Economy
Highlights The mood among investors is shifting from the recessionary gloom of this past summer. Equities worldwide are rallying, buoyed by a combination of dovish monetary policies, tentative signs of bottoming global growth and expectations of some sort of trade détente between the US and China. The latter is fueling more bullish sentiment towards equities in regions most exposed to global trade and manufacturing like Emerging Markets (EM) and Europe. Feature Chart 1Global Corporates: 2016 Revisited? Credit investors, in an unusual twist, have been far more optimistic than their equity brethren. Corporate bonds have delivered solid performance in 2019, with the Bloomberg Barclays Global Corporates total return index up +9.5% year-to-date. This is a surprising development, as global growth concerns triggered a major decline in developed market government bond yields but no widening of credit risk premia (Chart 1). With that in mind, this week we are presenting the latest update of our Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 15. The overriding message from the latest read of our CHMs is that the manufacturing-led slowing of global growth this year has not resulted in much deterioration in overall corporate creditworthiness. There are fascinating cross-currents within the data, however. On a regional basis, the CHMs in the euro area, the UK and Canada are in better shape than in the US and Japan. The most interesting differences are across credit quality, with our “bottom-up” high-yield (HY) CHMs looking better than the investment grade (IG) equivalents in both the US and euro area, mostly due to greater relative increases in IG leverage. Our current global corporate bond investment recommendations broadly follow the trends signaled by our CHMs: an aggregate overweight stance versus global government debt, but with a “reverse quality bias” favoring HY over IG in the US and Europe. With government bond yields now on the rise across the developed markets – and with credit spreads fairly tight across the majority of countries - the period of hyper-charged absolute corporate bond returns is over. Expect more carry-like excess returns over sovereigns during the next 6-12 months. US Corporate Health Monitors: Steady Deterioration, Mostly Within Investment Grade Our top-down US CHM is sending a negative message on credit quality, staying in the “deteriorating health” zone since 2015 (Chart 2). The structural declines in the profitability ratios (return on capital and operating margin), debt coverage and, more recently, short-term liquidity are the main causes of that deterioration in US corporate health. Not all the news is negative, however. While operating margins have clearly peaked, they remain at a very high level. The top-down interest coverage ratio is also improving, thanks to low corporate borrowing rates. That is a welcome development that will help extend the US credit cycle by keeping downgrade/default risk, and the credit spreads required to compensate for it, subdued. When looking at our bottom-up US CHMs, the story becomes more nuanced. The bottom-up US high-yield CHM is signaling a surprisingly positive story, spending the past two years in “improving health” territory. The bottom-up US IG CHM remains above the zero line, as has been the case since 2012 (Chart 3). The multi-year increase in the debt-to-equity ratio, and declines in return on capital and interest coverage over the same period, are the main reasons why US IG corporate health has worsened, even as profit margins have stayed high. Chart 2Top-Down US CHM: Steadily Worsening Chart 3Bottom-Up US IG CHM: Some Areas Of Concern The bottom-up US HY CHM is signaling a more positive story, spending the past two years in “improving health” territory (Chart 4), led by stable balance sheet leverage and improvements in operating margins and return on capital. The absolute levels of interest and debt coverage ratios for US HY remain low – a potential future risk for US HY when the US economy goes into its next prolonged downturn. One common signal from all our US CHMs, both top-down and bottom-up, is that short-term liquidity ratios have declined. Those moves are driven by increases in the denominator of the ratios (the market value of assets for the top-down CHM, and the value of current liabilities in the bottom-up CHMs), rather than declines in working capital or cash on corporate balance sheets – trends that would typically precede periods of corporate distress. Just last week, we downgraded US IG to neutral, while maintaining an overweight tilt on US HY.1 The rationale for the move was based on value, as spreads for all US IG credit tiers had tightened to our spread targets, which is not yet the case for HY. The message from our bottom-up US CHMs supports that recommendation. The combination of improving global growth and a Fed that will stay dovish until US inflation has sustainably moved higher paints a favorable backdrop for the relative performance of all US corporate debt versus Treasuries. However, given our expectation that US bond yields will continue to move higher over the next 6-12 months, the lower interest rate duration of US HY relative to IG also supports favoring the former over the latter (Chart 5). Chart 4Bottom-Up US HY CHM: Looking Better Than IG (!) Chart 5US Corporates: Stay Overweight HY & Neutral IG Euro Corporate Health Monitors: Some Cyclical Weakness Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area IG, the gap between domestic and foreign issuers has been widening, with the former now in “deteriorating health” territory (Chart 6). Leverage has gone up for all issuers, with debt/equity ratios now above 100%, but the pace of increase has been faster for domestic issuers. Return on capital and profit margins for domestic issuers have declined since the start of 2018 alongside the prolonged slowing of euro area economic growth. For domestic euro area IG issuers, interest coverage has been steadily climbing since 2015 when the ECB went to negative rates and, more importantly, started its Asset Purchase Program that included corporate debt. Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area HY, the signal from the bottom-up CHM is more positive for both domestic and foreign issuers (Chart 7), with both CHMs sitting just in the “improving health” zone. Leverage has declined, but profit-based metrics have worsened for both sets of issuers. Interest/debt coverage and liquidity, however, are far worse for domestic issuers than foreign issuers. Chart 6Bottom-Up Euro Area IG CHMs: Weak Growth Hitting Domestic Issuers Chart 7Bottom-Up Euro Area HY CHMs: Healthy, But Leverage Now Rising Within the euro area, our bottom-up IG CHMs for Core and Periphery countries have worsened over the past year, from healthy levels, with both above the zero line (Chart 8). Interest coverage is considerably stronger for Core issuers, although profitability metrics are remarkably similar. Short-term liquidity ratios have also fallen for both regional groups over the past year. We have maintained a moderate overweight stance on euro area corporates, both for IG and HY, since the summer of this year (Chart 9). This view was based on expectations that the European Central Bank (ECB) would ease monetary policy, not on a forecast that euro area growth would revive organically. That outcome came to fruition when the ECB cut rates in September and restarted asset purchases earlier this month. The ECB’s moves create a more supportive monetary backdrop (along with an undervalued euro) that will help keep euro area credit spreads tight – a trend that is reinforced by decent corporate health. Chart 8Bottom-Up Euro Area Regional IG CHMs: Heading In The Wrong Direction Chart 9Euro Area Corporates: Stay Overweight IG & HY Chart 10Relative Bottom-Up CHMs: Turning In Favor Of The US? We see no reason to alter our recommendations on euro area credit, based on our forecast of better global growth, with no change to the ECB’s ultra-accommodative monetary stance, in 2020. However, a stronger growth backdrop could benefit euro area HY performance more than IG, based on the comparatively healthier signal from the bottom-up euro area HY CHM. The gap between the combined IG/HY bottom-up CHMs for the US and euro area aligns with credit spread differentials between euro area and US issuers (Chart 10).2 latest trends show a narrowing of the gap between the US and euro area CHMs, suggesting relative corporate health favors US names (middle panel). At the same time, the stronger performance of the US economy, which is much less levered to global trade and manufacturing compared to Europe, continues to support US corporate performance versus euro area equivalents (bottom panel). UK Corporate Health Monitor: Some Improvement, Even With Brexit Uncertainty Despite the persistent uncertainty over the UK-EU Brexit negotiations that has weighed on UK economic confidence, our top-down UK CHM remains in the "improving health" zone (Chart 11). All of the individual components are contributing to the strength of the CHM, which even improved from those healthy levels in Q2/2019 (the most recent data available). A sustained easing of UK financial conditions – easy monetary policy alongside a deeply undervalued currency – have helped boost interest/debt coverage ratios by keeping UK corporate borrowing costs low. Top-down operating margins for UK non-financial firms have surprisingly increased and now sit just under 25%. Short-term liquidity remains solid with leverage holding at non-problematic levels. As we discussed in a recent Special Report, the UK economy has been holding up fairly well despite the political uncertainty that has driven a prolonged slowdown in productivity growth through weak business investment.3 The UK consumer has continued to spend, however, seemingly desensitized to the political drama, and the labor market has remained tight enough to support a decent pace of household income growth. Despite the persistent uncertainty over the UK-EU Brexit negotiations, our top-down UK CHM remains in the "improving health" zone. The near term performance of the UK's economy is highly dependent on the final result of Brexit negotiations. If a negotiated Brexit occurs, UK corporates can start to ramp up the capital spending that has been delayed due to the political uncertainty, which will eventually lead to an improvement in UK productivity growth and overall corporate performance. A strengthening pound and rising government bond yields, driven by markets unwinding Brexit risk premia, will mitigate some of that growth thrust, but the net effect will still boost the relative performance of UK corporate debt versus Gilts. There are still near-term political risks stemming from the UK parliamentary election next month, with the deadline for a UK-EU Brexit deal delayed until after the election. Thus, we continue to maintain only a neutral stance on UK IG corporates in our model bond portfolio, despite our overall bias to be overweight global corporate debt versus government bonds. We will reconsider that stance after we have more clarity on the final resolution of the Brexit uncertainty. At a minimum, however, we expect UK corporates to continue to deliver