and our analysis suggests output growth there likely will remain weak over the next few years, especially as Eskom rebuilds its failing power grid. This lack of diversity increases sourcing risks for automakers, who, not without reason, would not want to switch over to platinum only to find that supply is also in doubt down the road. The overall platinum market is 26% smaller than that of palladium. Assuming a one-for-one substitution of Pd to Pt in gasoline catalyzers, a 1.2mm oz reduction in Pd demand – the amount required to reduce palladium’s deficit to zero – would send platinum markets to a 1.4mm oz deficit.8 Without substantial production growth, platinum prices would spike, reducing the profitability of investing in these new catalysts. Thus, substitution will eventually impact the price ratio, but will not be large enough to overturn absolute price level trends. In addition, the amount of PGMs in the typical autocatalyst – ~ 5 grams – adds $400 to the cost of the average automobile (Chart 15, lower panel). We do not believe this cost drives automakers' decisions, which is another reason the substitution of Pt for Pd likely will remain a topic of discussion more than action. Chart 15Palladium's Price Surge Adds ~0 Per Gasoline Car Bottom Line: We believe substitution will commence over the coming years, but this is a gradual process and it will not happen on a meaningful scale this year. Thus, we expect the continuation of relative demand and inventory trends will provide a favorable setting for the Pd-to-Pt ratio this year (Chart 16). Chart 16Pd-to-Pt Price Ratio Will Increase Again in 2020 Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Commodities Round-Up Energy: Overweight Brent and WTI crude oil lost 5% and 4% this week, as fears of a global pandemic in the wake of the COVID-19 outbreak gripped markets. Reports of outbreaks in Asia ex-China, the Middle East and Europe fueled these concerns. Against this backdrop, OPEC 2.0 will be meeting in Vienna March 5 and 6 to consider cuts of 600k b/d recommended by its technical committee earlier this month. We continue to expect the full coalition to approve these cuts at the upcoming meetings. Saudi Arabia, Kuwait and the United Arab Emirates reportedly are considering an additional 300k b/d of cuts to offset the global demand hit delivered by COVID-19. The IEA estimates the COVID-19 outbreak will reduce Chinese refining throughput by 1.1mm b/d, and will reduce the call on OPEC crude by 1.7mm b/d in 1Q20. Base Metals: Neutral Iron ore prices weakened, following global equities lower, as the COVID-19 outbreak spread around the world. However, traders continue to report lower stocks of iron ore, which should keep prices supported, according to MB Fastmarkets (Chart 17). We remain long December 2020 high-grade iron ore (65% Fe) vs. short the benchmark 62% Fe contract on the Singapore Commodity Exchange, which we initiated November 7, 2019. This recommendation was up 5.3% as of Tuesday’s close, when we mark to market. Precious Metals: Neutral After retreating slightly from its run toward $1,700/oz earlier this week, gold remains well supported by safe-haven demand (Chart 18). In addition, actual and expected policy stimulus – e.g., Hong Kong's “helicopter money” drop of USD 1,200 to all permanent residents over the age of 18 – and expectations of additional central bank easing globally to offset the global spread of COVID0-19 will keep gold and precious metals generally supported. Markets should start pricing in higher inflation expectations as additional stimulus starts to roll in. Ags/Softs: Underweight Global grain markets could be set to rally sharply, as unusually wet weather in the Middle East and East Africa spawned by higher-than-usual cyclone activity produces perfect breeding conditions for desert locusts in the region over the next two months. According to National Geographic, by June the locusts could increase their populations “400-fold compared with today, triggering widespread devastation to crops and pastures in a region that’s already extremely vulnerable to famine.” This could put more than 13mm people in East Africa at risk of “severe acute food insecurity,” and imperil millions more. Chart 17China's Iron Ore Stocks Tight Chart 18Safe Havens Gold, USD Well Bid Footnotes 1 Please see New legislation planned in response to dieselgate, published by Autocar June 9, 2016. See also Johnson Matthey’s February 2020 Pgm Market Report. 