Style: Growth / Value
Highlights The ECB loaded a bazooka, and core Eurozone yields rose: The ECB surprised dovishly last Thursday, and European bond yields duly fell … for an hour. Then they began to back up as fast as they fell, and when Friday’s trading ended, only Greek and Italian yields were lower than where they started. The market action supports our contention that things are not so bad, assuming the worst-case trade scenarios do not materialize: Underpinned by a robust labor market, the U.S. should have little trouble growing at a trend pace over the next twelve months. Meanwhile, the global economy may be in the process of turning. Reversals within the U.S. equity market have gotten a lot of attention so far this month, but it’s too early to claim that a broad factor inflection is underway: If global growth prospects have bottomed, defensive sectors’ outperformance is due to reverse, which will cause havoc for momentum strategies. It is premature to call for a value revival, however. Feature Maybe long Treasury yields aren’t going to zero after all. After bottoming just below 1.43% the day after Labor Day, the 10-year Treasury yield surged 45 basis points across eight sessions as of Friday’s lunchtime peak (Chart 1). The move has been enough to retrace better than three-fifths of its steep slide from mid-July to the beginning of September, but relative to the extended plunge from 3.24% that began last November, the bounce barely registers. Chart 1Up, Up And Away Chart 2Pulled Lower By Expected Rate Cuts... The takeaway is that it’s important to keep the moves in context. Just as the collapse in Treasury yields didn’t indicate that the U.S. economy was headed for an imminent recession, their modest, if rapid, recovery doesn’t indicate that all the dark clouds are gone from the horizon. From a purely domestic perspective, the 180-basis-point (“bps”) peak-to-trough decline in the 10-year Treasury yield unfolded nearly step-for-step with an equivalent decline in the expected fed funds rate twelve months out (Chart 2). Since a 1.25% target fed funds rate this time next year is incompatible with our view of the economy, we expect rates will move higher. The ECB committed itself to accommodation for longer than markets had expected; … Chart 3...And Other Sovereign Yields Chart 4Better Times Ahead? The Treasury market doesn’t exist in a vacuum, however. Yield moves in similarly-rated sovereign bonds have an effect on Treasuries, and declines in European sovereign yields have exerted a gravitational pull all year long (Chart 3). The backup in yields that followed the ECB’s dovish surprise on Thursday suggests that Eurozone sovereign bond markets may have bought the rumor and sold the news. If global growth is in the process of bottoming, as global leading indicators suggest, falling yields would run counter to the fundamental backdrop (Chart 4). You May Fire When Ready, Draghi To judge by the spate of columns urging helicopter-style accommodation measures, the expectations bar for the European Central Bank’s long-awaited September meeting had been set pretty high. The cut in the ECB’s deposit facility rate to -0.5% from -0.4%, with provisions to mitigate the pressure negative rates exert on banks, was in line with the market consensus, as was a resumption of quantitative easing. Investors did not foresee that the ECB would embark on open-ended bond purchases, however, a plan quickly labeled “QE Infinity.” The ECB also dumped its no-hikes-before-mid-2020 guidance – now it won’t move until the inflation outlook “robustly” moves toward its 2% target – and lengthened the maturities on TLTRO loans while lowering their rates.1 The surprise indicated that the ECB is taking the slowdown seriously, at home (most evident in Germany, which is flirting with recession after a quarter-over-quarter GDP contraction) and abroad. It is premature to declare the action a flop, as headline writers were quick to do, citing the evanescent decline in core bond yields and the euro, because QE impacts are subject to several factors. Sovereign yields can rise on QE announcements if markets judge the impact of relaxed inflation vigilance will outweigh the impact of the entry of a new, price-insensitive buyer to the marketplace. As long as real yields fall, the central bank will have achieved its goal. … if it develops that the incremental accommodation wasn’t necessary, equities and spread product should reap the benefits. U.S. investors are mostly concerned with the impact on global markets and the global economy. Even if nominal sovereign yields have bottomed and competitive devaluation has neutered the currency channel, incremental easing should boost risk assets’ prospects, via pushing incumbent sovereign holders into spread product (the portfolio balance effect), promoting business and consumer confidence, incentivizing bank lending, and nudging other central banks (like Denmark’s, which immediately cut its policy rate in response) to ease monetary conditions themselves (Figure 1). On those counts, we view the ECB’s surprise as modestly improving the prospects for risk assets. TINA is alive and well. Figure 1Monetary Policy And The Economy The Employment Situation We have repeatedly cited the robustness of the labor market as a reason for not giving up on the U.S. economy, or equities and spread product. If expanding payrolls and increasing compensation can keep consumption growing at just a 2% clip, the probability of a U.S. recession, and of an equity bear market and a new default cycle, is fairly slim. If the labor market isn’t as strong as we’ve judged, more defensive portfolio positioning may be in order. Since the beginning of the second quarter, the monthly employment situation reports have revealed a slowing in hiring activity, halting the quickening that stretched from last year through the end of the first quarter (Chart 5). The slowing trend is less concerning than it might appear to be on its face. The current expansion, 122 months old and counting, is the longest on record, and now that it has already drawn considerable numbers of people back into the labor force and back to work, it has become increasingly difficult to find and attract new