Sectors
Our sector strategists recently examined the question of sector performance in an environment where the Fed is cutting rates. A Fed rate cut is not our base case view: leading indicators of inflation remain biased to the upside, the S&P 500 is close to…
Apple released its Q1 results last week. While not strong, they were better than the market had feared after the terrible Q4 print. Importantly, management commented that the rate of decline in China had eased significantly over the course of the…
Highlights Chart 1Is Low Inflation Transitory? Persistent /pə’sıst(ə)nt/ adj. If inflation runs persistently above or below 2 percent, then the Fed would be forced to adjust its policy stance to nudge it back towards target. Transitory /’trænsıtərı/ adj. If inflation’s deviation from target is only transitory, it means that it will return to target even if the Fed maintains its current policy stance. Symmetrical /sı‘metrık(ə)l/ adj. The Fed’s inflation target is symmetrical because the FOMC is as concerned with undershoots as it is with overshoots. More recently, some members are urging the Fed to demonstrate the target’s symmetry by explicitly pursuing an overshoot. Last week, Chair Powell described recent low inflation readings as transitory (Chart 1). In other words, the Fed believes that interest rates are already low enough to send inflation higher over time. Equally, with downbeat inflation expectations signaling doubts about the symmetry of the Fed’s target (bottom panel), the committee is in no rush to hike. The result is status quo monetary policy for the time being. With the market priced for 25 basis points of rate cuts over the next 12 months, investors should keep portfolio duration low. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 95 basis points in April, bringing year-to-date excess returns up to +365 bps. The corporate bond sector’s strong outperformance has resulted in spread tightening across the credit spectrum. In fact, average index spreads for the Aaa, Aa and A credit tiers are now at or below our fair value targets.1 Only the Baa credit tier, which accounts for about 50% of index market cap, remains attractively valued, with an average spread 11 bps above target (Chart 2). We recommend that investors focus their investment grade credit exposure on Baa-rated bonds. The combination of above-trend economic growth and accommodative Fed policy creates a favorable environment for credit risk. Spreads should continue to tighten in the near-term. However, we will turn more cautious once Baa spreads reach our target. Gross corporate leverage ticked higher in Q4, breaking a year-long downtrend (panel 4). Meantime, while C&I lending standards eased slightly in Q1 after having tightened in Q4 (bottom panel), C&I loan demand contracted for the third consecutive quarter. Weaker loan demand in the Fed’s Senior Loan Officer Survey often precedes tighter lending standards, and tighter lending standards usually coincide with wider corporate bond spreads. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 137 basis points in April, bringing year-to-date excess returns up to +710 bps. Junk spreads for all credit tiers remain above our spread targets (Chart 3).2 At present: The Ba-rated option-adjusted spread is 214 bps, 35 bps above target. The B-rated spread is 356 bps, 79 bps above target. The Caa-rated spread is 709 bps, 145 bps above target. An alternative valuation measure, the excess spread available in the junk index after accounting for expected default losses, is currently 267 bps, slightly above average historical levels (panel 4). However, this measure uses the Moody’s baseline default rate forecast of 1.7% for the next 12 months. For that forecast to be realized, it would require a substantial decline from the current default rate of 2.4%. In a previous Special Report, we flagged some reasons why the Moody’s forecast might be too optimistic.3 Among them is the increase in job cut announcements, which remains a concern despite last month’s drop (bottom panel). If we assume that the default rate holds at 2.4% for the next 12 months, the default-adjusted junk spread would fall to 237 bps. Still reasonably attractive by historical standards, and consistent with positive excess returns. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in April, dragging year-to-date excess returns down to +27 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, as a 5 bps widening in the option-adjusted spread (OAS) was partially offset by a 4 bps drop in the compensation for prepayment risk (option cost). At 42 bps, the conventional 30-year OAS now looks elevated compared to recent years, though it remains below the pre-crisis mean (Chart 4). In fact, we would assign high odds to MBS outperformance during the next few months. Not only is the OAS attractive, but mortgage refinancings – which have recently caused the nominal MBS spread to widen – have probably peaked (panel 2). Following its sharp decline earlier in the year, the 30-year mortgage rate has now leveled-off. Another downleg is unlikely, given the recent improvements in housing data. New home sales and mortgage purchase applications have both surged in recent months, while homebuilder optimism remains close to one standard deviation above its long-run mean.4 Moreover, even at current mortgage rates we calculate that only about 17% of the conventional 30-year MBS index is refinanceable. All in all, given that corporate credit offers higher expected returns, we continue to recommend only a neutral allocation to MBS. However, MBS spreads are very likely to tighten during the next few months. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 37 basis points in April, bringing year-to-date excess returns up to +152 bps. Sovereign debt outperformed duration-equivalent Treasuries by 83 bps on the month, bringing year-to-date excess returns up to +420 bps. Local Authorities outperformed the Treasury benchmark by 67 bps and Foreign Agencies outperformed by 40 bps, bringing year-to-date excess returns up to +208 bps and +192 bps, respectively. Domestic Agencies outperformed by 10 bps in April, bringing year-to-date excess returns up to +29 bps. Supranationals outperformed by 7 bps on the month, bringing year-to-date excess returns up to +23 bps. The Fed’s on-hold policy stance and signs of improvement in leading global growth indicators could set the U.S. dollar up for a period of weakness. All else equal, a softer dollar makes USD-denominated sovereign debt easier to service, benefiting spreads. However, a period of dollar weakness driven by improving global growth would also benefit U.S. corporate bonds, and valuation is heavily tilted in favor of U.S. corporate debt relative to sovereigns (Chart 5). Given that the last period of significant sovereign outperformance versus corporates was preceded by much more attractive valuation (panels 2 & 3), we maintain an underweight allocation to sovereign debt for the time being. We make an exception for Mexican sovereign debt, where spreads are attractive compared to similarly rated U.S. corporates (bottom panel). Our Emerging Markets Strategy service also thinks that the market is taking too dim a view of Mexican government finances.5 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 52 basis points in April, bringing year-to-date excess returns up to +105 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 3% in April, and currently sits at 78% (Chart 6). This is more than one standard deviation below its post-crisis mean and slightly below the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Long-dated municipal bonds (10-year, 20-year and 30-year) outperformed short-dated munis (2-year and 5-year) dramatically last month, but yield ratios at the long end remain well above those at the short end of the curve (panel 2). In other words, the best value in the municipal bond space continues to be found at the long-end of the Aaa muni curve. We showed in a recent report that lower-rated and shorter-maturity munis are much less attractive.6 First quarter GDP data revealed that state & local government tax revenues snapped back sharply in Q1, following a contraction in 2018 Q4. Meanwhile, current expenditures actually ticked down. Incorporating an assumption for Q1 corporate tax revenues, we forecast that state & local government interest coverage jumped to 16% in Q1 from 4% in 2018 Q4.7 This is consistent with municipal ratings upgrades continuing to outpace downgrades for the time being (bottom panel). Treasury Curve: Adopt A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in April. The 2/10 Treasury slope steepened 10 bps on the month and currently sits at 21 bps (Chart 7). The 5/30 slope steepened 7 bps on the month and currently sits at 60 bps. In recent reports we have urged investors to adopt barbell positions along the yield curve. In particular, investors should avoid the 5-year and 7-year maturities and instead focus their allocations at the very short and long ends of the curve.8 There are three main reasons to prefer a barbell positioning. First, the 5-year and 7-year yields are most sensitive to changes in our 12-month discounter. In other words, those yields fall the most when the market prices in rate cuts and rise the most when it prices in rate hikes. With recession likely to be avoided this year, the market will eventually price rate hikes back into the curve. Second, barbells currently offer a yield pick-up relative to bullets. The duration-matched 2/10 barbell offers 8 bps more yield than the 5-year bullet (panel 4), and the duration-matched 2/30 barbell offers 5 bps more yield than the 7-year bullet. This means that investors will earn positive carry in barbell positions while they wait for rate hikes to get priced back in. Finally, almost all barbell combinations look cheap according to our yield curve fair