BCA Indicators/Model
Highlights The risk/reward balance for risk assets remains unappealing this month, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The number of items that could take equity markets to new highs appears to fall well short of the number of potential landmines that could take markets down. Tensions vis-à-vis North Korea have eased, but the U.S./China trade war is heating up. Trump's voter base and many in Congress want the President to push China harder. Eurozone "breakup risk" has reared its ugly head once again. The Italian President is trying to install a technocratic government, but the interim between now and a likely summer election will extend the campaign period during which the two contending parties have an incentive to continue with hyperbolic fiscal proposals. The next Italian election is not a referendum on exiting the EU or Euro Area. Nonetheless, the risks posed by the Italian political situation may not have peaked, especially since Italy's economic growth appears set to slow. We are underweight both Italian government bonds and equities within global portfolios. It is also disconcerting that we have passed the point of maximum global growth momentum. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. One reason for the economic "soft patch" is that the Chinese economy continues to decelerate. Our indicators suggest that growth will moderate further, with negative implications for the broader emerging market complex. Dearer oil may also be starting to bite, although prices have not increased enough to derail the expansion in the developed economies. This is especially the case in the U.S., where the shale industry is gearing up. Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. Similar divergences are occurring in the inflation data. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. U.S. inflation is almost back to target and the FOMC signaled that an overshoot will be tolerated. Policymakers will likely transition from "normalizing" policy to targeting slower economic growth once long-term inflation expectations return to the 2.3%-2.5% range. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Feature The major stock indexes are struggling, even though 12-month forward earnings estimates continue to march higher (Chart I-1). One problem is that a lot of good earnings news was discounted early in the year. The number of items that could take markets to new highs appear to fall well short of the number of potential landmines that could take markets down. Not the least of which is ongoing pain in emerging markets and the return of financial stress in Eurozone debt markets. Last month's Overview highlighted the unappealing risk/reward balance for risk assets, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The advanced stage of the business cycle and our bias for capital preservation motivated us to heed the recent warnings from our growth indicators and 'exit' timing checklist. We also were concerned about a raft of geopolitical tensions. Fast forward one month and the backdrop has not improved. Our Equity Scorecard Indicator edged up, but is still at a level that historically was consistent with poor returns to stocks and corporate bonds (see Chart I-1 in last month's Overview). Our 'exit' checklist is also signaling that caution is warranted (Table I-1). Meanwhile, the "global synchronized expansion" theme that helped to drive risk asset prices higher last year is beginning to unravel and trade tensions are escalating. Chart I-1Struggling To Make Headway Table I-1Exit Checklist For Risk Assets U.S./Sino Trade War Is Back? The "on again/off again" trade war between the U.S. and China is on again as we go to press. Investors breathed a sigh of relief in mid-May when the Trump Administration signaled that China's minor concessions were sufficient to avoid the imposition of onerous new tariffs. However, the proposed deal did not go down well with many in the U.S., including some in the Republican Party. The President was criticized for giving up too much in order to retain China's help in dealing with North Korea. Trump might have initially cancelled the summit with Kim in order to send a message to China that he is still prepared to play hard ball on trade, despite the North Korean situation. We expect that U.S./North Korean negotiations will soon begin, and that Pyongyang will not be a major threat to global financial markets for at least the near term. It is a different story for U.S./China relations. Trump's voter base and many in Congress on both sides of the isle want the President to push China harder. This is likely to be a headwind for risk assets at least until the U.S. mid-term elections. The Return Of Eurozone Breakup Risk Turning to the Eurozone, "breakup risk" has reared its ugly head once again. Italian President Sergio Mattarella's decision to reject a proposed cabinet minister has led to the collapse of the populist coalition between the anti-establishment Five Star Movement (M5S) and the euroskeptic League. President Mattarella's choice for interim-prime minister, Carlo Cottarelli, is unlikely to last long. It is highly unlikely that he will be able to receive parliamentary support for a technocratic mandate, given the fact that he cut government spending during a brief stint in government from 2013-14. As such, elections are likely this summer. Chart I-2Italy: No Euro Support Rebound Investors continue to fret for two reasons. First, the interim period will extend the campaign period during which both M5S and the League have an incentive to continue with hyperbolic fiscal proposals. Second, M5S has suggested that it will try to impeach Mattarella, a long and complicated process that would heighten political risk, though it will likely fail in our view. As our geopolitical strategists have emphasized throughout 2017, Italy will eventually be the source of a major global risk-off event because it is the one outstanding major European country capable of reigniting the Euro Area break-up crisis.1 While a majority of Italians support the euro, they are less supportive than any other major European country, including Greece (Chart I-2). Meanwhile a plurality of Italians is confident that the future would be brighter if Italy were an independent country outside of the EU. That said, the next election is not a referendum on exiting the EU or Euro Area. The current conflict arises from the coalition wanting to run large budget deficits in violation of Europe's Stability and Growth Pact fiscal rules. Given that the costs of attempting to exit the Euro Area are extremely severe for Italy's households and savers, and that even the Five Star Movement has moderated its previous skepticism about the euro for the time being, it is likely going to require a recession or another crisis to cause Italy seriously contemplate an exit. We are still several steps away from such a move. Nonetheless, the risks posed by the Italian political situation may not have peaked. Italy's leading economic indicator points to slowing growth, which will intensify the populist push for aggressive fiscal stimulus. We are underweight both Italian government bonds and equities within global portfolios. Global Growth Has Peaked Chart I-3Past The Point Of Max Growth Momentum It is also disconcerting that we have passed the point of maximum global growth momentum, as highlighted by the indicators shown in Chart I-3. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. What is behind this year's loss of momentum? First, growth in 2017 was flattered by a rebound from the oil-related manufacturing recession of 2015/16. That rebound is now topping out, while worries regarding a trade war are undoubtedly weighing on animal spirits and industrial activity. Second, the Eurozone economy was lifted last year by the previous recapitalization of parts of the banking system, which allowed some pent-up credit demand to be satiated. This growth impulse also appears to have peaked, which helps to explain the sharp drop in some of the Eurozone's key economic indicators. Still, we do not expect European growth to slip back below a trend pace on a sustained basis unless the Italian situation degenerates so much that contagion causes significantly tighter financial conditions for the entire Eurozone economy. The third factor contributing to the global growth moderation is China. The Chinese economy surged in 2017 in a lagged response to fiscal and monetary stimulus in 2016, as highlighted by the Li Keqiang Index (LKI) and import growth (Chart I-4). Both are now headed south as the policy backdrop turned less supportive. Downturns in China's credit and fiscal impulses herald a deceleration in capital spending and construction activity (Chart I-4, bottom panel). The LKI has a strong correlation with ex-tech earnings and import growth. In turn, the latter is important for the broader EM complex that trade heavily with China. Weaker Chinese import growth has also had a modest negative impact on the developed world (Chart I-5). We estimate that, for the major economies, the contribution to GDP growth of exports to China has fallen from 0.3 percentage points last year to 0.1 percentage points now.2 Japan and Australia have been hit the hardest, but the Eurozone has also been affected. Interestingly, U.S. exports to China have bucked the trend so far. Chart I-4China Growth Slowdown... Chart I-5...Is Weighing On Global Activity China is not the only story because the slowdown in global trade activity in the first quarter was broadly based (Chart I-5). Nonetheless, softer aggregate demand growth out of China helps to explain why manufacturing PMIs and industrial production growth in most of the major developed economies have cooled. Our model for the LKI is still moderating. We do not see a hard economic landing, but our analysis points to further weakening in Chinese imports and thus softness in global exports and manufacturing activity in the coming months. Oil's Impact On The Economy... Finally, oil prices are no doubt taking a bite out of consumer spending power as Brent fluctuates just below $80/bbl. Our energy experts expect the global crude market to continue tightening due to robust growth and ongoing geopolitical tensions. Chief among these are the continuing loss of Venezuelan crude production and the re-imposition of U.S. sanctions on Iran. At the same time, we expect OPEC 2.0 to keep its production cuts in place in the second half of the year. Increasing shale output will not be enough to prevent world oil prices from rising in this environment, and we expect oil prices to continue to trend higher through 2018 and into early 2019 (Chart I-6). Brent could touch $90/bbl next year. There are a few ways to gauge the size of the oil shock on the economy. Chart I-7 shows the U.S. and global 'oil bill' as a share of GDP. We believe that both the level and the rate of change are important. Price spikes, even from low levels, do not allow energy users the time to soften the blow by shifting to alternative energy sources. Chart I-6Oil: Stay Bullish Chart I-7The Oil Bill The level of the oil bill is not high by historical standards. The increase in the bill over the past year has been meaningful, both for the U.S. and at the global level, but is still a long way from the oil shocks of the 1970s. U.S. consumer spending on energy as a share of disposable income, at about 4%, is also near the lowest level observed over the past 4-5 decades (Chart I-8). The 2-year swing in this series shows that rapid increases in energy-related spending has preceded slowdowns in economic growth, even from low starting points. The swing is currently back above the zero line but, again, it is not at a level that historically was associated with a significant economic slowdown. Chart I-8Oil's Impact On U.S. Consumer Spending Moreover, the mushrooming shale oil and gas industry has altered the calculus of oil shocks for the U.S. The plunge in oil prices in 2014-16 was accompanied by a manufacturing and profit mini recession in the developed countries, providing a drag on overall GDP growth. Chart I-9 provides an estimate of the contribution to U.S. growth from the oil and gas industry. We have included capital spending and wages & salaries in the calculation, and scaled it up to include spillover effects on other industries. Chart I-9Oil's Impact On Consumer Spending And Shale The oil and gas contribution swung from +0.5 percentage points in 2012 to -0.4 percentage points in 2016. The contribution has since become only slightly positive again, but it is likely to rise further unless oil prices decline in the coming months. We have included the annual swing in consumer spending on energy as a percent of GDP in Chart I-9 (inverted) for comparison purposes. At the moment, the impact on growth from the shale industry is roughly offsetting the negative impact on consumer spending. The bottom line is that the rise in oil prices so far is enough to take the edge off of global growth, but it is not large enough to derail the expansion in the