workers. Even the current monthly pace of job gains, 156,000 over the last three months, still puts downward pressure on the unemployment rate, as it takes less than 110,000 new jobs to maintain the status quo. With net job gains outpacing new entrants into the labor force, wages should rise. Average hourly earnings rose 3.2% in August on a year-over-year basis, though the 0.4% month-over-month gain suggests they may be about to challenge the top end of the tight 3.1-3.2% range that’s prevailed all year. Investors’ and economists’ patience with the Phillips Curve is increasingly wearing thin, as they wait for the decline in the unemployment rate to show up in wage gains, but we consider the underlying supply-demand relationship to be immutable. The prime-age employment-to-population ratio hit an 11-year high in August, and is solidly back in the middle of the range that has prevailed over the 30 years that female participation gains have stabilized (Chart 6). Chart 5Slower Payroll Gains... Chart 6...Will Still Tighten The Labor Market Chart 7The Unkinked Phillips Curve The prime-age employment-to-population ratio is an important measure for the Phillips Curve because it exhibits a consistent linear relationship with wage gains. The fit between the non-employment-to-population ratio (1 minus the employment-to-population ratio) and the employment cost index (Chart 7, top panel) is a little tighter than the fit with average hourly earnings (Chart 7, bottom panel), but both regression equations project an annual increase in wages of 3.3% at the current 20% (1-80%) level, and a 7-bps gain for every 20-bps decline in the prime-age non-employment-to-population ratio. Given that our payrolls model projects a pickup in the pace of hiring (Chart 8, top panel), and the quits rate just moved off of its extended plateau (Chart 9), upward pressure on wages will continue to build. Chart 8Demand For Workers Is Still Solid Chart 9Movin' On Up Bottom Line: Payroll gains are slowing, but they remain robust enough to push the key prime-age employment-to-population ratio higher, and exert upward pressure on wages. Factor Rotation Chart 10Momentum Hits The Wall,... Reversals within the U.S. equity market have been drawing increasing amounts of attention, as momentum stocks have hit a wall while long-suffering value stocks have begun to peel themselves off the canvas (Chart 10). We can easily see a scenario in which the momentum factor has a very difficult time, if relative performance shifts from defensive sectors to cyclical sectors as investors begin to perceive that they have been overly pessimistic about the domestic and global business cycle, and cease to hide in bond proxies like Utilities and REITs. Given the defensives’ run of outperformance over the last year, momentum indexes disproportionately favor them over cyclicals. The S&P 500, MidCap 400 and SmallCap 600 Momentum Indexes all show a pronounced defensives bias, with Health Care, Utilities and Real Estate all commanding double their baseline weight in at least one index (Table 1), making S&P’s momentum indexes vulnerable to a defensives-to-cyclicals rotation. Table 1The Dullest Stocks Have Been The Hottest Over the last three years, we have thought a lot about the value factor, asking how it should be defined, which financial statement metrics indicate its presence, and the business and monetary policy cycle backdrops that are most conducive to its outperformance. Low-priced stocks have been in a punishing extended slump versus high-priced stocks since early 2007 (Chart 11), and we think they have yet to bottom. The recent value stock rally has been a function of higher 10-year Treasury yields, and banks’ (which account for an outsized share of popular value benchmarks) recent tendency to trade in lockstep with them. We do not think a two-week backup in yields is the stuff that a genuine value factor inflection point is made of. Chart 11...But The Value Factor Has Yet To Turn A detailed explanation of our rationale is beyond the scope of this report,2 but the following points summarize our take: The value factor has gotten killed since the crisis, but we doubt that it’s dead. Value has historically treaded water during bull markets, and shined in bear markets. The fed funds rate cycle is the best predictor of value’s relative performance. Value has historically crushed the overall market when monetary policy is restrictive. The most popular style indexes have barely any factor merit. The S&P 500’s Growth and Value indexes are little more than Tech and Financials proxies. Value will shine again, but not until monetary policy is restrictive. If the Fed doesn’t hike the fed funds rate above the equilibrium fed funds rate until 2021, value investors will have to gut out another year-plus of underperformance. Bottom Line: The momentum factor could suffer in the near term if cyclicals reassert primacy over formerly hot defensives. The value factor’s fortunes will not turn for at least another year. Investment Implications We understand the discomfort of investors who feel like ZIRP, NIRP and QE have obliterated normal investing relationships. Disorienting as it has been to see nominal Treasury returns shrivel, the rising tide of negative-yielding bonds is like a surreal detail from a David Lynch movie. The investment world has indeed turned upside-down when investors buy bonds for capital gains to offset the interest they have to pay for the privilege of lending. Austrian School advocates are surely not the only dearly departed investing veterans rolling in their graves. It’s not the environment we wanted, but it’s the environment we got, so we’re going to buck up and do our best to squeeze excess returns out of it. We have to invest in the markets we have, however, not the markets we want. It does neither ourselves nor our clients any good to throw up our hands, bitterly lament our fate and wish ill upon the exponents of the activist, ultra-accommodative approach to central banking that is now in fashion. Some old relationships still apply, and the combination of a quietly improving global economic backdrop with incremental monetary accommodation everywhere one turns is good for risk assets. We continue to recommend that investors resist the urge to get defensive before the excess-return window closes for this cycle. We are not advocating that investors let their guard down, and assume that central banks will be able to keep the plates spinning indefinitely. They will not – monetary interventions are a poor substitute for organic growth in productivity or the size of the working-age population, and so are inefficiently directed fiscal spending programs – but we bet they can through the next quarterly or annual period over which an institutional manager is going to be evaluated. The upshot is that investors should remain especially vigilant for signs of trouble, and be prepared to act more tactically than normal to adjust their portfolios, but shouldn’t de-risk them yet, lest they miss the last of the fat-year returns they’ll need to tide themselves over during the coming lean years. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Targeted longer-term refinancing operations (TLTROs) are ECB loans to banks intended to encourage lending to households and non-financial corporations. 2 Interested readers should see the May 16, 2018 Global ETF Strategy/Equity Trading Strategy Special Report, “Smart-Beta ETF Selection Update – Is Value Still Worth It?,” the October 2018 Bank Credit Analyst Special Report, “Is It Time To Buy Value Stocks?,” and the October 2, 2018 U.S. Investment Strategy Special Report, “When Will Value Work Again?,” available at etf.bcaresearch.com, www.bcaresearch.com and usis.bcaresearch.com, respectively.
A client recently came to us asking the question: what percentage of the SPX was classified as value and what was classified as growth? While a simple enough question, it spurred some discussion regarding the classification itself. The S&P classifies the S&P 500 into value, growth and a lucky combination of value and growth (i.e. some constituents, including Google for example, belong to both lists). We thought it worthwhile to separate the stocks into their pureplay components and the result was interesting. As shown in the left piechart below, the market cap weighted styles are actually fairly evenly split between value, growth and the combination thereof. On a count basis (right pie chart), growth stocks fall to under a quarter of the SPX, a logical result considering the mega market cap sizes of the SPX’ growth companies. If you would like to receive our segmented list of tickers, please email our client requests department here.
Highlights U.S. growth remains robust, despite some temporary softness in recent months. Ex U.S., growth continues to fall but, with China probably now ramping up monetary stimulus, should bottom in the second half. Central banks everywhere have turned more dovish, partly in an attempt to push up inflation expectations. The combination of resilient growth and easier monetary policy should be good for global equities. We remain overweight equities versus bonds. Bond yields have fallen sharply everywhere. However, with U.S. inflation still trending up, and central banks unlikely to turn any more dovish this year, yields are unlikely to fall much further in 2019. We recommend a slight underweight on duration. We remain overweight U.S. equities, but are on watch to upgrade the euro zone and Emerging Markets when we have stronger conviction about China’s stimulus. Given structural headwinds in both Europe and EM, this would probably be only a tactical upgrade. We have been tilting our equity sector recommendations in a more cyclical direction, last month raising Industrials and Energy to overweight. We also prefer credit over government bonds within the fixed-income category, though we warn that spreads will not fall much further given weak corporate fundamentals. Feature Recommended Allocation Overview Don’t Fight The Doves The performance of risk assets essentially comes down to a battle between growth and monetary policy/interest rates. Last September, despite the fact that global economic growth was clearly slowing, the Fed sounded hawkish; this triggered an 18% drop in global equities in Q4. But, since late last year, all major developed central banks have turned more dovish, culminating in March’s decision of the ECB to push back its guidance for its first rate hike, and the FOMC’s wiping out its two planned hikes for 2019. But, at the same time, U.S. economic growth is showing resilience, and we see the first “green shoots” of a cyclical pickup in growth outside the U.S. This is an environment in which risk assets should continue to perform well. Why did the Fed back off? The most likely explanation is that it wants to give itself more room to act come the next recession. Inflation expectations have become unanchored, with 10-year breakevens over the past decade steadily below a level that would be consistent with the Fed achieving its 2% core PCE inflation target in the long run. In the period since the Fed formally introduced this (supposedly “symmetrical”) target in 2012, it has exceeded it in only four months (Chart 1). Around recessions over the past 50 years, the Fed has on average cut rates by 655 basis points (Table 1). It sees little risk, therefore, in letting the economy “run a little hot” and allowing inflation to rise somewhat above 2%. This would reanchor expectations, and eventually get nominal short- and long-term rates higher before the next recession. Chart 1Market Doesn’t Believe The Fed’s Target Table 1Fed Won’t Be Able To Cut This Much Next Time Chart 2Financial Conditions Now Much Easier Chart 3Housing Market Bottoming Out Meanwhile, U.S. growth seems to be stabilizing at a decent level after signs of weakness late last year caused by tighter financial conditions, a slowdown elsewhere in the world, and the six-week government shutdown. An easing of financial conditions since the beginning of the year should help to keep U.S. GDP growth above trend at around 2.0-2.5% this year (Chart 2). Most notably, interest-rate sensitive areas of the economy that were under pressure last year, especially housing, are showing signs of bottoming (Chart 3). Consumption also should be robust, given strong wage growth, consumer confidence close to historic record high levels, and