value models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 81 basis points in April, bringing year-to-date excess returns up to +157 bps. The 10-year TIPS breakeven inflation rate rose 13 bps on the month and currently sits at 1.91% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate rose 12 bps on the month and currently sits at 2.02%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. As we noted in a recent report, the Fed has clearly pivoted to a more dovish stance in an effort to re-anchor inflation expectations at levels more consistent with its 2% target.9 This change should support wider TIPS breakevens, though investors will also need to see evidence of firming realized inflation before meaningful upside materializes. So far, such evidence is in short supply. Year-over-year core PCE inflation dipped to 1.55% in March. However, as Fed Chair Powell went out of his way to mention in last week’s press conference, core PCE was dragged down by one-off adjustments in the ‘Clothing & Footwear’ and ‘Financial Services’ components. In fact, 12-month trimmed mean PCE inflation actually moved up in March. It now sits at 1.96%, just below the Fed’s target (bottom panel). The combination of a dovish Fed and above-trend economic growth should push TIPS breakevens higher over time. Maintain an overweight allocation to TIPS versus nominal Treasuries. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in April, bringing year-to-date excess returns up to +49 bps. The index option-adjusted spread for Aaa-rated ABS narrowed one basis point on the month and, at 32 bps, it remains close to its all-time low (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are also shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 40 basis points in April, bringing year-to-date excess returns up to +187 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month. It currently sits at 67 bps, below its average pre-crisis level but somewhat higher than levels seen last year (Chart 10). In a recent report, we noted that non-agency CMBS offer the best risk/reward trade-off of any Aaa-rated U.S. spread product.10 While we remain cautious on the macro outlook for commercial real estate, noting that prices are decelerating (panel 3) and banks are tightening lending standards (panel 4) amidst falling demand (bottom panel), we view elevated CMBS spreads as providing reasonable compensation for this risk for the time being. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 21 basis points in April, bringing year-to-date excess returns up to +95 bps. The index option-adjusted spread tightened 2 bps on the month and currently sits at 47 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 25 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of April 30, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of April 30, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +56 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 56 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 For further details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 2 For further details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A High Bar For Rate Cuts”, dated April 30, 2019, available at usbs.bcaresearch.com 5 Please see Emerging Markets Strategy Special Report, “Mexico: The Best Value In EM Fixed Income”, dated April 23, 2019, available at ems.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 7 Corporate tax revenue is not released until the second GDP estimate. We assume that the 2019 Q1 value equals the 2018 Q4 value. 8 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
Underweight (High-Conviction) The last two weeks have seen earnings reports from the S&P interactive media & services index’s heavyweights Alphabet (the parent of Google) and Facebook and the prints were varied. Facebook reported revenue ahead of estimates and falling, but still solid, margins and the stock price soared. However, Alphabet reported slowing growth that drove the worst single-day share performance in seven years. A theme in both quarterly results were regulatory fines; privacy violations saw Facebook set aside $3 billion for an expected fine from the Federal Trade Commission while Alphabet’s earnings were lowered by the $1.7 billion fine over advertising violations from the EU. As a reminder, increasing regulation is core to our high-conviction underweight thesis. With respect to fundamentals, the S&P interactive media & services index’s forward earnings growth has fallen below that of the broad market (second panel) while above-market share price performance so far in 2019 has driven the valuation premium to extreme levels (bottom panel). This is a mismatch that we expect to be resolved via significant relative underperformance in the year to come. We reiterate our high-conviction underweight recommendation. The ticker symbols in the stocks in this index are: S5INMS – GOOGL, GOOG, FB, TWTR and TRIP.