2 Our view of strong Chinese fiscal and monetary stimulus was discussed in detail in our February 13, 2020 weekly report titled Iron Ore, Steel Poised For Rally. 3 Historically produced as an inferior byproduct from nickel, gold, and platinum mines, the price incentive from palladium alone isn’t enough to generate the needed investments in new mine production. According to Nornickel, this is slowly changing, palladium is an increasingly large part of mining companies’ revenues, making the metal a valuable co-product. This could improve mines investments’ responsiveness to movement in palladium prices over the medium term. 4 According to Eskom, “Load shedding is aimed at removing load from the power system when there is an imbalance between the electricity available and the demand for electricity. If we did not shed load, then the whole national power system would switch off and no one would have electricity.” The company’s load-shedding program includes 8 stages, where each stage represents the removal of 1000MW of demand – e.g., stage 5 removes 5000MW. This is done by shutting down specific sections of the grid. 5 The PGMs are ruthenium, rhodium, palladium, osmium, iridium, and platinum. 6 Things got worse after the December load-shedding event. Less than a month later, Reuters noted more than two times the power shed in December went “offline because of plant breakdowns. 7 This can be seen in the close to 12mm oz. decline in UK and Switzerland – home of the largest secured vaults of Palladium and Platinum – net imports. 8 Technological improvement in palladium catalysts has made the metal more efficient in for gasoline-powered engines vs. platinum. It has superior properties in terms of thermal durability and NOx reduction. Thus, the conversion could be greater than 1-to-1 and would imply a smaller share of palladium autocatalyst substitution could be absorbed by existing platinum supplies. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades
The malaise in global bourses intensified as the coronavirus epidemic is spreading like wildfire. The chart shows that the SPX and Google Trends searches worldwide for the word “coronavirus” are 100% inversely correlated. The longer the uncertainty around the coronavirus and its definitive effects on economic growth primarily and SPX EPS growth secondarily, the longer equity investors will remain nervous. Granted, at some point short-term selling will get exhausted and equities will have a reflex rebound. The big questions will be, do investors fade the knee jerk reaction rally or do they buy the dip? We would side with the former and please look forward to our upcoming Monday Weekly Report for additional details and further analysis as to why we remain cautious on a 9-12 month time horizon. Bottom Line: Stay cautious on the prospects of the broad equity market.
In this week’s report, we highlighted that from a technical perspective the SPX remained vulnerable. Specifically, its deviation from the 200-day moving average reached levels similar to the early-2018 blow-off top level (second panel). Similarly, drilling beneath the surface we noted that the percentage of S&P 500 groups trading above their 50-day and 200-day moving averages in absolute terms was also running high (third panel). At the same time, investor complacency reigned supreme. The coronavirus scare lasted a few days and despite AAPL’s recent warning, which is likely the tip of the iceberg as other companies are slated to issue Q1 profit warnings, investors were ignoring all the bad news and piling into equities in general and teflon-tech stocks in particular. As a reminder, the late-2019 peak in profit growth expectations came prior to the coronavirus outbreak (bottom panel). Bottom Line: We remain cautious on the prospects of the broad equity market.