developed countries. This is especially the case in the U.S., where the shale industry is gearing up. ...And Asset Prices As for the impact on asset prices, it is important to ascertain whether rising oil prices represent more restrictive supply or expanding demand. A mild rise in oil prices might simply be a symptom of increased demand caused by accelerating global growth. Higher oil prices are thus reflective of robust demand, and thus should not be seen as a threat. In contrast, the 1970s experience shows that supply restrictions can send the economy into a tailspin. In order to separate the two drivers of prices, we regressed WTI oil prices on global oil demand, inventories and the U.S. dollar. By excluding supply-related factors such as production restrictions, the residual of the regression model gives an approximate gauge of supply shocks (panel 2, Chart I-10). This model clearly has limitations, but it also has one key benefit: it estimates not just actual disruptions in supply, but also the premium built into prices due to perceived or expected future supply disruptions. For example, the 1990 price spike appears as quite a substantial deviation from what could be explained by changes in demand alone. Similar negative supply shocks are evident in 2000 and 2008. Chart I-10Identifying Supply Shocks In The Oil Market We then examined the impact that supply shocks have on subsequent period returns for both Treasury and risk assets. We divided the Supply Shock Proxy into four quartiles corresponding to the four zones shown in Chart I-10: strong positive shock, mild positive shock, mild negative shock and strong negative shock; the last of these corresponds to the region above the upper dashed line, which we have shaded in the chart. The performance of risk assets does not vary significantly across the bottom three quartiles of the supply shock indicator (Chart I-11). However, performance drops off precipitously in the presence of a strong negative supply shock. This is consistent with the "choke point" argument: investors are initially unconcerned with a modest appreciation in oil prices. It is only when prices are driven sharply above the level consistent with the current demand backdrop that risk assets begin to discount a more pessimistic future. The total returns to the Treasury index behave in the opposite manner (Chart I-12). Treasury returns are below average when the oil shock indicator is below one (i.e. positive supply shock) and above average when oil prices rise into negative supply shock territory. In other words, an excess of oil supply is Treasury bearish, as it would tend to fuel more robust economic growth. Conversely, a supply shock that drives oil prices higher tends to be Treasury bullish. This may seem counterintuitive because higher oil prices can be inflationary and thus should be bond bearish in theory. However, large negative oil supply shocks have usually preceded recessions, which caused Treasurys to rally. Chart I-11Effect On Risk Assets Chart I-12Effect On Treasurys The model clearly shows that the drop in oil prices in 2014/15 was a positive supply shock, consistent with the oil consumption data that show demand growth was fairly stable through that period. The model indicator has moved up toward the neutral line in recent months, suggesting that the supply side of the market is tightening up, but it is still in "mild positive supply shock" territory. The latest data point available is April, which means that it does not capture the surge in oil prices over the past month. Some of the recent jump in prices is clearly related to the cancelled Iran deal and other supply-related factors, although demand continues to be supportive of prices. The implication of this model is that it will probably require a significant further surge in prices, without a corresponding ramp up in oil demand, for the model to signal that supply constraints are becoming a significant threat for risk assets. A rise in Brent above US$85 would signal trouble according to this model. As for government bonds, rising oil prices are bearish in the near term, irrespective of whether it reflects demand or supply factors. This is because of the positive correlation between oil prices and long-term inflation expectations. The oil bull phase will turn bond-bullish once it becomes clear that energy prices have hit an economic choke point. Desynchronization Last year's "global synchronized growth" story is showing signs of wear. First quarter U.S. GDP growth was underwhelming, but the long string of first-quarter disappointment points to seasonal adjustment problems. Higher frequency data are consistent with a robust rebound in the second quarter. Forward looking indicators, such as the OECD and Conference Board's Leading Economic Indicators, continue to climb. This is in contrast with some of the other major economies, such as the Eurozone, U.K., Australia and Japan (Chart I-13). First quarter real GDP growth was particularly soft in Japan and the Eurozone, and one cannot blame seasonal adjustment in these cases. Chart I-13Growth & Inflation Divergences The divergence in economic performance likely reflects Washington's fiscal stimulus that is shielding the U.S. from the global economic soft patch. Moreover, the U.S. is less exposed to the oil shock and the China slowdown than are the other major economies. Similar divergences are occurring in the inflation data. While U.S. inflation continues to drift higher, it has lost momentum in the euro area, Japan and the U.K. (Chart I-13). Renewed stresses in the Italian and Spanish bond markets have sparked a flight-to-quality in recent trading days, depressing yields in safe havens such as U.S. Treasurys and German bunds. Nonetheless, prior to that, the divergence in growth and inflation was reflected in widening bond yield spreads as U.S. Treasurys led the global yields higher. Long-term inflation expectations have risen everywhere, but real yields have increased the most in the U.S. (prior to the flight-to-quality bond rally at the end of May). This is consistent with the growth divergence story and with our country bond allocation: overweight the U.K., Australia and Japan, and underweight U.S. Treasurys within hedged global portfolios. The dollar lagged earlier this year, but is finally catching up to the widening in interest rate spreads. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. Expect More Pain In EM Dollar strength and rising U.S. bond yields are a classic late-cycle combination that often spells trouble for emerging market assets. We do not see the recent selloff across EM asset classes as a buying opportunity since markets have only entered the first stage of the classic final chapter; EM assets underperform as U.S. bond yields and the dollar rise, but commodity prices are resilient. In the second phase, U.S. bond yields top out, but the U.S. dollar continues to firm and commodity prices begin their descent. If the current slowdown in Chinese growth continues, as we expect, it will begin to weigh on non-oil commodity prices. Thus, emerging economies may have to deal with a deadly combination of rising U.S. interest rates, a stronger greenback, falling commodity prices and slowing exports to China (Chart I-14). Which countries are most exposed to lower foreign funding? BCA's Emerging Market Strategy services has ranked EM countries based on foreign funding requirements (Chart I-15). The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-14EM Currencies Exposed To China Slowdown Chart I-15Vulnerability Ranking: Dependence On Foreign Funding Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. These mostly stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen as it becomes more difficult to service the foreign debt.3 It is too early to build positions even in Turkish assets. Our EM strategists believe that it will require an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms, to create a buying opportunity in Turkish financial instruments. FOMC Expects Inflation Overshoot Escalating turmoil in EM financial markets could potentially lead the Federal Reserve to put the rate hike campaign on hold. However, that would require some signs of either domestic financial stress or slowing growth. The FOMC is monitoring stress in emerging markets and in the Eurozone, but is sticking with its "gradual" tightening pace for now (i.e. 25 basis points per quarter). May's FOMC minutes signaled a rate hike in June. However, the minutes did not suggest that the Fed is getting more hawkish, despite the Staff's forecast that growth will remain above trend and that the labor market will continue to tighten at a time when core inflation is already pretty much back to target. Some inflation indicators, such as the New York Fed's Inflation Gauge, suggest that core inflation will overshoot. The minutes signaled that policymakers are generally comfortable with a modest overshoot of the 2% inflation target because many see it as necessary in order to shift long-term inflation expectations higher, into a range that is consistent with meeting the 2% inflation target on a "sustained" basis (we estimate this range to be 2.3-2.5% for the 10-year inflation breakeven rate). The fact that the FOMC took a fairly dovish tone and did not try to guide rate expectations higher contributed to some retracement of the Treasury selloff in recent weeks. Nonetheless, an inflation overshoot and rising inflation expectations will ultimately be bond-bearish, especially when the FOMC is forced to clamp down on growth as long-term inflation expectations reach the target range. As discussed in BCA's Outlook 2018, one of our key themes for the year is that risk assets are on a collision course with monetary policy because the FOMC will eventually have to transition from simply removing accommodation to targeting slower growth. Timing that transition will be difficult, and depends importantly on how much of an inflation overshoot the FOMC is prepared to tolerate. Is 2½% reasonable? Or could inflation go to 3%? The makeup of the FOMC has changed, but we expect Janet L. Yellen4 to shed light on this question when she speaks at the BCA Annual Investment Conference in September. Investment Conclusions The risks facing investors have shifted, but we do not feel any less cautious than we did last month. Geopolitical tensions vis-à-vis North Korea have perhaps eased. But trade tensions are escalating and investors are suddenly faced with another chapter in the Eurozone financial crisis. The major fear in the first and second chapters was that bond investors would attack Italy, given the sheer size of that economy and the size of Italian government debt. That dreadful day has arrived. The profit backdrop in the major economies remains constructive for equity markets. However, even there, the bloom is coming off the rose. Global growth is no longer synchronized and the advanced economies have hit a soft patch with the possible exception of the U.S. While far from disastrous, our short-term profit models appear to be peaking across the major countries (Chart I-16). Chart I-16Profit Growth: Solid, But Peaking The typical U.S. late cycle dynamics are also threatening emerging markets, at a time when investors are generally overweight and many EM countries have accumulated a pile of debt. U.S. inflation is set to overshoot the target, the FOMC is tightening and the dollar is rising. Throw in slowing Chinese demand and the EM space looks highly vulnerable. If the global economic slowdown is pronounced and drags the U.S. down with it, then bonds will rally and risk assets will take a hit. If, instead, the soft patch is short-lived and growth re-accelerates, then the U.S. Treasury bear market will resume. Stock indexes and corporate bond excess returns would enjoy one last upleg in this scenario, but downside risks would escalate once the Fed begins to target slower economic growth. Either way, EM assets would be hit. Our base case remains that stocks will beat government bonds and cash on a 6-12 month horizon. However, the risk/reward balance is unattractive given the geopolitical backdrop. Thus, we remain tactically cautious on risk assets for the near term. We still expect that the 10-year Treasury yield will peak at close to 3½% before this economic expansion is over. Nonetheless, this would require a calming of geopolitical tensions and an upturn in the growth indicators in the developed world. The risk/reward tradeoff for corporate bonds is no better than for equities and we urge caution in the near term. On a 6-12 month cyclical horizon, we still expect corporate bonds to outperform government bonds, at least in the U.S. European corporates are subject to the ebb and flow of the Italian bond crisis, and face the added risk that the ECB will likely end its QE program later this year. Looking further ahead, this month's Special Report, beginning on page 19, analyzes the Eurozone corporate sector's vulnerability to the end of the cycle that includes rising interest rates and, ultimately, a recession. We find that domestic issuers into the Eurozone market are far less exposed than are foreign issuers. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2018 Next Report: June 28, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available on gps.bcaresearch.com 2 This underestimates the impact on the major countries because it does not account for third country effects (i.e. trade with other countries that trade with China). 3 For more information, please see BCA Emerging Market Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018, available on ems.bcaresearch.com 4 Janet L. Yellen, Chair, Board of Governors, Federal Reserve System (2014-2018). II. Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. We previously identified the U.S. corporate bond market as a definite candidate. This month we look at European corporates. European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. Foreign issuers are much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond relative returns this year. More important will be the end of the ECB's asset purchase program. We recommend an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Risk assets remain on a collision course with monetary policy, which is the main reason why the "return of vol" is a key theme in the BCA 2018 Outlook. In the U.S., rising inflation is expected to limit the FOMC's ability to cushion soft patches in the economic data or negative shocks from abroad. We expect that ECB tapering will add to market stress, especially now that Eurozone breakup risks are again a concern. We also believe that geopolitics will remain a major source of uncertainty and volatility. All this comes at a time when corporate bond spreads offer only a thin buffer against bad news. On a positive note, we remain upbeat on the earnings outlook in the major countries. The U.S. recession that we foresaw in 2019 has been delayed into 2020 by fiscal stimulus. The longer runway for earnings to grow keeps us nervously overweight corporate bonds, at least in the U.S. That said, corporates are no more than a carry trade now that the lows in spreads are in place for the cycle. We are keeping a close eye on a number of indicators that will help us to time the next downgrade to our global corporate bond allocation. Profitability is just one, albeit important, aspect of the financial backdrop. What about the broader trend in financial health? Does the trend justify wider spreads even if the economy and profits hold up over the next year? We reviewed U.S. corporate financial health in the March 2018 monthly Bank Credit Analyst, using our bottom-up sample of companies. We also stress-tested these companies for higher interest rates and a medium-sized recession. We concluded that the U.S. corporate sector's heavy accumulation of debt in this expansion will result in rampant downgrade activity during the next economic downturn. As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. The U.S. corporate bond market is a definite candidate. This month we extend the analysis to the European corporate sector. The European Corporate Health Monitor The bottom-up version of the Corporate Health Monitor (CHM) is a complement to our top-down CHM, which uses macro data from the ECB to construct an index of six financial ratios for the non-financial corporate sector. While useful as an indicator of the overall trend in corporate financial health, it does not shed light on underlying trends across credit quality, countries and sectors. It also fails to distinguish between domestic versus foreign issuers in the Eurozone market. A number of features of the European market limit the bottom-up analysis to some extent relative to what we are able to do for the U.S.: the Eurozone market is significantly smaller and company data typically do not have as much history; foreign issuers comprise almost 50% of the market, a much higher percentage than in the U.S.; and the Financial sector features more prominently in the Eurozone index, but we exclude it because our CHM methodology does not lend itself well to this sector. We analyzed only domestic issuers in our study of U.S. corporate health. However, we decided to include foreign issuers in our Eurozone analysis in order to maximize the sample size. Moreover, it is appropriate for some bond investors to consider the whole picture, given that important benchmarks such as Barclay's corporate indexes include both foreign and domestic issuers. The relative composition of domestic versus foreign, investment-grade versus high-yield, and industrial sectors in our sample are comparable with the weights used in the Barclay's index. The CHM is calculated using the median value for each of six financial ratios (Table II-1). We then standardize1 the median values for the six ratios and aggregate them into a composite index using a simple average. The result is an index that fluctuates between +/- 2 standard deviations. A rising index indicates deteriorating health, while a downtrend signals improving health. We defined it this way in order to facilitate comparison with trends in corporate spreads. Table II-1Definitions Of Ratios That Go Into The CHMs One has to be careful in interpreting our Eurozone Monitor. The bottom-up version only dates back to 2005. Thus, while both the level and change in the U.S. CHM provide important information regarding balance sheet health, for the Eurozone Monitor we focus more on the change. Whether it is a little above or below the zero line is less important than the trend. Top-Down Versus Bottom-Up Chart II-1 compares the top-down and bottom-up Eurozone CHMs for the entire non-financial corporate sector.2 The levels are different, although the broad trends are similar. Key differences that help to explain the divergence include the following: the top-down CHM defines leverage to be total debt as a percent of the market value of equity, while our bottom-up CHM defines it to be total debt as a percent of the book value of the company. The second panel of Chart II-1 highlights that the two measures of leverage have diverged significantly since 2012; the top-down CHM defines profit margins as total cash flow as a percent of sales. For data-availability reasons, our bottom-up version uses operating income/total sales; and most importantly, the top-down CHM uses ECB data, which includes only companies that are domiciled in the Eurozone. Thus, it excludes foreign issuers that make up a large part of our company sample and the Barclay's index. When we recalculate the bottom-up CHM using only domestic investment-grade issuers, the result is much closer to the top-down version (Chart II-2). Both CHMs have been in 'improving health' territory since the end of the Great Financial Crisis. The erosion in the profitability components during this period was offset by declining leverage, rising liquidity and improving interest coverage for domestic issuers. Chart II-1Top-Down Vs. Bottom-Up Chart II-2Top-Down Vs. Domestic Bottom-Up It has been a different story for foreign IG issuers (Chart II-3). These firms have historically enjoyed a higher return on capital, operating margins, interest coverage, debt coverage and liquidity. Nonetheless, heavy debt accumulation has undermined their interest- and debt-coverage ratios in absolute terms and relative to their domestic peers until very recently. In other words, while domestic issuers have made an effort to clean up their balance sheets since the Great Recession, financial trends among foreign issuers look more like the trends observed in the U.S. No doubt, this is in part due to U.S. companies issuing Euro-denominated debt, but there are many other foreign issuers in our sample as well. Some analysts prefer total debt/total assets to the leverage measure we use in constructing our CHMs. However, the picture is much the same; leverage among IG domestic and foreign firms has diverged dramatically since 2010 (Chart II-4). Chart II-3Bottom-Up: Domestic Vs. Foreign IG Chart II-4Diverging Leverage Trends Over the past year or so there has been some reversal in the post-Lehman trends; domestic health has stabilized, while that of foreign issuers has improved. Leverage among foreign companies has leveled off, while margins and the liquidity ratio have bounced. The results for high-yield (HY) issuers must be taken with a grain of salt because of the small sample size. Chart II-5 highlights that the HY CHM is improving for both domestic and foreign issuers. Impressively, leverage is declining for both the domestic and foreign components. The return on capital, interest coverage, and debt coverage have also improved, although only for foreign issuers. Chart II-5Bottom-Up: Domestic Vs. Foreign HY Corporate Sensitivity The bottom line is that, while there have been some relative shifts below the surface, the European corporate sector's finances are generally in good shape in absolute terms and relative to the U.S. This is particularly the case for domestic issuers that have yet to catch the equity buyback bug. However, less accommodative monetary policy and rising borrowing rates have focused investor attention on corporate sector vulnerability. Downgrade risk will mushroom if corporate borrowing rates continue rising and, especially, if the economy contracts. If there is a recession in Europe in the next few years it will likely be as a result of a downturn in the U.S. We expect a traditional end to the U.S. business cycle; the Fed overdoes the rate hike cycle, sending the economy into a tailspin. The U.S. downturn would spill over to the rest of the world and could drag the Eurozone into a mild contraction. We estimated the change in the interest coverage ratio for the companies in our bottom-up European sample for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt (i.e. the coupons reset only for the bonds, notes and loans that mature in the next three years). We make the simplifying assumptions that all debt and loans maturing in the next three years are rolled over, but that companies do not take on net new obligations. We also assume that EBIT is unchanged in order to isolate the impact of higher interest rates. The 'x' in Chart II-6 denotes the result of the interest rate shock only. The 'o' combines the interest rate shock with a recession scenario, in which EBIT contracts by 15%. The interest coverage ratio declines sharply when rates rise by 100 basis points, but the ratio moves to a new post-2000 low only for foreign issuers. The ratio for domestic issuers falls back to the range that existed between 2009 and 2013. The median interest coverage ratio drops further when we combine this with a 15% earnings contraction in the recession scenario. Again, the outcome is far worse for foreign than it is for domestic issuers. Chart II-7 presents a shock to the median debt coverage ratio. Since debt coverage (cash flow divided by total debt) does not include interest payments, we show only the recession scenario result that reflects the decline in profits. Once again, foreign issuers appear to be far more exposed to an economic downturn than their domestic brethren. Chart II-6Interest Coverage Shocks Chart II-7Debt Coverage Shock Indeed, the results for foreign issuers are qualitatively similar to the shocks we previous published for our bottom-up sample of IG corporates in the U.S. (Chart II-8 and Chart II-9). In both cases, higher interest rates and contracting earnings will take the interest coverage and debt coverage ratios into uncharted territory. Chart II-8U.S. Interest Coverage Shocks Chart II-9U.S. Debt Coverage Shock Conclusions European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers, where balance sheet activity has focused on lifting shareholder value since the last recession. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. There has been a small convergence of financial health between Eurozone domestic and foreign issuers over the past year or so, but the latter are still much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond returns relative to European government bonds or to U.S. corporates this year. More important will be the end of the ECB's asset purchase program later in 2018. We expect spreads to widen as this important liquidity tailwind fades. For the moment, our Global Fixed Income Strategy service recommends an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Standardizing involves taking the deviation of the series from the 18 quarter moving average and dividing by the standard deviation of the series. 2 Note that a rising CHM indicates deteriorating health to facilitate comparison with quality spreads. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in May. We remain cautious, despite the supportive profit backdrop. The U.S. net earnings revisions ratio fell a bit in May, but it remains well in positive territory. Forward earnings continued their ascent, and the net earnings surprise index rose further to within striking distance of the highest levels in the history of the series. Normally, an earnings backdrop this strong would justify an overweight equity allocation within a balanced portfolio. Unfortunately, a lot of good earnings news is discounted based on our Composite Valuation Indicator and extremely elevated 5-year bottom-up earnings growth expectations (see the Bank Credit Analyst Overview, May 2018). Moreover, our equity indicators are sending a cautious signal. Our U.S. Willingness-to-Pay indicator continued to decline in May. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Our Revealed Preference Indicator (RPI) for stocks remained on its 'sell' signal in May, for the second month in a row. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Moreover, our composite equity Technical Indicator is on the verge of breaking down and our Monetary Indicator moved further into negative territory in May. Meanwhile, market froth has not been completely extinguished according to our Speculation Indicator (which is a negative sign for stocks from a contrary perspective). As for bonds, the powerful rally at the end of May has undermined valuation, but the 10-year Treasury is not yet in expensive territory. Our technical indicator suggests that previously oversold conditions are easing, but bonds are a long way from overbought. This means that yields have room to fall further in the event of more bad news on Italy or on the broader geopolitical scene. The dollar has not yet reached overbought territory according to our technical indicator. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst
Dear Clients, Please note that next week's report will be a joint effort with our geopolitical team, focused on North Korea. The report will be sent to you two days later than usual, on Friday June 8. Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Highlights Most episodes of negative relative Chinese equity performance this year have been driven by global stock market selloffs or related to the trade dispute with the U.S. Since Chinese ex-tech stocks have continued to outperform their global peers during this period, we recommend against downgrading China for now, barring hard evidence of a pernicious global slowdown or that severe protectionist action from the U.S. will indeed occur. Our list of charts to watch over the coming months highlights, among several other important points, that monetary conditions are not overly restrictive and that financial conditions are not tightening sharply. This is in spite of a recent clustering in corporate bond defaults that has concerned some investors. Besides broad-based stimulus in response to an impactful trade shock, a sustained pickup in housing construction remains the most plausible catalyst for an acceleration in domestic demand. For now tepid sales volume casts doubt on this scenario, but investors should continue to watch Chinese housing market dynamics closely. Feature There have been several developments affecting Chinese and global stock markets over the past two weeks. On the trade front, Secretary Mnuchin's statement on May 20 that the U.S. would be "putting the trade war" with China on hold was greeted by a material pushback from Congressional Republicans, particularly the administration's plan to ease previously announced sanctions on ZTE Group. The administration's trade rhetoric has since become more hawkish, as evidenced by yesterday's statement from the White House that referenced specific dates for the imposition of tariffs and the announcement of new restrictions on Chinese investment. This uptick in tough language sets the scene for Secretary Ross' Beijing visit this weekend to continue negotiations. More recently, a political crisis in Italy has caused euro area periphery bond yields to rise sharply, roiling global financial markets. The Italian President's rejection of Paolo Savona as proposed finance minister by the anti-establishment Five Star Movement (M5S) and Euroskeptic Lega has led to the installation of a caretaker government until the fall, when new elections are set to take place. The sharp tightening in financial conditions for Italy and Spain over the past week has exacerbated concerns about a potential growth slowdown in Europe, and has fed a relative selloff in emerging market equities that began in late-March. Despite the recent turmoil, our recommendation to investors is to avoid making any major changes to their allocation to Chinese ex-tech stocks within a global portfolio. Unless presented with hard evidence that the slowdown in the global economy is more than a simple deceleration from an above-trend pace, or that protectionist action from the U.S. will occur in a severe fashion, Table 1 suggests that investors should stay overweight Chinese ex-tech stocks (with a short leash). The table highlights that most episodes of negative relative Chinese ex-stock performance since the beginning of the year been driven by global stock market selloffs or related to the trade dispute with the U.S., despite the ongoing slowdown in China's industrial sector that we have repeatedly flagged. Since Chinese ex-tech stocks have continued to outperform their global peers during this period, our interpretation is that investors are well aware of the deceleration in China's economy, but do not yet regard it as a material threat to ex-tech equity prices. Table 1YTD Weakness In Chinese Stock Prices Has Been Driven By Global Events Clearly, however, this assessment on the part of global investors can change, underscoring that the situation in China merits continual re-assessment. With the goal of providing investors with a toolkit to continually monitor the state of the Chinese economy and the resulting implications for related financial asset prices, this week's report presents a list of 11 charts "to watch" across five categories of analysis. In our view these charts span key potential inflection points for the economic and profit outlook, and will serve as an important basis for us to update our view on China over the months ahead. Monetary & Fiscal Policy Chart 1: The Policy Rate Versus Borrowing Rates Chart 1Borrowing/Policy Rate Divergence Should Not Last,##br## But Is Worth Monitoring An interesting divergence has occurred lately between the 3-month interbank repo rate (currently the de-facto policy rate) and both corporate bond yields and the average lending rate. While the repo rate fell non-trivially after it became apparent in late-March that the PBOC would extend the deadline for the implementation of new regulatory standards for asset management products, corporate bond yields have recently risen sharply and China's weighted-average lending rate ticked higher in Q1. As we highlighted in last week's Special Report, the recent clustering of corporate bond defaults does not (for now) appear to be a source of systemic risk. First, by our estimation, the recent defaults cited above account for only 0.09% of outstanding corporate bonds. Second, the latest PBOC monetary report changed the tone from emphasizing "deleveraging" to "stabilizing leverage and restructuring", which shows that regulators are as concerned about the stability of the economy as they are about reducing excessive debts. But the possibility remains that the ongoing crackdown on China's shadow banking sector will cause some degree of persistence in the recent divergence between the interbank market and actual borrowing rates, implying that investors should continue to watch Chart 1 over the months for signs of materially tighter financial conditions. Chart 2: The Correlation Between Sovereign Risk And The Repo Rate We noted in a February Special Report that investors could use the rolling 1-year correlation between the 3-month interbank repo rate and the relative sovereign CDS spread between China and Germany as a gauge of whether Chinese monetary policy has become too restrictive for its economy.1 Despite the fact that actual sovereign credit risk in China is extremely low, Chart 2 shows that the relative CDS spread has acted as a good bellwether for growth conditions in the Chinese economy. It shows that the correlation between this spread and the 3-month interbank repo rate was initially positive in late-2016 (representing concern on the part of investors that monetary policy is restrictive), but has since come back down into negative territory. Interestingly, the correlation was consistently positive from mid-2011 to mid-2014, when average lending rates averaged 7% or higher and the benchmark lending rate exceeded the IMF's Taylor Rule estimate by about 1%.2 For now the correlation remains negative (as it was when we published our February report), meaning that it currently supports our earlier conclusion that monetary conditions are not overly restrictive and that financial conditions more generally are not tightening sharply (despite the recent rise in corporate bond yields). Chart 2No Sign Yet That Monetary Policy Is Overly Restrictive Chart 3Watch For Signs Of Fiscal Stimulus Chart 3: The Fiscal Spending Impulse Chart 3 presents the Chinese government's budgetary expenditure as an "impulse", calculated as expenditure over the past year as a percent of nominal GDP. Panel 2 shows the year-over-year change in the impulse. When compared with a similar measure for private sector credit, cyclical fluctuations in China's government spending impulse are relatively small. For this reason, BCA's China Investment Strategy service has not strongly emphasized fiscal spending as a major driver of China's business cycle. However, we also noted in a recent report that fiscal stimulus stands out as one of the "least bad" options available to policymakers to combat a negative export shock from U.S. protectionism, were one to occur.3 The potential for broader stimulus from Chinese authorities in response to an impactful trade shock raises the interesting possibility of another economic mini cycle in China, since the economy accelerated meaningfully in response to the last episode of material fiscal & monetary easing. As such, investors should closely watch over the coming months for signs that fiscal spending is accelerating, particularly if combined with potential signs of easing monetary policy. External Demand Chart 4: Global Demand And Chinese Export Growth Chart 4For Now, Resilient Exports ##br##Are Supporting China's Economy We have noted in several recent reports that a resilient export sector remains the most favorable pillar of Chinese growth. Besides the clear risk to Chinese trade from U.S. protectionism, two other factors have the potential to negatively impact the trend in export growth. The first (and most important) of these risks is a reduction in global demand, which some investors have recently been concerned about given the decline in global manufacturing PMIs. However, Chart 4 highlights that our global PMI diffusion indicator has done an excellent job of leading the global PMI over the past few years, and has barely registered a decline over the past few months. From our perspective, the odds are good that the recent deceleration in the PMI has been caused by sudden caution (even in developed countries) over the Trump administration's protectionist actions, and does not reflect a material or long-lasting slowdown in the global economy. But we will be closely watching the PMI releases over the coming months to rule out a more painful slowdown in global demand. Importantly, we have also highlighted that stronger exports may actually presage a further slowdown in China's industrial sector if it emboldens policymakers to intensify their reform efforts over the coming year. We argued in our May 2 Weekly Report that China's reform pain threshold is positively correlated with global growth momentum,4 meaning that the external sector of China's economy may have less potential to counter weakness in the industrial sector than many investors believe. In this regard, extreme export readings (to the up and downside) should be regarded by investors as a potentially problematic development. Chart 5: The Competitiveness Impact Of A Rising RMB Chart 5 highlights the second non-protectionist risk to Chinese export growth, namely the significant appreciation in the RMB that has occurred since mid-2017. The chart shows the percentile rank of three different trade-weighted RMB indexes since 2014, and highlights that all three are between their 70th & 80th percentiles (with our BCA Export-Weighted RMB index having risen the most). Importantly, the 2015-high shown in Chart 5 represents the strongest point for the currency in over two decades, suggesting that further currency strength may exacerbate the significant deceleration in export prices that has already occurred. Chart 5A Surging RMB Could Undercut Competitiveness Housing Chart 6: Housing Sales Versus Starts We have presented a variation of Chart 6 several times over the past few months, but it is important enough that it deserves to be continually monitored by investors over the coming year. Chart 6 tells the story of China's housing market from the perspective of an investor who is primarily interested in the sector because of its implications for growth. The chart highlights that residential