Highlights In Indonesia, investors are ignoring the weakness in global growth, which is an important driver of the country’s financial markets. The Indonesian currency, equities and local currency bonds all remain vulnerable. We continue to recommend underweighting Indonesian assets for now. In Turkey, additional adjustments in the exchange rate and interest rates are unavoidable. Stay put/underweight Turkish financial markets. In the UAE, the economy is set to improve marginally this year. We recommend overweighting UAE equities and corporate spreads within their respective EM portfolios. Feature Indonesia: The Currency And Bank Stocks Are At Risk Indonesian financial assets have benefited from the Federal Reserve’s dovish turn and corresponding fall in U.S. bond yields (Chart I-1, top panel). Moreover, the market is cheering President Joko Widodo’s lead in the presidential vote tally. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate (Chart I-1, middle panel). Going forward, the Indonesian currency, equities and local currency bonds all remain vulnerable: Falling global growth in general and Chinese imports in particular will intensify Indonesia’s exports contraction and worsen the country’s already wide current account deficit. In turn, the latter will induce currency depreciation, which will then lead to higher interbank rates (Chart I-2). Chart I-1Global Growth Matters For Indonesian Markets Chart I-2Falling Current Account Deficit = Higher Local Rates Upward pressure on local interbank rates will cause a slowdown in domestic private loan growth. The Indonesian central bank – Bank Indonesia (BI) – has been attempting to lower interbank rates, which have been hovering above the central bank's policy rate (Chart I-3). To achieve this, the central bank has substantially increased excess reserves in the banking system (Chart I-4). It has done so by purchasing central bank certificates from commercial banks, conducting foreign exchange swaps and providing repo lending. Chart I-3A Sign Of Liquidity Strains Chart I-4Bank Indonesia Is Injecting Liquidity Yet by expanding banking system liquidity so aggressively, BI risks renewed currency depreciation. Like any central bank in a country with an open capital account, BI cannot expect to have full control over the exchange rate while simultaneously targeting local interest rates. The Impossibly Trinity dilemma dictates that a central bank needs to choose between controlling the two. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate. Therefore, if BI continues to inject local currency liquidity to cap or bring down interest rates (interbank rates), the resulting excess liquidity could encourage and facilitate speculation against the rupiah. Scratching below the surface, the recent strong outperformance of Indonesian equities has been entirely due to the surge in the country’s bank share prices (Chart I-5, top panel). Remarkably, the performance of Indonesian non-financial as well as small-cap stocks has been especially dismal (Chart I-5, middle and bottom panels). This is an upshot of poor profitability among Indonesia’s non-financial listed companies (Chart I-6). Chart I-5Indonesian Bank Stocks Are The Only Outperformers Chart I-6Falling Non-Financial Corporate Profitability Furthermore, deteriorating financial health of non-financial corporates, especially small companies, will lead to higher NPLs on banks’ books. Notably, Indonesian banks are more heavily exposed to businesses than to households. As NPLs rise anew, Indonesian commercial banks will need to lift their bad-loan provisioning levels, generating a major profit relapse (Chart I-7). Importantly, Indonesian commercial banks have been boosting their profits by reducing NPL provisions since early 2018. Reversing this will materially affect their earnings. Chart I-7Indonesian Bank Share Prices Are Vulnerable Additionally, bank stocks are vulnerable due to falling net interest income margins. Moreover, their share prices are overbought and not cheap. To be clear, we are not negative on Indonesia’s structural outlook. The above-mentioned alarms are more near-to-medium terms issues. Still, foreign ownership of local currency bonds and stocks – at 38% each – are high, and could be a major source of potential outflows if the rupiah depreciates. This would cause Indonesian stocks and local currency bonds to sell off severely. Bottom Line: The global growth slowdown/commodities downturn and the U.S. dollar upturn are not yet over. Consequently, foreign flows into EM will diminish, which will be particularly negative for Indonesian financial markets. We recommend investors continue underweighting Indonesian equities and avoid Indonesian local currency bonds for now. We continue to recommend a short position in the IDR versus USD. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Turkey’s Foreign Debt Bubble: The Worst Is Not Yet Behind Us Turkish financial assets, and the currency especially, will remain under selling pressure in the coming months. Additional adjustments in the exchange rate and interest rates - as well as in the real economy and current account balance - appear unavoidable. The key imbalance remains the gap between foreign debt obligations (FDOs) and the availability of foreign currency to meet these debt obligations. Turkey’s FDOs in 2019 are equivalent to $180 billion (Chart II-1). FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. This consists of $15 billion in interest payments, $65 billion in debt amortization and $100 billion in maturing short-term (under one year) claims. In theory, these debt obligations can either be rolled over, or the nation should generate current account and capital account surpluses and use these surpluses to pay down FDOs. Even though the current account deficit is shrinking, it is still in a deficit of $18 billion. Net FDI inflows remain weak at US$10 billion. Hence, it appears that Turkey’s only options are either to roll over maturing foreign currency debt or to lure foreign investors into local currency assets and use the surplus in net portfolio inflows to meet these FDOs. The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. However, due to a lack of credibility in the Turkish government’s macro policies - in addition to the ongoing deep economic recession and heightened financial market volatility - external creditors will be unwilling to roll over the debt. In fact, net portfolio flows into government debt and equities have tumbled for the same reason. Typically, when foreign funding dries up temporarily, a country can use its foreign exchange reserves to meet its FDOs. However, Turkey’s foreign exchange reserves have already plummeted to extremely low levels (Chart II-2). The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. This is negligible compared with the $180 billion FDO figure due in 2019. Chart II-1Turkey: A Large Foreign Debt Servicing Burden Chart II-2Foreign Exchange Reserves Are Too Small The recent plunge in the central bank’s net foreign exchange reserves excluding swaps (i.e. net international reserves) has put many pertinent metrics at record lows. In particular, net international reserves are at a precarious level relative to both total imports and external debt (Chart II-3). Finally, the net international reserves-to-broad money supply ratio has fallen to 7% (from 15% in 2014) despite the fact that the massive lira depreciation reduced the U.S. dollar measure of broad money supply (Chart II-4). Chart II-3FX Reserves Do Not Cover Imports Or External Debt Chart II-4Low Coverage Of Broad Money By International Reserves The currency will have to depreciate further and interest rates will have to move higher to shrink domestic demand/imports more. This is needed to generate a current account surplus that could be used to service FDOs, or that otherwise entices foreign creditors to be willing to roll over foreign debt or invest in Turkey. Finally, while the adjustment in the real economy is advanced, it is unlikely to be over, due to the large foreign debt bubble. Importantly, with large foreign and local currency debt obligations coming due for both companies and households - in addition to the deterioration in economic activity and higher interest rates - NPLs are bound to rise (Chart II-5). This is especially likely to occur because a lot of borrowing has been used in the property market both for construction and purchases. Notably, real estate volumes are shrinking, and prices are deflating in real terms (Chart II-6). Chart II-5NPLs Will Rise A Lot Chart II-6Turkey: Real Estate Is In Free Fall Bottom Line: The macro adjustment in Turkey is not yet complete. The country still lacks foreign currency supply to service its enormous 2019 FDOs. Further currency depreciation and higher interest rates are required to depress domestic demand/imports and push the current account into surplus. Stay put / underweight Turkish financial markets. The authorities are becoming desperate, and the odds of capital control enforcement are not negligible. While such an outcome is not possible to forecast with any certainty or time frame, investors should consider this very real risk. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Overweight UAE Equities And Corporate Bonds Over the next six to nine months, we believe both UAE equities and corporate spreads will outperform their respective emerging market (EM) benchmarks. The UAE economy is set to improve marginally this year (Chart III-1). It will benefit from expansionary fiscal policy, rising oil output, a buoyant tourism sector, a resilient banking sector and less of a drag from the real estate sector. First, sizable fiscal spending will lead to rising non-oil economic growth. The UAE’s federal budget spending for 2019 will increase by 17.3% from a year ago, much higher than the 5.5% year-on-year growth in 2018. Second, UAE oil output could increase by 15% later this year from current levels (Chart III-2). The