Highlights Portfolio Strategy Boeing’s 737 MAX grounding, China’s looming slowdown on the back of the coronavirus epidemic and weak industry operating metrics, all warrant a downgrade alert in the US aerospace index. Red hot demand for defense capital goods, defense industrial production that is firing on all cylinders, enticing industry operating metrics and pristine balance sheets, all suggest that it still pays to be long the pureplay defense index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities remained untethered last week, and floated skyward to fresh all-time highs. The second panel of Chart 1 shows that from a technical perspective the SPX has returned close to the early-2018 blow-off top level, when the deviation from its 200-day moving average reached a zenith. Similarly, drilling beneath the surface the percentage of S&P 500 groups trading above their 50-day and 200-day moving averages in absolute terms is also running high (third panel, Chart 1). Investor complacency reigns supreme. The coronavirus scare lasted a few days and despite AAPL’s recent warning, which is likely the tip of the iceberg and other companies are slated to issue Q1 profit warnings, investors are ignoring all the bad news and piling into equities in general and teflon-tech stocks in particular. Keep in mind that 12-month forward profit growth remains positively correlated with the 10-year US treasury yield. The former crested in early 2020, predating the coronavirus epidemic (bottom panel, Chart 1). The end result is a new multiple expansion phase with the S&P 500 forward P/E clearing the 19 handle. Chart 1Dizzying Heights Such complacency transcends the equity market and spills over to the junk bond market. The hunt for yield remains intact and the Barclays US total return high yield index is following up the path of the SPX. Momentum is also tracking closely the broad equity market (top & middle panels, Chart 2). Nevertheless, we remain cautious. Last week we highlighted that the “tenuous trio” cannot go up indefinitely and a simultaneous rise in all three asset classes (stock prices, bond prices and the US dollar) typically portends an equity market crack.1 The big risk is that a surging greenback will short-circuit EPS growth and our worst case EPS scenario of -1% profit growth in calendar 2020 as we highlighted in mid-January will materialize.2 Worrisomely, while the S&P 500 made fresh all-time highs last week, the DXY came close to breaking above par, the VIX stayed stubbornly glued near 15 and gold bullion eclipsed $1,600/oz (third & bottom panels, Chart 2). Something has got to give. Meanwhile, Chart 3 updates our Corporate Pricing Power Indicator (CPPI) that recently came out of the deflation zone. This tick up in the CPPI coupled with still softening wage inflation have pushed our S&P 500 profit margin proxy slightly higher but still below the zero line, signaling that the margin contraction phase will likely run its course this year (bottom panel, Chart 3). Chart 2Spiking Greenback And Bullion Signal Trouble Chart 3Modest Profit Margin Improvement Drilling beneath the surface, our CPPI remains soft and vulnerable to a deflationary shock if the coronavirus epidemic severely wounds the global economy. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power A bit less than half of the industries we cover are lifting selling prices by more than 1%, and 35% are outright deflating. Worrisomely, 60% of the sectors we cover fail to raise prices at a faster clip than overall inflation. With regard to pricing power trends, roughly half of the industries we cover are either flat or in a downtrend (Table 2). Gold bullion remains on top of our table climbing at a 22%/annum rate despite the greenbacks recent rise, and only five additional commodity-related industries made it to the top thirty (Table 2). Most of the commodity complex is deflating courtesy of the appreciating US dollar, and the recent coronavirus epidemic will definitely sustain the downward pressure on commodity inflation as demand will likely suffer a major setback. Importantly, defensive sectors still occupy half of the top ten spots, similar to our last update in October 2019. On the flip side, four of the bottom eight industries are commodity related, a trend we expect to pick up steam in the coming quarters. This week we update our views on the two industrials sub-groups that are moving in opposite directions. Put The Aerospace Index On Downgrade Watch We are compelled to put the pureplay aerospace subgroup (currently rated neutral) on downgrade alert. A little over four years ago, we split the aerospace & defense coverage into pureplay aerospace and pureplay defense, as the profit drivers of these two industries started to steeply diverge. True, the yet to be completed UTX acquisition of RTN will re-complicate matters, but we will continue to cover these two groups independently. From a technical perspective, a head and shoulders pattern has likely formed, warning that the next leg down will be a rather painful one, especially if support at current