floor space started, our best proxy for the real contribution to growth from residential investment, has fallen significantly relative to sales since 2012-2014. This appears to have occurred because of a significant build up in housing inventories, which has since reversed materially (even though the level remains elevated). To us, this suggests that the gap between housing sales and construction that has persisted for the past several years may finally be over, suggesting that the latter may pick up durably if sales trend higher. For now sales volume remains tepid, but this will be a key chart for investors to watch over the coming year given our view that housing is a core pillar of China's business cycle. The Industrial Sector Chart 7: The BCA Li Keqiang Leading Indicator And Its Components Chart 7 presents our leading indicator for the Li Keqiang index (LKI), which we developed in a November Special Report.5 There are six components of the indicator, all of which are related to changing monetary/financial conditions, and the growth in money and credit. Chart 6Housing Construction Could Accelerate##br## If Sales Pick Up Chart 7A Downtrend In Our LKI Leading Indicator, ##br##Within A Wide Component Range The indicator is at the core of our view, and we have been presenting monthly updates of the series in our regular reports since late last year. However, Chart 7 looks at the indicator from a different perspective, by showing it within a range that identifies the weakest and strongest components at any given point in time. Two points are noteworthy from the chart: While the overall LKI indicator has been trending down since early-2017, there is currently a wide range between the components. This gap is in stark contrast to the very narrow range that prevailed from 2014-2015, when the economy slowed considerably. This could mean that some of the components of the indicator are unduly weak, which in turn could imply that the severity of the slowdown in China's industrial sector will be less intense than the overall indicator would otherwise suggest. At least one component provided a lead on the subsequent direction of the overall indicator from late-2011 to late-2012, the last time that a significant gap existed between the components. This is in contrast to the situation today, in that all of the components are currently in a downtrend (albeit with differing paces as well as magnitudes). The key point for investors from Chart 7 is that all of the components of our indicator are moving in the same direction, which suggests with high conviction that China's economy is slowing. However, the wide range among the components suggests that indicator's message about the intensity of the slowdown is less uniform than it has been in the past, meaning that investors should be sensitive to a sustained pickup in the top end of the range. Equity Market Signals Chart 8: The Beta Of Our BCA China Sector Alpha Portfolio Chart 8 revisits a unique insight that we presented in our May 16 Weekly Report.6 The chart shows the rolling 1-year beta of our BCA China Investable Sector Alpha Portfolio versus the investable benchmark alongside China's performance versus global stocks, and suggests that the former may reliably lead the latter. While we noted in the report that drawing market-wide inferences from the beta characteristics of risk-adjusted performers is a not a conventional approach, finance theory is supportive of the idea. If investors are seeking to maximize their risk-adjusted returns and are engaging in tactical allocation across sectors, then it is entirely possible that beta-adjusted sector returns reflect the risk-on/risk-off expectations of market participants. For the purposes of China-related investment strategy over the coming year, our emphasis on Chart 8 will increase markedly if we see a sharp decline in the beta of our Sector Alpha Portfolio. As we noted in our May 16 report, the model is for now sending a curiously bullish signal, which we see as partial validation of our view that investors should have a high threshold to cut exposure to China within a global equity portfolio. Chart 8Watch For A Decline In The Beta Of ##br##Our Sector Alpha Portfolio Chart 9Decelerating Earnings Growth Could##br## Undermine Investor Sentiment Chart 9: Ex-Tech Earnings Versus The Li Keqiang Index We noted above that predicting the Li Keqiang index (LKI) is at the core of our view, and Chart 9 highlights why. The chart shows that a model based on the LKI closely fits the year-over-year growth rate of Chinese investable ex-tech earnings and, crucially, provides a lead. While the chart does not suggest that an outright contraction in ex-tech earnings is in the cards over the coming year, it does show that earnings growth is about to peak. This is potentially problematic, and warrants close attention, for two reasons: First, our leading indicator for the LKI suggests that it will decelerate further over the coming year, which could push our earnings growth estimate towards or below zero. Second, the peak in earnings growth could dampen investor sentiment towards Chinese ex-tech stocks, especially since bottom up analyst estimates for 12-months forward earnings growth have recently moved higher and are currently above what is predicted by our model. Chart 10: The Alpha Of Chinese Banks By now, the narrative surrounding Chinese banks is well known among global investors. The enormous leveraging of China's non-financial corporate sector is viewed by many as a clear sign of capital misallocation, meaning that a (potentially material) portion of the loan book of Chinese banks will have to be written off as bad debt. The ultimate scope of the bad debt problem in China is far from clear, but these longstanding concerns about loan quality suggest that Chinese bank stocks are likely to materially underperform their global peers if China's shadow banking crackdown begins to pose a significant threat to growth via restrictions on the provision of credit to the real economy. As such, we recommend that investors monitor Chart 10 over the coming year, which shows the rolling 1-year alpha significance for Chinese banks vs their global peers. While the rolling 1-year alpha of small banks has become less positive over the past few weeks, it remains in positive territory, similar to that of investable bank stocks. So, for now, this indicator supports our earlier conclusion that recent divergence between the interbank market and actual borrowing rates highlighted in Chart 1 is not heralding a material tightening in Chinese financial conditions. Chart 10Investors Should Monitor Chinese Bank Alpha ##br##For Significant Declines Chart 11No Technical Breakdown (Yet) In Ex-Tech Relative Performance Chart 11: The Technical Performance Of Ex-Tech Stocks BCA's approach to forecasting financial markets rests far more on top-down macroeconomic assessments than it does on technical analysis. However, technical indicators do contain important information, particularly when our top-down macro approach signals that a change in trend may be imminent. In this regard, technical indicators can provide valuable opportunities to enter or exit a position. To the extent that the technical profile of Chinese ex-tech stocks is informative in the current environment, Chart 11 shows that it is telling investors to stay invested despite the myriad risks to the economic outlook. This message is consistent with that of Table 1, namely that the negative performance of Chinese ex-tech stocks has been in response to global rather than idiosyncratic, China-specific risk. From our perspective, a technical breakdown in relative Chinese ex-tech stock performance in response to China-specific news would serve as a strong basis for a downgrade within a global equity portfolio, and we will be monitoring closely for such a development over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Seven Questions About Chinese Monetary Policy", dated February 22, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Monetary Tightening In China: How Much Is Too Much?" dated January 18, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Question That Won't Go Away", dated April 18, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "China: A Low-Conviction Overweight", dated May 2, 2018, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 6 Please see China Investment Strategy Weekly Report, "The Three Pillars Of China's Economy", dated May 16, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights 0 To 3 Months: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. 6 to 12 Months: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. Total Return Forecasts: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Feature Chart 1Two Milestones The U.S. bond market reached one noteworthy milestone last week and is quickly closing in on another. The first milestone is that the 10-year Treasury yield decisively broke through the 3% level that had defined its most recent peak (Chart 1). The second milestone is that the market is now close to fully pricing-in the likely near-term path for Fed rate hikes. We noted in a recent report that the Fed's "gradual" rate hike path is quite clearly defined as one 25 basis point rate hike per quarter.1 This equates to 100 bps on our 12-month Fed Funds Discounter, which currently sits at 91 bps, just below this key level (Chart 1, bottom panel). We continue to see upside in Treasury yields on a cyclical horizon. Though tactically, the likelihood of a near-term pullback in yields has increased greatly during the past few days. In this week's report we outline the case for a near-term (0-3 month) pullback in Treasury yields, but also look ahead by introducing a simple framework investors can use to make total return forecasts for all different U.S. bond sectors. The Case For A Near-Term Pullback In addition to the fact that the market is closer to fully discounting the likely near-term path of rate hikes than it has been for some time, there are two other reasons to expect a near-term, temporary pullback in yields. The first is that the below-benchmark duration trade has become the consensus position in the market (Chart 2). Net speculative short positions in 10-year Treasury futures have rarely been greater, and since the financial crisis large net short positions have correlated quite strongly with a decline in the 10-year yield during the subsequent three months. Similarly, positions reported in the JP Morgan Duration Survey are firmly in "net short" territory for both the "all clients" and "active clients" surveys. The Marketvane survey of bond sentiment has also turned bearish for only the fourth time since 2010. Each of the other three times has coincided with a near-term drop in yields. Chart 2Bond Market Looks Oversold But positioning alone would not be enough to convince us that yields might decline in the near-term. Investors also need a catalyst. An excuse to take profits on large net short positions that have been working well. That catalyst is typically a period of worse-than-expected economic data. To judge the trend in economic data relative to expectations we turn to the Economic Surprise Index. Chart 3Economic Surprise Index In a report from last year we demonstrated that if the Economic Surprise Index ends a month below (above) the zero line, it is very likely that Treasury yields fell (rose) during that month.2 Also, we know that the surprise index is mean reverting by its very nature. A long period of positive (negative) data surprises will certainly be followed an upward (downward) revision to investors' economic expectations. Eventually expectations become so elevated (depressed) that they become impossible to surpass (disappoint). The index will then start to mean revert. In that same report from last year we also introduced a simple auto-regressive model of the surprise index, designed to capture its average speed of mean reversion. Based on that model, which is purely a function of the index's own lags, we would expect the surprise index to dip slightly into negative territory in one month's time (Chart 3). Though given the large amount of uncertainty in the model, a fairer assessment would be that it is no longer a given that the surprise index will remain above the zero line in the near-term. Bottom Line: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. Less nimble investors are better off riding out any potential near-term volatility and maintaining below-benchmark portfolio duration on a 6-12 month horizon. The Cyclical Picture Is Unchanged On a 6-12 month investment horizon, we are sticking with the playbook of our Two-Stage Bond Bear Market.3 The first stage is characterized by the re-anchoring of inflation expectations, and here, long-maturity TIPS breakeven inflation rates are still slightly below our target range of 2.3% to 2.5% (Chart 4). We also think bond investors should maintain an overweight allocation to spread product, though the time to trim exposure is approaching. Because the Fed's support for credit markets will