U.S. announced on April 22 that all Iran sanction waivers will not be extended beyond the early-May expiration date. The U.S. administration also stated that it has secured pledges from Saudi Arabia and the UAE to increase their oil production in order to offset disrupted supply from Iran. Rising oil output will mitigate the negative impact of potentially lower oil prices on the UAE’s economy. Chart III-1Improving UAE Economy Chart III-2Rising Oil Output Third, the outlook for the tourism sector is also positive. The number of tourists is set to rise as Expo 2020 approaches. The government is targeting 20 million visitors in 2020, 26% higher than last year’s levels. The UAE is building theme parks, museums, hotels and infrastructure to attract more tourists. The UAE economy is set to improve marginally this year. Fourth, the UAE’s banking sector will enjoy rising credit growth, robust profitability and improved asset quality this year. The banking system has been in consolidation mode since January 2016, with a 15% reduction in branches and a 14% drop in the number of employees. This has improved the banking sector’s profitability by cutting operating costs and increasing efficiency. The improving growth outlook will lift credit growth. The central bank’s most recent Credit Sentiment Survey suggests banks’ lending standards for both business and personal loans are loosening (Chart III-3). In addition, UAE banks enjoy large capital buffers. Despite rising non-performing loans (Chart III-4), UAE banks still reported a Tier-1 capital adequacy ratio of 17% as of December 2018. Chart III-3Credit Growth Is Likely To Increase Chart III-4Rising NPLs, But Still Large Capital Buffers Lastly, the real estate markets in both Dubai and Abu Dhabi have suffered from oversupply (from both mushrooming supply and weaker demand) over the past several years. Property prices have already fallen over 20% in both Dubai and Abu Dhabi from their 2014 peaks (Chart III-5). Odds are high that the most dangerous phase of the property market downturn is behind us. Chart III-5Real Estate Adjustment Is Advanced In addition, the government’s efforts to attract people to stay in the country longer will somewhat offset the ongoing exodus of expatriates. Last May, the UAE introduced a new visa system that will allow investors, innovators and talented specialists in the medical, scientific, research and technical fields to stay in the country for up to 10 years. Overall, a potential bottom in property demand and restrained supply will likely make the real estate sector less of a drag on this bourse this year. Finally, the authorities are also more open to increasing the foreign ownership cap in the banking sector, albeit not up to 100%. For example, in early April, the largest UAE lender – First Abu Dhabi Bank – obtained regulatory approval to increase its foreign ownership limit to 40% from 25%. This has boosted foreign equity purchases and has supported the equity index. Bottom Line: We recommend an overweight position in UAE equities within an EM portfolio this year (Chart III-6). For fixed income investors, we recommend overweighting UAE corporate credit in an EM corporate credit portfolio. UAE corporate credit is a lower beta market and will outperform as EM corporate spreads widen (Chart III-7). Most UAE-dollar corporate bonds have been issued by banks. Banks in the UAE do not suffer from structural overhangs, and the cyclical downturn in the property market is well advanced. This is why they have been, and will remain, a lower beta sector within an EM corporate credit portfolio. Chart III-6Overweight UAE Equities Within An EM Portfolio Chart III-7UAE Corporate Credit Will Likely Outperform EM Benchmark Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Overweight The S&P tech hardware, storage & peripherals (THSP) index was cheering yesterday as index heavyweight Apple reported results that, while not strong, were better than the market had feared after the terrible Q4 print. Importantly, management commented that the rate of decline in China had eased significantly over the course of the quarter while services revenues hit a new record. Perhaps more important to equity investors was the $27 billion the company returned to shareholders in Q1, the authorization of another $75 billion for share repurchases and a 5% increase in the dividend. In the context of the still-pristine sector balance sheets (bottom panel), further shareholder friendly actions seem likely. Nevertheless, while sector valuations have bounced off the recent relative lows, the S&P THSP index continues to trade at a wide (though shrinking) discount to the broad market (second panel). We continue to find this discount excessive in anticipation of a sector rerating. Bottom Line: Troughing results in China, progress in services and a surge in return of capital to shareholders all point to more gains for the S&P THSP index; stay overweight. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.