levels gives way (top panel, Chart 4). Boeing (BA) dominates the pureplay aerospace subgroup and sustained delays to recertify the 737 MAX have weighed heavily on share prices. While the FAA and other country air safety regulators may give the green light for flights to resume for Boeing’s workhorse commercial jetliner, consumers may be reluctant to board this plane given all the negative publicity. This remains a big risk to BA and thus to the aerospace index. Chart 4Prior To Coronavirus Epidemic… On the macro front, prior to the coronavirus epidemic, the global PMI was on the path to recovery with a plethora of countries climbing above the boom/bust line (middle & bottom panels, Chart 4). In China specifically, Bloomberg’s story count of China slowdown has returned to the historical lower band of this time series, at a time when BCA’s Chinese credit & fiscal easing impulses were ticking higher (second & third panels, Chart 5). Tack on the ongoing Chinese monetary easing, and factors were falling into place for a robust recovery in demand for US aerospace products (bottom panel, Chart 5). Chart 6 shows why China is so important to this industry. Not only is future commercial aircraft demand growth centered round China, but also China at the recent peak accounted for 15% of total US aerospace exports. In fact, aerospace exports to China tripled since the GFC. Chart 5…Macro Data Were Firming Chart 6China Matters Most To Aerospace Unfortunately, the coronavirus epidemic changes all the China-related calculus and will further dampen demand for aerospace products, at least in the near-term. Granted, US aerospace sales are already nosediving and so are operating profits. Industry new orders are in a freefall of late courtesy of the 737 MAX grounding and halt in production (second & third panels, Chart 7). As a result, profit margins have collapsed probing the Great Recession lows (bottom panel, Chart 7). Similarly, aerospace shipments have taken it to the chin and inventories are sky high, whereas backlogs are contracting, albeit mildly (top, middle and fourth panels, Chart 8). Worrisomely, aerospace industrial production ground to a halt last month, with the resource utilization rate gaping down a whopping 560bps on a month-over-month basis (second & bottom panels, Chart 8). Boeing’s production ails will likely remain in place for the next three months, and sustain the downward pressure on output growth and capacity utilization. All of this suggests that profits are in for a rough ride. Chart 7737 MAX Ills… Chart 8…Weighing Heavily Executives’ knee-jerk reaction has been to tap credit lines in order to fend off this profit contraction phase, which has pushed the industry’s leverage to the stratosphere. In fact, the aerospace industry’s 3.5x net debt-to-EBITDA reading is the highest since the history of the data set, even higher than the aftermath of the 9/11 induced recession Chart 9). Finally, valuations have skyrocketed, rising to over three standard deviations above the past four decade mean. In marked contrast, relative technicals are washed out, probing two decade lows (Chart 10). Chart 9Rapid B/S Degradation Chart 10Overvalued, But Oversold In sum, Boeing’s 737 MAX grounding, China’s looming slowdown on the back of the coronavirus epidemic and weak industry operating metrics, all warrant a downgrade alert in the US aerospace index. Bottom Line: We are awaiting a bounce before downgrading the US aerospace index to a below benchmark allocation. It is now on our downgrade watch list. The ticker symbols for the stocks in the pureplay US aerospace index are: BA, UTX, TDG, TDY, TXT, HEI, SPR, HEI.A. Defense Rules Unlike their aerospace brethren, pureplay defense stocks are on fire on multiple fronts, and we reiterate our cyclical and secular (ten-year time horizon) overweight recommendations.3 Defense industrial production (IP) surpassed the end of the Cold War highs and is now in uncharted territory. On a year-over-year rate of change basis IP is running over 7% or fifteen percentage points higher than aerospace IP (Chart 11). This is a remarkable feat as overall IP is contracting and the US is still fighting off a manufacturing recession. Meanwhile, relative defense performance is in a V-shaped recovery, whereas relative aerospace performance is moving down along the right side of a lambda formation (top panel, Chart 11). As we mentioned above, M&A activity is also boosting takeover premia and the reduction of defense stock supply is bullish for stock prices (Chart 12). Chart 11Defense Is The Mirror Image Of Aerospace Chart 12Supportive M&A Upbeat defense outlays underpin relative share prices. Given that a global arms race is ongoing, demand for weapons will remain robust for the duration of this decade according to SIPRI’s estimates (Chart 13). Importantly, defense capital goods new orders are flirting with all-time highs, industry backlogs are not far behind and defense related exports are running red hot (Chart 14). Chart 13Insatiable… Chart 14…Demand… Besides the global rearmament, a global space race along