weaken as inflation pressures mount, we will start reducing exposure to spread product once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are within our target 2.3% to 2.5% band. The intuition that the credit cycle is long in the tooth is further supported by the fact that the 2/10 Treasury curve is close to 50 bps (Chart 4, bottom panel). In a recent report we showed that while corporate bond excess returns relative to Treasuries usually remain positive until the yield curve inverts, they decline dramatically once the slope dips below 50 bps.4 Valuation also remains tight in the corporate bond market. While investment grade corporate bond spreads have widened in recent months, the junk spread is still close to its post-crisis low, as is the differential between the junk and investment grade spread (Chart 5). Chart 4Inflation Compensation Chart 5Flirting With The Lows The recent widening of investment grade corporate spreads appears to simply reflect a reversion to more reasonable valuation levels, after they had been extremely expensive at the start of the year. Chart 6 shows the 12-month breakeven spread for each investment grade credit tier. We look at the breakeven spread - defined as the spread widening required to lose money versus Treasuries on a 12-month horizon - in order to adjust for the changing duration of the index over time. Chart 6 also shows the breakeven spread as a percentile rank relative to history. In other words, it shows the percentage of time that the breakeven spread has been lower in the past. Notice that earlier in the year investment grade corporate spreads had been approaching all-time expensive levels. They are now closer to the 25th percentile, much more in line with similar spreads for the High-Yield credit tiers (Chart 7). Chart 6Investment Grade Breakeven Spreads Chart 7High-Yield Breakeven Spreads There is no longer a risk-adjusted opportunity in high-yield corporate bonds relative to investment grade. Bottom Line: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. A Simple Framework For Forecasting Total Returns In a recent report we observed that, using a 12-month investment horizon, the difference between market expectations for the change in the federal funds rate and the actual change in the federal funds rate closely tracks the price return from the Bloomberg Barclays Treasury index.5 With that in mind, this week we extend that analysis to develop a simple framework for forecasting bond total returns. The framework relies on the fact that the "12-month rate hike surprise" described above is correlated with the 12-month change in Treasury yields. The Appendix to this report shows the historical correlation between the 12-month rate hike surprise and the 12-month change in several different par-coupon Treasury yields. Unsurprisingly, the correlation is very strong for short maturity yields, and gradually weakens as we move further out the curve. This is important because it means that the total return forecasts we generate from this exercise will be more accurate for bond sectors with low duration than for those with high duration. Table 1 shows the total return forecasts we generated for the Bloomberg Barclays Treasury Master Index and for several of its maturity buckets. The results are presented in such a way that readers can impose their own forecasts for the number of Fed rate hikes that will occur during the next 12 months, and then map that forecast to a reasonable expectation for Treasury total returns. Table 1Treasury Index Total Return Forecasts For example, in a scenario where the Fed lifts rates four times (100 bps) during the next year, given current market pricing the rate hike surprise will be modestly negative.6 Using the historical correlations shown in the Appendix, we map that rate hike surprise to changes in the par-coupon Treasury curve and then use the duration and convexity attributes of each individual index to determine how that shift in the Treasury curve will impact index returns. In the scenario described above we would expect the Treasury Master Index to return +2.13% during the next year. While this is a slightly positive number, it is close enough to zero that it does not provide much insulation from changes in long-dated yields that are unrelated to the near-term path for rate hikes. Further, in the four rate hike scenario, investors moving from the Treasury Master Index to the 1-3 year index need only sacrifice 12 bps of expected return to reduce their duration risk by a factor of three. Such a risk/reward trade-off clearly favors a below-benchmark duration stance on a 12-month investment horizon. Table 2 repeats the same exercise but for the major spread sectors of the U.S. bond market. To estimate spread sector total returns we need to forecast both the shift in the Treasury curve and whether spreads will widen, tighten or remain constant. Specifically, we assume that spreads either widen or tighten by the standard deviation of annual spread changes for each index, calculated using a post-crisis interval. Table 2Spread Product Total Return Forecasts The results show that, in a four rate hike scenario, we should expect 12-month investment grade corporate bond total returns of approximately 3.4%, assuming also that spreads stay flat. In a scenario where the average index spread widens by 42 bps, we should expect total returns of only 1%. Bottom Line: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Spread product returns should continue to beat Treasuries for the time being, but the window for outperformance is starting to close. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix Chart 8Change In 1-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 9Change In 2-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 10Change In 3-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 11Change In 5-Year Yield Vs.12-Month ##br##Fed Funds Rate Surprise Chart 12Change In 7-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 13Change In 10-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 14Change In 30-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Coming To Grips With Gradualism", dated May 8, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 6 The 12-month rate hike surprise is defined as the 12-month Fed Funds Discounter less the actual change in the fed funds rate during the following 12 months. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights An examination of the three pillars of China's economy provides an unambiguous signal that a slowdown is underway. This would normally warrant, at most, a neutral allocation to Chinese stocks, but several factors argue against cutting exposure for now. Stay overweight, but with a short leash. Recent changes in the BCA China Investable Sector Alpha Portfolio's recommended allocation have validated two of our recent investment recommendations. In addition, the model is providing a curiously bullish signal about the relative performance of Chinese vs global stocks that heightens our reluctance to reduce Chinese equity exposure. Our China Reform Monitor signals that investors do not view the current pace of structural reforms as being overly burdensome for the economy. In addition, while Chinese policymakers have made some significant gains in improving China's air quality over the past 18 months, these changes have mostly occurred from a near-hazardous starting point (suggesting that more progress will be needed). As such, we recommend that investors stick with our long ESG leaders / short investable benchmark trade over the coming year. Feature Global investor sentiment improved modestly on Monday, in response to statements from President Trump indicating a possible détente between the U.S. and China on the issue of trade. In particular, Mr. Trump signaled a willingness to assist ZTE, a Chinese telecommunications equipment maker, whose operations would have been enormously impacted by the U.S. Commerce Department's decision last month to ban American companies from selling to the firm. In the view of our Geopolitical Strategy Service, announcements like these should be viewed as marginally positive developments within the context of a serious downtrend in U.S./China relations. Investors appear to be eager to respond to positive news about waning U.S. protectionism, but the reality is that several important decisions related to the U.S.' section 301 probe have yet to be announced.1 As we noted in last week's Special Report,2 this underscores that the near-term risks to China from the external sector are clearly to the downside. Abstracting from the day-to-day assessment of the trade picture, we have emphasized that other core elements of the China outlook have deteriorated. As we present below, an aggregate view of the three pillars of China's economy continues to argue for a (contained) slowdown, with protectionism acting as a downside risk to an already sober economic outlook. Extremely cheap valuation and the high-beta nature of Chinese ex-tech stocks continue to justify an overweight stance versus global equities, but we recommend that investors keep Chinese stocks on downgrade watch for the remainder of Q2 as the risks to the Chinese economy warrant an ongoing assessment of what is currently a finely balanced equity allocation decision. Assessing The Three Pillars Chart 1 presents our stylized framework for analyzing China's economy. It highlights that China's business cycle is largely driven by three "pillars": industrial activity, the housing market, and trade. While the services sector, the Chinese consumer, and/or the technology sector are of interesting secular relevance, generally-speaking China's business cycle continues to be subject to its "old" growth model centered on investment and exports. Chart 1The Three Pillars Of China's Business Cycle Industrial Activity: We took an empirical approach to predicting China's industrial sector activity in our November 30 Special Report,3 and tested the ability of 40 different macro data series to lead the Li Keqiang index (LKI). While the LKI is closely followed and somewhat cliché, we have focused on it because of its strong correlation with ex-tech earnings and import growth. The results of our November report pointed to the success of monetary condition indexes, money supply, and credit measures to reliably predict the LKI since China's real GDP growth peaked in 2010. We constructed our BCA Li Keqiang Leading Indicator based on these measures, and we have frequently highlighted over the past few months that the indicator is pointing to a continued deceleration in China's industrial activity (Chart 2). Housing: We noted in our November report that housing market data also correlates with the LKI, albeit less well than the components of our Leading Indicator. One important observation about China's housing market that we highlighted in our February 8 Weekly Report is that residential floor space sold appears to have reliably led floor space started (a proxy for real residential investment) since 2010 (Chart 3). Over the past 6-8 months, however, floor space started appears to have diverged from the trend in floor space sold, which may have been caused by a non-trivial reduction in housing inventories over the past few years.4 Nonetheless, we also noted that the level of inventories remains quite elevated, suggesting that the uptrend in floor space started is unlikely to continue without a renewed uptrend in sales volume. In our view, this conclusion implies that the housing outlook over the coming 6-12 months is neutral, at best. Chart 2China's Industrial Sector ##br##Will Continue To Slow Chart 3Resi Sales Volume Does Not Point To ##br##A Sustained Pickup In Construction Trade: The third pillar of China's economy is the external sector, which remains important even though net exports have fallen quite significantly in terms of contribution to China's growth. We noted in our April 18 Weekly Report that there is a strongly positive relationship between the annual change in contribution to growth from China's net exports and subsequent gross capital formation, highlighting that external demand provides an important multiplier effect for Chinese activity. For now, nominal export growth (in CNY terms) remains at the high end of its 5-year range, reflecting the strength of the global economy. But three significant risks remain to the export outlook: 1) the clear and present danger of U.S. import tariffs, 2) the possibility that Chinese policymakers may accelerate their reform efforts to take advantage of the "window of opportunity" provided by robust global demand,4 and 3) the very substantial rise in the export-weighted RMB (Chart 4), which is fast approaching its 2015 high. As a final point on trade, Chart 5 highlights that the recent divergence between the LKI and nominal import growth is resolved when examining the latter in CNY terms. The chart suggests that while export growth has been buoyed by a strong global economy, China's contribution to the global growth impulse is diminishing. The very tight link