Core to our thesis is that content is king and Disney is the reigning consolidator. Notably, the company’s Avengers property, acquired via the $4 billion acquisition of Marvel a decade ago, just set the record for box office openings this weekend with their…
Highlights Open an equity market relative overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, the majority of this year’s absolute gains have already been made. Core euro area bond yields will edge modestly higher… …and EUR/USD will appreciate, as the backward-looking data on which the ECB depends catches up with the more perky real-time economic data. Feature Vertical charts scare us, as we contemplate falling over the edge. But they also excite us, as we contemplate a lucrative investment opportunity. Right now, the vertical chart that is causing us palpitations is technology versus healthcare (Chart of the Week). Chart of the WeekTechnology Versus Healthcare Has Gone Vertical! The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Meaning that the technology versus healthcare relative performance has unavoidable consequences for regional and country stock market allocation (Chart I-2 and Chart I-3). The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Chart I-2When Technology Underperforms Healthcare, Netherlands Underperforms Switzerland Chart I-3When Technology Underperforms Healthcare, China Underperforms Switzerland Specifically, from a European stock market perspective, the Netherlands is overweight technology while Switzerland and Denmark are both overweight healthcare. Further afield, the U.S. is overweight technology while China is both overweight technology and underweight healthcare. Explaining Verticality And The Subsequent Fall What creates vertical charts? To answer the question, let’s turn it on its head: what prevents vertical charts? The answer is: the presence of value investors. In a healthy market, a cohort of value investors will sit on the side lines and only transact with the marginal seller when the price falls to a semblance of value. In other words, the value sensitive investors help to set the price, preventing verticality. But if the value sensitive cohort switches out of character to join a strong uptrend, the cohort will suddenly become value insensitive. In this case, the marginal seller will set the price higher and the formerly uninterested value sensitive buyer will now buy at the higher price. The market has morphed into a trend-following market. As more of the value cohort switch sides, the process adds rocket fuel to the rally. Driven by the ‘fear of missing out’ the marginal buyer will buy at larger and larger price increments, and the chart becomes vertical. What triggers the subsequent fall? When all of the value cohort have joined the uptrend, the fuel has run out: the marginal seller will no longer find a willing marginal buyer at the elevated price. At this critical point, one of two things will happen. Either: a completely new cohort of even deeper value investors will switch out of character and provide new fuel to the trend, allowing it to continue. Or: the deep value investors will stay true to character and will only deal with the marginal seller when the price falls, perhaps sharply, to a semblance of deep value. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased. Both the theoretical and empirical evidence suggests that at this critical point, the probability of trend-continuation decreases to about a third and the probability of a trend-reversal increases to about two-thirds. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased (Chart I-4). Chart I-4Technology Versus Healthcare: The Probability Of A Trend-Reversal Is High Therefore, on a tactical horizon, it is now appropriate to underweight technology versus healthcare – which, to reiterate, carries unavoidable consequences for country and regional stock market allocation: Open an overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. Distinguishing Between Valuation And Growth Is Extremely Difficult There is another problem for value investors. Over short periods – meaning less than a year – it is very difficult, if not impossible, to decompose a price return into its two components: the component coming from the change in valuation and the component coming from the change in earnings growth expectations. A stock market’s actual earnings are highly sensitive to small changes in economic growth. This is universally the case but is especially true in Europe, because the European stock market’s skew towards growth-sensitive cyclicals gives it a very high operational leverage to GDP growth: a seemingly minor 0.5 percent change in economic growth translates into a major 25 percent change in stock market earnings growth (Chart I-5). The slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Chart I-5A Minor Upgrade To Economic Growth = A Major Upgrade To Profits Growth Given this very high operational leverage, the slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Which of course lifts the market’s price, P, very sharply. In contrast, equity analysts’ forecasts for earnings, which drive the market’s ‘official’ forward earnings, E, adjust much more slowly. As my colleague, Chris Bowes explains: “analysts get married to a view and usually require overwhelming evidence to materially change it.” The upshot is that the P rises very sharply but the official forward E does not, meaning that the official forward P/E also rises very sharply. This