amid no signs of a deterioration in the labor market (Chart 4). Chart 4No Signs Of Weaker Labor Market Chart 5Some 'Green Shoots' For Global Growth A key question for us over the next few months will be when to shift allocations to more cyclical, higher-beta equity markets such as the euro area and Emerging Markets. These have underperformed year-to-date despite the strong risk-on market. China’s nascent reflationary stimulus will decide the timing and level of conviction of this shift. As we explain in detail on page 6, we think the jury is still out on whether China is injecting liquidity on anything like the same scale as it did in 2016. Even if it is, historically it has taken six to 12 months before the effect showed through via a rebound in global trade, commodity prices, and other China-related indicators. The first early signs of a bottoming are emerging: Chinese fixed-asset investment and the Caixin Manufacturing PMI beat expectations last month, the German ZEW Expectations indicator has started to recover, and the diffusion index of the Global Leading Economic Indicator (which often leads the LEI itself by a few months) has picked up (Chart 5). We are on watch to shift our allocation1 but, given the long-term structural headwinds against both Europe and EM, we need to be more convinced about the strength of Chinese stimulus before doing so. The seeds of recession are sown in expansions. Eventually, we see the newly dovish Fed falling behind the curve. The Fed Funds Rate is still below the range of estimates of the neutral rate – hard though this is to estimate in real time (Chart 6). If the economy remains as strong as we expect, sometime next year inflation could begin rising to uncomfortable levels (and asset bubbles start to be of concern), which would push the Fed back into hiking mode. Given that the market is pricing in Fed rate cuts, not hikes, and that the Fed can hardly sound any more dovish than it does now without moving to an outright easing path, it seems to us that long-term rates are very unlikely to fall from here (Chart 7). Chart 6Fed Still Below Neutral Chart 7Can The Fed Get Any More Dovish Than This? In this environment, therefore, we continue to expect global equities to outperform bonds over the next 12 months. However, a recession is possible in 2021 triggered by the Fed late next year needing to put its foot abruptly on the brake. What Our Clients Are Asking Chart 8Ex-U.S. Equities Driven By China Stimulus When Is The Time To Switch Allocations To Europe And EM? It is slightly surprising that the 12% rally in global equities this year has been led by the low-beta U.S., up 13%, rather than Europe (up 9%) or emerging markets (up 9% - and much less if the strong Chinese market is excluded). Is it time to switch to these underperforming, more cyclical markets? Our answer is, not yet. Global growth ex-U.S. continues to weaken. It is likely to bottom sometime in the second half, as a result of Chinese growth stabilizing. However, the jury is still out on whether the increase in Chinese credit creation in January was a one-off, or major policy reversal. Even if it is the latter, a revival in global growth (and cyclical markets) has typically lagged Chinese stimulus by 6-12 months (Chart 8, panel 1). There are also significant structural headwinds for both the euro zone and Emerging Markets which make us reluctant to overweight them unless there are clear cyclical reasons to do so. Both have lagged global equities fairly consistently since the Global Financial Crisis, with only brief outperformance during periods of economic acceleration, such as in 2016 and 2012 (panel 2). The euro zone remains challenged by its banking system. Loan growth has been stagnant for years, and banks remain undercapitalized relative to their U.S. peers, and highly fragmented (panels 3 and 4). Emerging markets are hampered by their high level of foreign-currency debt (which makes them highly sensitive to U.S. financial conditions), dependence on China, and lack of structural reform. We could see ourselves shifting our recommendation from the U.S. to the euro area and EM, and becoming outright bearish on the U.S. dollar (a counter-cyclical currency), over the coming months if we find confirmation of a bottoming of global cyclical growth and become more confident in the size of China’s stimulus. But given the structural headwinds, and the steady underperformance of these markets, we need stronger evidence first. Chart 9Oil, Positioning, And Housing Why Is The 10-Year Bond Yield So Depressed? Despite U.S. equities rallying back to within 4% of a record high, the U.S. Treasury bond yield has fallen further this year (Chart 9, panel 1). Moreover, the 3-month/10-year yield curve has briefly inverted. Besides the Fed’s recent more dovish turn, what has depressed bond yields? We would pin the cause on the following factors: Dampened inflation expectations: Over the past few years the 10-year yield has been closely correlated with the oil price via inflation expectations. A temporary supply shock in Q4 caused oil prices to decline sharply. But tighter supply this year should allow the oil price to recover further. This should cause a rise in inflation expectation (panel 2). Trade positioning: Late last year, speculative short positions in government bonds were at their highest levels since 2015. However, the Q4 equity selloff pushed investors to cover their positions; these are now close to neutral (panel 3). Home Sales: Housing data has been weak over the past few quarters, with both existing and new home sales declining. But there are now signs of recovery: mortgage applications have started to pick up, which should in turn push home sales higher (panel 4). This should also allow for a rise in bond yields. Our key take-away from March’s FOMC meeting, when the tone turned decidedly dovish, is that the Fed is focusing on re-anchoring inflation expectations, which should push nominal yields higher. We think the market is very pessimistic by pricing in 42 and 56 bps of rate cuts over the next 12 and 24 months respectively. It would take a significant further weakening of economic data to make the Fed’s stance turn even more dovish and for nominal