demonstrated in Chart 5 also suggests that industrial activity is the most important pillar to watch among the three noted above, which means that Chart 2 argues for a negative export outlook for China's major trading partners. Chart 4A Non-Trivial Deterioration ##br##In Competitiveness Chart 5The Rise In CNYUSD Is Flattering ##br##Imports Measured In Dollars Our assessment of the three pillars of China's economy points to a conclusion that we have highlighted frequently in our recent reports: China's industrial sector is slowing, and there are downside risks to the export outlook. The character of the slowdown does not suggest that a major shock to the global economy is likely to emanate from China over the coming 6-12 months, but the outlook is more consistent with a reduction than an expansion in China's contribution to global growth. Under normal circumstances, at best this would warrant a neutral asset allocation outlook to China-related financial assets. Chart 6The Uptrend In Relative Chinese ##br##Ex-Tech Performance Is Intact However, we have also argued that the relatively attractive valuation and the technical profile of Chinese equities suggests that investors should have a high threshold for reducing their exposure to China within a global equity portfolio. Chart 6 highlights that Chinese ex-tech share prices continue to demonstrate resilient performance versus their global peers, despite the ongoing slowdown in China's economy. In addition, as we will note below, our BCA China Investable Sector Alpha Portfolio is providing a curiously bullish signal about the relative performance of Chinese stocks, which heightens our reluctance to cut exposure. Bottom Line: An examination of the three pillars of China's economy provides an unambiguous signal that a slowdown is underway. This would normally warrant, at most, a neutral allocation to Chinese stocks, but several factors argue against cutting exposure for now. Stay overweight, but with a short leash. Reading The Tea Leaves From Our Sector Alpha Portfolio We introduced our BCA China Investable Sector Alpha Portfolio in a January Special Report, in part to demonstrate that the concept of alpha persistence (i.e. alpha that is persistently positive or negative) has material implications for portfolio returns. In particular, we noted that the portfolio's strategy of allocating to China's investable equity sectors based on the significance of alpha has resulted in over 200bps of long-term outperformance versus the investable benchmark, without taking on any additional risk (Table 1). Table 1An Alpha-Based Sector Model Has Historically Outperformed China's Investable Stock Market Table 2 presents the portfolio's current allocation, relative to the current benchmark weights for each sector as well as the portfolio's sectoral allocation when we published our January report. Two observations are noteworthy: The model recommends an overweight allocation to resources; consumer staples; health care; utilities; and real estate, at the expense of industrials; consumer discretionary; financials; technology; and telecom services. These positions are largely in-line with the model's recommendations in January, except for a non-trivial increase in exposure to energy and financials, and a significant reduction in technology and consumer discretionary. The portfolio's reduced exposure to technology and consumer discretionary stocks validate two recent investment recommendations from BCA's China Investment Strategy team: we recommended a long consumer staples / short consumer discretionary trade on November 16,5 and we recommend that investors retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector on February 15.6 Table 2Our Sector Alpha Portfolio Has Validated Two Of Our Recent Recommendations Chart 7 highlights another interesting insight from the model, by presenting the beta of the portfolio relative to the investable benchmark alongside the benchmark's performance versus global stocks. First, the chart underscores the limited systemic risk of the portfolio, as the portfolio's beta rarely deviates materially from 1. But more importantly, it appears that the portfolio's beta versus the investable benchmark is somewhat correlated with (and leads) China's performance versus global stocks: Chart 7A Curiously Bullish Signal From ##br##Our Sector Alpha Portfolio Prior to the global financial crisis, the portfolio's beta was above 1 and rising, until early-2007 (preceding the peak in relative performance by about a year). Following the crisis, the portfolio beta steadily declined until late-2014/early-2015, interrupted only by a brief rise back above 1 from 2009-2010. Chinese stock prices steadily underperformed global equities during this period. The portfolio beta rose back to 1 in mid-2015, and stayed flat until early last year. Chinese stocks technically underperformed global stocks during this period, but by a much more modest amount than what occurred on average from 2009 to 2014. In this case, the rise in the portfolio beta in 2015 appeared to correctly signal that a sharply underweight stance towards Chinese stocks was no longer warranted. Finally, the portfolio beta surged rapidly higher last year, in line with a material rise in the relative performance of Chinese stocks. It has fallen modestly since January, but remains at one of the highest levels seen over the past 15 years. Drawing pro-cyclical inferences from the beta characteristics of risk-adjusted performers is a novel approach for BCA's China Investment Strategy service, and for now we regard the results of Chart 7 as a curious signal that warrants further examination. Still, this bullish sign is consistent with the general resilience of Chinese stocks that we have observed over the past several months, which continues to argue in favor of a high threshold to cut exposure to China within a global equity portfolio. Bottom Line: Recent changes in the BCA China Investable Sector Alpha Portfolio's recommended allocation have validated two of our recent investment recommendations. In addition, the model is providing a curiously bullish signal about the relative performance of Chinese vs global stocks that heightens our reluctance to reduce Chinese equity exposure. An Update On The "Reform Trade" We noted in the aftermath of last November's Communist Party Congress that China was likely to step up its reform efforts in 2018, and make meaningful efforts to: Pare back heavy-polluting industry Hasten the transition of China's economy to "consumer-led" growth7 Halt leveraging in the corporate/financial sector Eliminate corruption and graft As a result of this outlook, we highlighted that the pace of renewed structural reforms would be a key theme to watch this year, in order to ensure that the pursuit of these policies would not unintentionally cause a repeat of the significant slowdown in the economy that occurred in 2014/2015. We presented our framework for monitoring this risk in our November 16 Weekly Report, which was to track an index that we called the BCA China Reform Monitor. The monitor is calculated as an equally-weighted average of four "winner" sectors that outperformed the investable benchmark in the month following the Party Congress relative to an equally-weighted average of the remaining seven sectors. We argued that significant underperformance of "loser" sectors could be a sign that reform intensity has become too burdensome for the economy (and thus a material headwind ex-tech equity performance), and highlighted that we would be watching for signs that our monitor was rising largely due to outright declines in the denominator. Using this framework, Chart 8 suggests that structural reform efforts are ongoing but that investors do not view the current pace of these reforms as overly burdensome for the economy. In particular, panel 2 highlights that recent movements in our Reform Monitor have been driven by fairly steady outperformance of the "winner" sectors, with "loser" sectors simply trending sideways. While it is possible that Chinese policymakers will intensify their efforts to reform the economy over the coming 6-12 months,4 for now our China Reform Monitor continues to support an overweight stance towards Chinese ex-tech stocks vs their global peers. However, given the message of our Reform Monitor, it is somewhat surprising that another of our reform-themed trades has fared so poorly over the past three months. Chart 9 presents the performance of our long investable environmental, social and governance (ESG) leaders / short investable benchmark trade, which was up approximately 4% since inception in late-January but is now down 1.4%. The basis of this trade was to overweight stocks that are best positioned to deliver "sustainable" growth, which we argued would fare well in a reform environment. Does the underperformance of this trade suggest that the reform theme is unlikely to be investment-relevant over the coming year? Chart 8Structural Reforms Not Viewed As ##br##Economically Restrictive By Investors Chart 9ESG Leaders Should Fare Quite ##br##Well In A Reform Environment In our view, the answer is no. First, while the MSCI ESG leaders index maintains roughly similar sector weights as the investable benchmark (which limits the beta risk of the trade), Table 3 highlights that differences do exist. These modest differences in sector allocation do appear to be impacting performance (Chart 10), in particular the underweight allocation to energy stocks (which are outperforming) and the overweight allocation to technology (which has sold off since mid-March). Table 3Sector Allocation Has Impacted The Recent Performance Of China's ESG Leaders Chart 10Sector Allocation Impacting Recent ##br##Performance Of ESG Leaders Second, while China made significant gains last year in improving air quality in several major population centers (such as Beijing and Shanghai), these improvements have mostly occurred from a near-hazardous starting point and have simply rendered China's air to be less unhealthy. Even in Beijing, Chart 11 highlights that PM2.5 readings have started to increase again, from a level that only briefly reached "good" quality. In addition, Chart 12 highlights that some of the improvement in air quality last year occurred, at least in part, because China shifted polluting activity from one province to another. This implies that Chinese policymakers will continue to wrestle with improving the country's air quality for some time to come, which in our view continues to favor ESG leaders over the coming year and beyond. Chart 11Some Significant Recent Gains In Air ##br##Quality, But Part Of An Ongoing Battle Chart 12Air Quality Gains In Some Provinces, At The Expense Of Others Bottom Line: Our China Reform Monitor signals that investors do not view the current pace of structural reforms as being overly burdensome for the economy. In addition, while Chinese policymakers have made some significant gains in improving China's air quality over the past 18 months, these changes have mostly occurred from a near-hazardous starting point (suggesting that more progress will be needed). As such, we recommend that investors stick with our long ESG leaders / short investable benchmark trade over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Inside The Beltway," dated May 2, 2018, available on gps.bcaresearch.com 2 Please see Geopolitical Strategy and China Investment Strategy Special Report "China's "Red Line" In The Trade Talks," dated May 9, 2018, available on cis.bcaresearch.com 3 Please see China Investment Strategy Special Report "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available on cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report "China: A Low-Conviction Overweight," dated May 2, 2018, available on cis.bcaresearch.com 5 Please see China Investment Strategy Weekly Report "Messages From The Market, Post-Party Congress," dated November 16, 2017, available on cis.bcaresearch.com 6 Please see China Investment Strategy Weekly Report "After The Selloff: A View From China," dated February 15, 2018, available on cis.bcaresearch.com 7 Investors should note that BCA's China Investment Strategy service has long been skeptical of calls to shift China's economy to a consumption-driven growth model, because it significantly raises the odds that the country will not be able to escape the middle income trap. For example, please see Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights At just under 3-in-10 odds, the probability Brent crude oil prices will exceed $80/bbl by year-end is now more than double what it was at the beginning of the year, following President Trump's announcement he would withdraw the U.S. from the 2015 Joint Comprehensive Plan of Action (JCPOA), and re-impose all economic sanctions against Iran (Chart of the Week). Chart of the WeekProbability Brent Exceeds $90/bbl Is Understated By Markets We believe these odds are too low. Indeed, we think the odds of Brent prices ending above $90/bbl this year are higher than the 1-in-8 chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. We also expect sharper down moves going forward, as news flows become noisier. Speculators have loaded the boat on the long side, and they will be exquisitely sensitive to any unexpected softening in fundamentals - e.g., a supply increase or the whiff of lower demand - given their positioning (Chart 2). Chart 2Specs Have Loaded the Boat##BR##Getting Long Brent and WTI Exposure Our research indicates that spec positioning in the underlying futures can, under some circumstances, dominate the evolution of oil options' implied volatility, the markets' key gauge of risk and the essential component of option pricing. As new risk factors arising from Trump's decision emerge, we expect option implied volatility to increase, as the frequency of spec re-positioning increases. Energy: Overweight. We are getting long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectation. We also recommend getting long Aug/19 $75 Brent calls vs. short Aug/19 $80/bbl calls. We already are long Dec/18 $65/bbl Brent calls vs. short $70/bbl calls expiring at the end of Oct/18, which are up 74.2% since they were recommended in Feb/18. Rising vol favors long options positions. The new positions will put on at tonight's close. Base Metals: Neutral. Refined copper imports in China grew 47% y/y in March. For the first four months of 2018 they are up 15% y/y. Imports of copper ores and concentrates were up 9.7% y/y in the January - April period. Precious Metals: Neutral. We remain strategically long gold and tactically long spot silver. A stronger USD continues to weigh on both. Ags/Softs: Underweight. The USDA's weekly Crop Progress report indicates farmers in the U.S. are catching up in their spring planting, converging toward averages for this time of year. Nevertheless, the condition of winter wheat remains a concern. Feature The wild swings in crude oil prices following President Trump's decision not to waive nuclear-related sanctions against Iran - down ~ 2% after Trump's announcement Tuesday, then up more than 2.5% the following morning - resolved one of the more important "known unknowns" ahead of schedule - to wit, would the U.S. re-impose nuclear-related sanctions against Iran, or continue to waive them.1 Ahead of Trump's announcement this week, speculators clearly were building long positions in Brent and WTI, as seen in Chart 2. Among other things, stout fundamentals, which we have been highlighting, and a possible tightening of supply on the back of the re-imposition of U.S. sanctions were obvious catalysts for building the bullish positions. We find specs do not Granger-cause oil prices, and typically these traders are reacting to fundamental news.2 This is consistent with other research into this topic.3 In other words, we find specs essentially follow the fundamentals, they don't lead them, and, as a result, the level of oil prices largely is explained by supply, demand and inventories. Based on the Granger-causality tests and our fundamental modeling, we believe oil markets are, to a very large extent, efficient in the sense that prices reflect most publicly available information.4 This is not to say, however, that the role of speculation can be dismissed as trivial to price formation. Spec Positioning Matters For Implied Volatility In Oil Our most recent research, building on earlier work on speculation in oil markets, finds that the concentration of speculators on the long side or the short side of the market actually does play a significant role in how volatility evolves (Chart 3, bottom panel).5 Other factors are important to the evolution of volatility, as well - i.e., U.S. financial conditions, particularly the stress in the system as measured by the St. Louis Fed's Financial Stress Index; EM equity volatility; and y/y percent changes in WTI oil prices themselves (Chart 3). But spec positioning clearly dominates: In periods of rising or elevated volatility, it explains most of the change in WTI option implied volatilities (Chart 4). This can push volatility higher when it occurs. However, on the downside, this does not hold - Working's T Index is not material to the evolution of implied volatility when uncertainty about future oil prices is low or decreasing. Chart 3Key Variables##BR##Explaining Volatility Chart 4Spec Positioning Dominates##BR##Evolution of WTI Implied Volatility Working's T Index and implied volatility are independent of price direction - they are directionless, therefore they cannot be used to forecast prices.6 These variables tend to increase when the quality of information available to the market deteriorates - i.e., when it becomes more difficult to form expectations about future oil prices. This is, we believe, an attractive time for informed speculators to enter the market and use their information to make profits. We find two-way Granger-causality between WTI implied volatility and Working's T, when the annual change in excess speculation is one-standard deviation above or below its mean. This means the more specs are concentrated on one side of the market in the underlying futures - long or short - the more influence their positioning has on volatility, and that the higher volatility is the more specs are drawn to the market. Given that specs' beliefs are different, this means there is a rising number of long or short spec contracts relative not only to specs on the other side of the market, but also to long and short hedgers. Why Speculation Is Important Prices do not suddenly manifest themselves in markets fully aligned with fundamentals. They are made efficient by hedgers off-loading risk based on their marginal costs, and speculators uncovering information that is material to the level at which prices clear markets. The goal of speculation is to buy low and sell high. Hedging and speculation are both done in the presence of noise, or pseudo-information that has no real connection with where markets clear.7 Information is to noise as substance is to a void. Noise can look like information, as Black (1986) notes, and people can trade on it, but they will lose money and eventually go out of business. Information, on the other hand, is costly, as Grossman and Stiglitz (1980) point out. To incentivize someone (a speculator) to gather it and feed it into prices via the market clearing - i.e., buying and selling based on information - they have to be able to make a profit. Speculators supply the liquidity necessary for trading - and, most importantly, hedging - to occur. Successful speculators make profits. Therefore, the information on which they trade is more often germane to the market-clearing process than not. To be successful they have to be willing to buy when prices are low, expecting them to go higher, and to sell when prices are high, expecting them to go lower. As Paul Samuelson wryly observed, "Is there any other kind of price than 'speculative' price? Uncertainty pervades real life and future prices are never knowable with precision. An investor is a speculator who has been successful; a speculator is merely an investor who last lost his money."8 Known Unknowns Will Keep Vol Elevated Chart 5BCA's Oil Price Forecast Unchanged,##BR##Following Trump's Iran Announcement In the wake of Trump's announcement, the fundamental and geopolitical landscape has been re-cast, creating additional "known unknowns", particularly re how the U.S. will implement the renewed sanctions and the timing of these moves. Among the new known unknowns, which can only be resolved with the passage of time, are: The precise timing and extent of the re-imposed sanctions on the part of the U.S., which will evolve over the next 90 to 180 days. Demand-side implications of higher prices, particularly in EM economies where policymakers used the low prices following OPEC's 2014 - 16 market-share war to eliminate fuel subsidies, which prevented high prices from being experienced by their citizens. The supply-side implications of higher prices on U.S. shale production - does production and investment, including pipeline take-away capacity, take another leg higher? The Kingdom of Saudi Arabia's (KSA) ability to raise output, given the Kingdom said it would be raising output in the event Iranian volumes are lost to export markets. The fate of the Saudi Aramco IPO, and how the re-imposition of sanctions by the U.S. on Iran affects the royal family's decision on whether to float 5% of the company publicly. Will production in distressed states in- and outside of OPEC be negatively affected by increasing geopolitical risk?9 Among the "known unknowns," Iran's next moves rank high, as do responses to such moves by the U.S. and its allies. The U.S. and its Gulf allies clearly view Iran as a threat and, with the re-imposition of sanctions against Iran, are confronting it. Iran has a similar view vis-à-vis the U.S. and its Gulf allies. Left to be determined: Does Iran increase its level of direct action against KSA, upping the ante, so to speak, in its ongoing proxy wars with the Kingdom? Is Gulf production threatened? Are U.S. - European relations threatened by Trump's action? Thus far, European leaders have indicated they remain committed to the sanctions deal Trump walked away from. What would it take for OPEC 2.0 to restore actual production cuts we estimate at 1.1 to 1.2mm b/d to the market? What would it take to trigger a release of the U.S. Strategic Petroleum Reserve (SPR), estimated at just under 664-million-barrel, which could be released to the market at a rate of 500k to 1mm b/d? These known unknowns are not causing us to change our price forecast for this year - $74/bbl for Brent and $70/bbl for WTI, based on our fundamental modeling (Chart 5). However, we do think price risk is to the upside in both markets, given the elevated geopolitical tensions in the market. We continue to expect more frequent prices excursions to and through $80/bbl for the balance of the year, particularly for Brent. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 We lay out some of these "known unknowns" in BCA Research's Commodity & Energy Strategy Weekly Report "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," published April 19, 2018. In addition to the Iran issues, which have been resolved, Venezuela looms large. Oil production declined by 900k b/d between December 2015 and March 2018, with half of that occurring in the past six months. We are carrying Venezuela's current production at ~ 1.5mm b/d, although other estimates have it lower. With the country moving closer to collapsing as a functioning state, the risk to its oil output and exports is high. 2 Granger-causality refers to an econometric test developed by Clive Granger, the 2003 Nobel laureate in economics. It determines whether past values of one variable can be said to predict, or cause, the present value of another variable. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, available at ces.bcaresearch.com. See also the International Energy Agency's "Oil: Medium-Term Market Report 2012;" and "The Role of Speculation in Oil Markets: What Have We Learned So Far?" by Bassam Fattouh, Lutz Kilian and Lavan Mahadeva, published by The Oxford Institute For Energy Studies. Also, see "Speculation, Fundamentals, and The Price of Crude Oil," by Kenneth B. Medlock III, published by the James A. Baker III Institute for Public Policy at Rice University, August 2013. 4 This is the semi-strong form of market efficiency. For a discussion of how markets impound information in prices, please see Eugene Fama's Noble lecture, "Two Pillars of Asset Pricing," which was reprinted in the June 2014 issue of The American Economic Review (p. 1467). 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, in which we introduce Holbrook Working's "T Index," a measure of speculative concentration in futures and options markets. It is available at ces.bcaresearch.com. Briefly, Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market. Excessive speculation - spec positioning in excess of hedging demand by commercial interests - could be read into index values above 1.0. However, the U.S. CFTC notes values of Working's T at or below 1.15 do not provide sufficient liquidity to support hedging, even though "there is an excess of speculation, technically speaking." Formally, Working's T Index looks like this: 6 Please see Irwin, S. H. and D. R. Sanders (2010), "The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results", OECD Food, Agriculture and Fisheries Working Papers, No. 27. 7 Please see Black, Fischer (1986), "Noise," in the Journal of Finance, 41:3; and Grossman, Sanford J., and Stiglitz, Joseph E. (1980), "On the Impossibility of Informationally Efficient Markets," in the June issue of the American Economic Review. 8 Please see Samuelson, Paul A. (1973), "Mathematics Of Speculative Price," in the January 1973 SIAM Review, 15:1. 9 Please see "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," published by BCA's Energy Sector Strategy on May 9, 2018, which discusses these production risks in depth. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017