with the real threat of cyberattacks – especially on governments – underscores that defense companies are well positioned to benefit from these two additional sources of revenues for years to come. This firm demand backdrop is reflected in near double digit sales growth outshining the broad market by a factor of 2:1. The last time defense sales were growing so briskly was during the Iraqi war in the early 2000s (Chart 15). However, one key difference between now and 2002 is margins. Back then profit margins were falling in the aftermath of the 9/11 induced recession. Fast forward to today and profit margins have doubled even eclipsing non-financial corporate sector margins (Chart 15). Given the industry’s high operating leverage, robust top line growth will flow straight to the bottom line and sustain the earnings-led relative share price outperformance phase. Keep in mind that not only are non-financial corporate sector profits contracting, but the sell-side community also expects defense EPS to continue to deflate in the coming twelve months (fourth & bottom panels, Chart 15). This represents a low bar for the defense industry to surpass. Defense stocks also have a fortress of a balance sheet: the net debt-to-EBITDA ratio runs below the broad market and the interest coverage ratio trounces the overall market. Tack on a soaring return-on-equity, and there is a long runway ahead for pureplay defense stocks (Chart 16). Chart 15…Underpins Operating Metrics Finally on the relative valuation front, while defense stocks trade at a massive premium to the broad market on a P/B basis, they are changing hands at a discount on both an EV/EBITDA and P/E basis. Defense stocks also command a higher dividend yield compared with the non-financial corporate sector (Chart 17). If our thesis continues to pan out, we deem that defense stocks will grow into their pricey P/B valuations, similar to what happened during the MAD doctrine era of the 1960s.4 Chart 16Fortress Of A B/S Chart 17Far From Overvalued On Most Ratios Netting it all out, red hot demand for defense capital goods, defense industrial production that is firing on all cylinders, enticing industry operating metrics and pristine balance sheets, all suggest that it still pays to be long the pureplay defense index. Bottom Line: Stay overweight the pureplay defense index both on a cyclical and secular time horizon. The ticker symbols for the stocks in this index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “Will The Fed Save The Day, Again?” dated February 18, 2020, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available atuses.bcaresearch.com. 3 Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For The Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 4 Please see BCA US Equity Strategy Special Report, “Brothers In Arms” dated October 31, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Overweight Investors tend to overreact to events such as virus epidemics, but we deem that such fears typically create trading opportunities, especially in the hardest-hit sectors. Similar to hotels (that we upgraded to neutral last week), airlines are part of the tourism-related industries that have suffered disproportionately. Were we not overweight the S&P airlines index, we would not hesitate to initiate such a position. True, consumer and business demand for air transportation services will come under pressure in the near-term, however, looking further out such demand destruction will likely prove transitory. The chart on the right highlights that the cyclical demand backdrop is robust for the US airline industry. Overall consumer outlays jumped recently, PCE services momentum is perking up, airfare PCE is outpacing overall consumer spending – an impressive feat – and consumer confidence is perched near cycle highs sustaining a wide gap with relative share prices. Bottom Line: Stay overweight the S&P airlines index. The ticker symbols for the stocks in this index are: BLBG S5AIRLX – LUV, DAL, UAL, AAL, ALK. For additional details please refer to this Monday’s Weekly Report.
Neutral It has been particularly difficult to distinguish a clear signal from noise lately with regard to the cyclicals versus defensives ratio. Relevant macro drivers, operating metrics and profit fundamentals, valuations and technicals all have been emitting conflicting messages. The recent coronavirus epidemic will likely make the waters murkier still. US Equity Strategy’s Global Trade Activity Indicator has turned south recently following in the footsteps of the Chinese manufacturing PMI data that ticked down and are slated to drop below the boom/bust line in the current month (top & bottom panels). The bond market also reflects a gloomy global economic backdrop with the global 10-year Treasury yield sinking like a stone. Such a lackluster bond market will likely weigh on relative share prices (middle panel). Bottom Line: Remain on the sidelines on cyclicals versus defensives. For more details on the positive data on the cyclicals/defensives ratio please refer to this Monday’s Weekly Report.