yields to fall even further. How Will U.S. Corporate Bonds Perform In The Next Recession? Historically high levels of U.S. corporate debt, as well as declining credit quality in the investment-grade space, have started to worry investors (Chart 10). Specifically, investors are worried that, when the next default cycle comes, a large portion of investment-grade debt will be downgraded to junk, forcing fund managers who are constrained to hold certain credit qualities to sell. These worries seem to be justified. Investment-grade bonds of lower credit quality tend to experience large increases in migration to junk status during credit recessions (Chart 11). Given the current composition of the U.S. investment-grade corporate bond universe, a credit recession would imply a downgrade to junk status of 4.6% of the index if we assume similar behavior to previous recessions. Depending on the speed of the selloff, such a downgrade could also have grave consequence for liquidity. According to the Securities Industry and Financial Markets Association (SIFMA), average daily turnover in the U.S. corporate bond market was 0.34% in 2018. Thus, it is not hard to envision a situation where forced selling could surpass normal levels of liquidity. However, it is hard to tell what would be the effect of such a fire-sale on credit spreads, given that they tend to widen in recessions regardless. While this asset class could perform poorly in the next recession, we don’t expect that its weakness will translate to the real economy. Leveraged institutions such as banks hold just 18% of corporate credit. Furthermore, despite being at all-time highs, U.S. nonfinancial corporate debt to GDP is still at a much healthier level than in other countries (Chart 12). Chart 10Declining Quality In Investment Grade Chart 12U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World Chart 13A Value Rebound? Is It Time To Favor Value Over Growth Again? Since it peaked in May 2007, the ratio of global value to growth has attempted to rebound several times amid a sustained downtrend (Chart 13). Due to the cyclical nature and the neutral relative valuation of the value/growth indexes, we have preferred to use sector positioning (cyclicals vs. defensives) to implement a value/growth style tilt in our global portfolio since March 20162 (Chart 13, panel 1). Lately, we have received many requests on the topic of the value-versus-growth-ratio. After reaching a historical low in August 2018, the value/growth ratio slightly rebounded in Q4 2018 before reversing some of its gains so far this year. Additionally, the value/growth valuation gap as measured by both price-to-book and forward P/E has reached a historically low level (Chart 13, panel 4). As we have often noted, the sector composition of both the value and growth indexes changes over time.2 Chart 14 shows the current sector weights of S&P Pure Value and Pure Growth Indexes.3 It’s clear that now a bet on Pure Value versus Pure Growth is essentially a bet on Financials (which account for 35% of the Pure Value index) versus Tech and Healthcare (which together account for 38% of the Pure Growth index) - see also Chart 13, panel 2. Given the cyclical nature of the value/growth ratio and also the sector concentration, it’s not surprising that the value/growth play is also a play on euro area versus U.S. equities (Chart 13, panel 3). Currently, we are neutral on Financials and Tech, while overweight Healthcare in our global sector portfolio, and we are putting the euro area on an upgrade watch (see page 14). Therefore, maintaining a neutral stance between value and growth is in line with our sector and country views. However, a close watch for a possible upgrade of value is also warranted given the extreme valuation measures. Global Economy Overview: U.S. growth has slowed recently, though it remains more robust than in the more cyclical economies in Europe and emerging markets. Central banks almost everywhere have recently turned dovish. However, China’s increased monetary stimulus should help global growth bottom out in H2. This could lead the Fed and central banks in other healthy economies to return to a rate-hiking path. U.S.: The U.S. economy has been weak in recent months. The Citigroup Economic Surprise Index (Chart 15, panel 1) has collapsed, and the Fed NowCasts point to only 1.3-1.7% QoQ annualized GDP growth in Q1 (compared to 2.2% in Q4). But the slowdown is mostly due to the six-week government shutdown (which probably took 1% off growth), some seasonal adjustment oddities (which leave Q1 as the weakest quarter almost every year), and tighter financial conditions in H2 2018 which have now largely reversed. The manufacturing and non-manufacturing ISMs in February were still healthy at 54.2 and 59.7 respectively. Consumption (propelled by strong employment growth and accelerating wages) and capex remain strong (panel 3). BCA expects GDP growth in 2019 to be around 2.0-2.5%, still above trend. Euro Area: The European economy continues to slow, driven by weak exports to emerging markets, troubles in the banking sector, and political uncertainty. Q4 GDP growth was only 0.8% QoQ annualized, and the manufacturing PMI has fallen to 47.6 (with Germany as low as 44.7). But there are some early signs of an improvement. The ZEW Expectations index for Germany has bottomed (Chart 16, panel 1), fiscal policy should boost euro area growth this year by around 0.5 percentage points, and wage growth has begun to accelerate. The key remains Chinese stimulus, whose positive effects should help European exports recover sometime in H2. Chart 15U.S. Growth Slowing But Still Robust Chart 16Signs Of Bottoming In Global Ex-U.S.? Japan: Japan also remains highly dependent on a Chinese stimulus. Machine tool orders (the best indicator of capex demand from China) fell by 29% YoY in February. Despite stronger wage growth, now 1.2% YoY, inflation shows no signs of moving up towards the Bank of Japan’s target of 2%: ex energy and food CPI inflation is still only 0.4%. The biggest risk in 2019 is October’s planned consumption tax hike from 8% to 10%. Prime Minister Abe has said that he will cancel this only in the event of a shock on the scale of Lehman