gives the impression that the move is mostly valuation driven, but the truth is that the move is mostly earnings growth driven. In a similar vein, when central banks guide interest rates lower, how much of the equity market’s move is due to a higher valuation, and how much is due to improved prospects for economic growth resulting from the central bank policy change? Over relatively short periods of time, it is extremely difficult to tell. All of which provides an important lesson: over short periods, do not focus on separately forecasting the valuation change and earnings growth change of a stock market. Much better to forecast the stock market price directly, by focussing on the two main things which will drive it: changes to central bank policy, and changes to short-term real-time economic growth. Focus On Central Banks And Short-Term Economic Growth Central bank policy now ‘depends’ on relatively longer-term changes (say, year-on-year) in backward-looking data, most notably the consumer price index. Whereas the stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators (Chart I-6). Chart I-6Quarter-On-Quarter Growth Is Rebounding Hence, the ‘sweet spot’ for equity markets is when, in simple terms, year-on-year CPI inflation is decelerating, implying central banks will become more dovish, while quarter-on-quarter economic growth is accelerating, implying the market will upgrade earnings growth (Chart I-7). The stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators. The ‘weak spot’ for equity markets is the exact opposite, when year-on-year CPI inflation is accelerating, implying central banks will become less dovish, while quarter-on-quarter economic growth is decelerating, implying the market will downgrade earnings growth. As 2019 progresses, our high-conviction prediction is that equity markets will move from a sweet spot to a weak spot. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, it implies that the majority of 2019’s gains have already been made in the first four months of the year – and the market is unlikely to be significantly higher at the end of the year. Compared to the equity market, the bond, interest rate, and currency markets are – almost by definition – much more dependent on central banks’ lagging reaction functions than on real-time growth. Which solves the mystery as to why bond yields are close to new lows while equity markets are close to new highs. It also solves the mystery as to why EUR/USD has lagged the very clear recovery in euro area real-time growth and in euro area stock markets (Chart I-8). Central banks are following lagging indicators. Chart I-7Stock Markets Take Their Cue from Real-Time Indicators Chart I-8Central Banks Are Following Lagging Indicators, Stock Markets Are Following Real-Time Indicators But as the backward-looking data, on which the ECB depends, catches up with the more perky real-time data, core euro area bond yields will edge modestly higher, and EUR/USD will gently appreciate. Next week, in lieu of the usual weekly report, I will be giving this quarter’s webcast titled ‘From Sweet Spot to Weak Spot?’ live on Wednesday May 8 at 10.00 AM EDT (3.00 PM BST, 4.00 PM CEST, 10.00 PM HKT). Through a series of key charts, the webcast will reveal the prospects and opportunities for all asset-classes through the remainder of 2019. At the end of the webcast, I will also unveil a brand new investment recommendation. So don’t miss it! Fractal Trading System* Supporting the arguments in the main body of this report, fractal analysis suggests that the recent rally in China’s stock market is at a technical point that has reliably signaled previous major reversals. Accordingly, this week’s recommended trade is a stock market pair trade, short China versus Japan. Set the profit target at 2.5 percent with a symmetrical stop-loss. We now have six 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-9Short China Vs. Japan 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 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
Overweight Last week we highlighted a number of reasons why the S&P movies & entertainment index had turned a corner, underscoring our upgrade to overweight.1 Core to our thesis is that content is king and Disney is the reigning consolidator. Notably, the company’s Avengers property, acquired via the $4 billion acquisition of Marvel a decade ago, just set the record for box office openings this weekend with their latest offering earning $1.2 billion. This bested their own record set last year with an offering from the same media property. Stocks in the S&P movies & entertainment index have been soaring to reflect the eager movie-going sentiment of consumers. Such exuberant consumption of entertainment, combined with Disney-specific optimism from their upcoming streaming service and majority stake of Hulu, an already formidable streaming competitor, should be met with analyst optimism. However, we have seen just the opposite as pessimism has dominated the sell-side and forward EPS are set to materially trail the broad market (second panel), while revisions are headed lower (bottom panel). We think this bearishness should prove fleeting and would lean against it. Bottom Line: Analyst pessimism appears offside in an exceptional box office environment. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5MOVI – DIS, NFLX, VIAb. 1 Please see BCA U.S. Equity Strategy Weekly Report, “Mixed Signals” dated April 22, 2019, available at uses.bcaresearch.com.