Brothers’ bankruptcy. The government has put in place measures to soften the impact (most notably a 5% rebate on purchases at small retailers after October 1 paid for electronically), but consumption is still likely to fall significantly. Emerging Markets: China seems to have ramped up its monetary stimulus, with total social financing in January and February combined up 12% over the same months last year. Recent data have shown signs of a stabilization of growth: the manufacturing PMI rebounded to 49.9 in February from 48.3, and fixed-asset investment beat expectations at 6.1% YoY in January and February combined. Nonetheless, the size of liquidity injection is likely to be smaller than in previous episodes such as 2016, since Premier Li Keqiang and the PBOC have warned of the risk of excessive speculation. Elsewhere, some emerging economies (notably Brazil and Mexico) have showed signs of recovery after last year’s deterioration, whereas others (such as South Africa, Indonesia, and Poland) continue to suffer. Interest rates: Central banks worldwide have generally turned more dovish in recent months, with the Fed and ECB both moving to signal no rate hikes this year. This has pushed down long-term rates globally, with 10-year bond yields falling below 0% again in Germany and Japan. However, with global growth likely to bottom over the next few months, rates may not stay at current depressed levels. U.S. inflation, in particular, continues to trend up, and the Fed’s target PCE inflation measure is likely to exceed 2% over coming months. We see the Fed turning more hawkish by year-end, and long rates globally more likely to rise than fall from current levels. Global Equities Chart 17Watch Earnings Remain Cautiously Optimistic: We added risk in our January Portfolio Update4 by putting cash back to work in global equities, and then in the March Portfolio Update5 we reduced the underweight in EM equities and increased the tilt to cyclicals at the expense of defensives, to hedge against a continuing acceleration in Chinese credit growth. All these came after our risk reduction in July 2018.6 GAA’s portfolio approach has always been to take risks where they are most likely to be rewarded. BCA’s macro view is that global economic growth data is likely to be on the weak side in the coming months, but will pick up in the second half. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. At the asset-class level, our positioning of overweight equities versus bonds while neutral on cash, reflects the “optimistic” side of our allocation. However, the rebound in global equities since the December sell-off has been driven completely by a valuation re-rating, while earnings growth has been revised down sharply. (Chart 17). As such, within global equities, our preference for low-beta countries (favoring DM versus EM, and favoring the U.S over the rest of DM) reflects the “cautious” aspect of our allocation. Our macro view hinges largely on what happens to China. There are signs that China may have abandoned its focus on deleveraging, yet it is too early to tell if it has switched back to a reflationary path. Therefore, our global equity sector overlay has a slight cyclical tilt by overweighting Industrials and Energy, which are among the main beneficiaries of Chinese reflationary policies or a positive resolution to U.S.-China trade negotiations. Chart 18Warming Up To The Euro Area Euro Area Equities: On Upgrade Watch We have favored U.S. equities relative to the euro area since July 2018.7 Since then, the U.S. has outperformed the euro area by 11% in USD terms and by 8% in local currency terms, with the difference being attributed to the weakness of the euro versus the U.S. dollar. Given BCA’s view on the global economy and the U.S. dollar, however, we are watching closely to switch our recommendation between the U.S. and euro area equities, for the following reasons: First, as shown in Chart 18, panel 1, the relative performance between the euro area and the U.S. is highly correlated with the EUR/USD exchange rate. BCA believes that the U.S. dollar is set for a period of weakness starting in the second half of the year,8 which bodes well for the outperformance of euro area equities. Second, relative earnings growth between the euro area and the U.S. is driven by the underlying strength of the economies, as represented by PMIs (panel 2). Both the relative earnings growth and relative PMI have stopped falling and have begun to bottom in favor of the euro area; Third, even though the euro area’s beta has been declining while that of the U.S. has increased, euro area beta is still higher than that in the U.S., making it more of a beneficiary of a global growth recovery; However, the relative valuation of euro area equities to their U.S. counterparts is now neutral not at the extreme level which historically has been a good entry-point into eurozone equities (panel 4). Chart 19Becoming Less Defensive Global Sector Allocation: Gradually Becoming Less Defensive GAA’s sector portfolio took profits on its pro-cyclical positioning and went defensive in July 20189 and remained so until the March Monthly update10 when we upgraded Energy and Industrials to overweight from neutral, while downgrading Consumer Staples two notches to underweight from overweight (Chart 19). The upgrade of Industrials was mainly a hedge against further acceleration in China’s credit growth. But why did we upgrade Energy to overweight yet maintained an underweight in Materials? Long-term GAA clients know that, in terms of global sector allocation, we have structurally favored the oil-related Energy sector to the metals-related Materials sector since October 2016, because oil supply/demand is more global in nature while the supply/demand of metals, especially industrial metals, is closely linked to China (see also the Commodity section of this Quarterly on page 18). From a cyclical perspective, the relative performance of the two sectors has historically closely correlated with the relative prices of oil and metals, as shown in panel 2. This is not surprising because changes in forward earnings for the two sectors are also closely linked to change in the corresponding commodity prices (panels 3 and 4). BCA’s Commodity and Energy Strategy service has an overweight rating on oil and a neutral stance on metals, implying that the growth in the oil price will outpace that of metal prices, which suggests that the Energy sector will outperform the Materials sector (panel 2). Government Bonds Maintain Slight Underweight On Duration. Global equities have recovered 16% since reaching the low of 2018 on December 24, yet the global bond yield has decreased by 21 bps over the same period. While the directional movement of bond yields is somewhat puzzling given such strong performance in equities (see page 7 for some explanations), it’s evident that the bond markets have been driven by the recent weakness in global growth (Chart 20, panel 3), and are pricing out any expectation of rate hikes over the coming year in major developed economies. Given the surprisingly dovish tone at the March FOMC meeting and BCA’s House View that global economic growth will rebound in the second half, bond yields are now highly exposed to any hawkish shift in central bank policies and any recovery in inflation expectations. As such, it’s still appropriate to maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Depressed inflation expectations have been one reason why global bond yields have decoupled from equities. However, the crude oil price, which closely correlates with inflation expectations, has stabilized. BCA’s Commodity & Energy Strategy service expects Brent crude to end 2019 at US$75 per barrel (Chart 21). This implies a significant rise in inflation expectations in the second half of the year, supporting our preference for inflation-linked bonds over nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest “buying TIPS on dips”. Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive versus their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Chart 20Rates: Likely More Upside Risk Chart 21Favor Inflation Linkers Corporate Bonds Chart 22Tactical Upside Remains For Credit In February, we raised credit to overweight within a fixed-income portfolio while underweighting government bonds. So far, this has proven to be the right decision, as corporate bonds have generated excess returns of 90 basis points over duration-matched Treasuries. We based our positioning on the mounting evidence that global growth is turning up: credit impulses are starting to rebound in several major economies, monetary conditions have eased, and our diffusion index of global leading indicators has rebounded sharply, indicating that there remains tactical upside for global credit (Chart 22– panel 1 and 2). When will we close our tactical overweight? Our U.S. Bond Strategy Service has set a target for spreads of U.S. corporate bonds with different credit ratings. According to their targets, which denote the median spread typical of late-cycle environments, there is still some room for further spread compression in non-AAA credits (Chart 22 – panel 3 and 4). However, the upside is limited and, if spreads keep tightening, we will probably close our position by the end of Q2. On a cyclical horizon, the fundamentals of corporate health are still a headwind, with both the interest-coverage and liquidity ratio for U.S. investment-grade corporates standing near 10-year lows.11 Moreover, we expect these ratios to deteriorate further, as corporate profits will likely come under pressure due to increasing wage growth. Finally, we expect that the Fed will turn more hawkish by the end of 2019, turning monetary policy from a tailwind to a headwind. Thus, we recommend investors to remain overweight, but be ready to turn bearish in the back end of the year. Commodities Chart 23Prefer Oil, Watch Metals Energy (Overweight): Stable demand, declining Venezuelan production due to U.S. sanctions, instability and possible outages in Libya, Iraq, and Nigeria, alongside the GCC’s commitment to cut output through year-end, should support oil prices and allow further upside (Chart 23, panels 1 & 2). While U.S. crude production is on the rise, bottlenecks in its export capabilities should limit market oversupply. Crude supply shocks should outweigh any slowdown in demand, specifically from emerging markets. BCA’s energy strategists expect Brent to average $75 and $80 throughout 2019 and 2020 respectively, and for the gap between WTI and Brent to narrow significantly. Industrial Metals (Neutral): China, the world’s largest consumer, still plays a big role in the direction of industrial metals. Year-to-date, metals prices have been supported partly by a more stable dollar. For now, we maintain a neutral stance until we see confirmation that Chinese stimulus will trigger further upside to metal prices perhaps in the second half. However, a lack of sustained Chinese demand, alongside weaker global growth over the next few months, would weigh down on metal prices (panel 3). Precious Metals (Neutral): Gold has reversed its downslide and rallied by over 10% from its Q4 2018 low. With the market pricing out any Fed rate hikes this year, rising inflation expectations, a weaker USD by year-end, and lower real rates should help gold outperform other commodities in this late-cycle phase. We recommend an allocation to gold as an inflation hedge, as well as a hedge against geopolitical risks (panel 4). Currencies Chart 24The End Of The Dollar Bull Market U.S. Dollar: Our bullish stance on the dollar has proven to be correct, as the trade-weighted dollar has appreciated by 5% in the past 12-months thanks to the slowdown in global growth. However, the two reasons for the growth slowdown – Fed tightening and Chinese deleveraging – have started to ease. On March 20 the Fed revised its forward guidance to no rate hikes in 2019 and only one rate hike in 2020. Meanwhile, Chinese total social financing relative to GDP has bottomed, indicating that Chinese authorities have opted for a pause in their deleveraging campaign (Chart 24, panel 1). These developments will likely boost global growth and hurt the countercyclical greenback. Therefore, we recommend investors to slowly shift to a cyclical underweight on the dollar. Euro: Most of the factors that dragged the euro down last year are fading: political risk in Italy has eased, fiscal policy is moving from a headwind to a tailwind, and the relative LEI between the EU and the US has started to pick up (panel 2). Moreover, we see little scope for euro area monetary policy to turn any more dovish versus the U.S., since forward rate expectations currently stand near 2014 lows (panel 3). Thus, we expect the euro to be one of the best performing currencies this year. Yen: Easy monetary policy by global central banks will boost asset prices and reduce volatility, creating a risk-on environment that is typically negative for the yen (panel 4). Moreover, the IMF still projects Japan to have a negative fiscal drag of 0.7% this year, which will force the BoJ to prolong its yield curve control regime. As a result, we expect the yen to be one of the worst performing currencies this year. Alternatives Intro: Investors’ allocation to alternatives is on the rise as we get closer to the end of the business cycle along with increasing realized volatility in traditional assets. In the alternatives assets space, we recommend thinking about allocations through three buckets: 1) return enhancers, means of outperforming traditional equity, fixed income, and mixed-asset strategies; 2) inflation hedges, means of preserving capital throughout periods of elevated inflation; and 3) volatility dampeners, means of reducing drawdowns and portfolio volatility during periods of market drawdowns. Return Enhancers: In our July and October 2018 Quarterly reports, we recommended investors trim back on PE allocations and reallocate towards hedge funds. Growing competition in the PE space has pushed up multiples. Given where the business cycle currently is, we favor macro hedge funds, as they tend to outperform in this sort of environment as well as in downturns and recessions (Chart 25, panel 1). Inflation Hedges: In our July 2018 Quarterly, we recommended investors pare back their real estate allocations, given the backdrop of a slowdown/sideways trend in the sector, and specifically within the retail segment. Given that the end of the current cycle is likely to be accompanied by elevated levels of inflation, we recommend clients to modestly allocate to commodity futures on the likelihood of a softer dollar and rising energy prices (panel 2). Volatility Dampeners: We continue to recommend both farmland and timberland since they have lower volatility than other traditional and alternative asset classes (panel 3). While timberland is more impacted by economic growth via the housing market, farmland has a near-zero correlation with economic growth. We do not favor structured products due to their unattractive valuations. Chart 25Prefer Hedge Funds Over Private Equity Risks To Our View Our economic outlook is quite sanguine. What would undermine this scenario? Many investors have become nervous about the inversion of the U.S. yield curve. And we have shown in the past that an inversion of the 3-month/10-year yield curve has been a reliable indicator of recessions 12-18 months ahead.12 Its inversion in March, then, is a concern. But note that the indicator works only using a three-month moving average (Chart 26); the curve often inverted for a brief period without signaling recession. We expect long-term rates to rise from here, steepening the curve. But a prolongation of the current inversion would clearly be a worrying signal. The direction of China continues to play a key role in defining the macro picture. Our current allocation is based on the view that China is doing some monetary and fiscal stimulus but that, at the current pace, it will be much smaller than in 2016 (Chart 27). The weak response of money supply growth suggests, as Premier Li Keqiang has complained, that the liquidity is mostly going into speculation (note that A-shares have risen by 20% this year) rather than into the real economy. The March Total Social Financing data, released in mid-April, will give a better read of the degree of the reflation. If it is bigger than we expect, this would suggest a quicker shift into euro area and Emerging Market equities than we currently advocate. The U.S. dollar remains a key driver of asset allocation. The dollar is a counter-cyclical currency and, with global growth slowing, has continued to appreciate moderately this year (Chart 28). We see a weakening of the dollar later this year, when global growth picks up. But if this were to happen more quickly or dramatically than we expect – not impossible given the currency’s over-valuation and crowded long-dollar positions – EM stocks and commodity prices, given their strong inverse correlation with the dollar, could bounce sharply. Chart 26Yield Curve Inversion Chart 27How Much Is China Reflating? Chart 28Dollar Is Counter-Cyclical Garry Evans, Chief Global Asset Allocation Strategist garry@bcaresearch.com Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com Juan Manuel Correa Ossa, Senior Analyst juanc@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com Footnotes 1 Please see the Equities Section of this Quarterly on page 14 for more details. 2 Please see Global Asset Allocation “GAA Quarterly,” dated March 31, 2016 available at gaa.bcaresearch.com 3 Please see https://us.spindices.com/documents/methodologies/methodology-sp-us-style.pdf 4 Please see Global Asset Allocation “Monthly - January 2019,” dated January 2, 2019 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation “Monthly - March 2019,” dated March 1, 2019 available at gaa.bcaresearch.com 6 Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 7 Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 8 Please see Global Investment Strategy Weekly Report, “What’s Next For The Dollar?” dated March 15, 2019 available at gis. bcaresearch.com 9 Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 10 Please see Global Asset Allocation “Monthly Portfolio Update,” dated March 1, 2019 available at gaa.bcaresearch.com 11 Based on BCA’s Global Fixed Income Strategy’s bottom-up health monitor. 12 Please see Global Asset Allocation Special Report, “Can Asset Allocators Rely On Yield Curves?” dated June 15, 2018 available at gaa.bcaresearch.com GAA Asset Allocation
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