solid excess returns versus UK Gilts (Chart 12). Chart 11UK Top-Down CHM: Solid Improvement, Despite Brexit Chart 12UK Corporates: Stay Neutral Japan Corporate Health Monitor: A Further Cyclical Deterioration Our bottom-up Japan CHM remains in the "deteriorating health" zone, as has been the case since the start of 2018 (Chart 13).4 The message from the individual CHM components, however, is that this is a cyclical, not structural, deterioration in Japanese corporate credit quality, and from a very healthy starting point. Leverage, defined here as the ratio of total debt to the book value of equity, is slightly above 100%, well below the 100-140% range seen between 2006 and 2015. A similar trend exists for return on capital, which has dipped below 5% but remains high relative to its history (although very low by global standards). Operating margins, debt coverage and short-term liquidity are down from recent peaks but all remain well above the lows of the decade since the 2008 financial crisis. Interest coverage has suffered a more meaningful deterioration relative to its history. However, this is more a cyclical issue related to falling profits (the numerator of the ratio) rather than rising interest costs (the denominator), with the latter remaining subdued thanks to the Bank of Japan’s hyper-easy monetary policy. For the former, the cyclical momentum in Japan’s economy is not improving, despite some recent evidence that global growth may be stabilizing. According to the latest Tankan survey, Japanese manufacturers – who saw profits fall -31% on a year-over-year basis in Q2/2019 - reported a worse business outlook than previously expected, both for large and small firms. This is not surprising, as Japan’s economy remains highly levered to global growth and export demand, in general, and China, in particular. Yet the less trade-sensitive services sector has also weakened – forecasts of the Tankan non-manufacturing index have already rolled over and the services PMI dropped to 49.7 in October. Japan’s corporate spread has widened slightly (+10bps) since the beginning of this year (Chart 14), in contrast to the spread tightening seen in other major developed economy corporate bond markets. This is sign that the markets have responded to the slowing growth momentum in Japan with a bit of a wider risk premium. Yet despite that widening, Japanese corporates with small positive yields continue to generate positive excess returns (on a duration-matched basis) versus Japanese Government Bonds (JGBs); yields on the latter will remain anchored near zero by the Bank of Japan’s Yield Curve Control policy. Thus, we continue to recommend an overweight stance on Japanese corporates vs JGBs as a buy-and-hold carry trade, even with the softening in our Japan CHM. Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Chart 14Japan Corporates: Stay Overweight Vs JGBs For Carry Canada Corporate Health Monitors: Continuous Improvement Our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health, with both remaining in the “improving” zone as of the latest data available from Q2/2019 (Chart 15). The cyclical components (return on capital and operating margins) have gradually improved over the past three years, but remain relatively weak compared to history. Leverage is rising (now above 120% in our bottom-up CHM), but interest/debt coverage ratios remain steady and, in the case of the bottom-up CHM, have outright improved over the past year. We reviewed the Canadian economy last week5 and concluded that a Bank of Canada interest rate cut was unlikely because of signs of improving domestic growth momentum at a time when core inflation was at the midpoint of the BoC’s 1-3% target range. Overall, Canadian growth has been resilient in the face of the 2019 global manufacturing downturn, and should re-accelerate in the next year led by a firm consumer with rebounding housing and business investment. This should help boost the cyclical components of our Canada CHMs, especially if some improvement in global growth helps lift demand for Canadian commodity exports. We also introduced a framework to analyze Canadian corporate bonds in a Special Report published in late August.6 We concluded that Canadian companies’ financial health remains a positive for corporate bond returns on a cyclical basis, but high leverage and mediocre profitability were longer-term concerns. We also noted that the higher credit quality of Canadian corporates, where only 40% of the investment grade index is rated BBB, made them more potentially appealing on a creditworthiness basis relative to the lower quality markets in the US (50% BBB share) and euro area (52%). We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. Spreads have held in a well-established range of 100-200bps since the 2009 recession (Chart 16), even during periods when our CHMs were indicating worsening corporate health. Accommodative monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates relatively attractive, in an environment of decent growth and firm corporate health. Chart 15Canada CHMs: Still Healthy, Despite Slower Growth Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the US, euro area, the UK and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.7 The financial data of a broad set of individual US and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcareseach.com. 2 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from US companies that issue in the euro area market that are part of our US CHMs. 3 Please see BCA Research Global Fixed Income Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated September 20, 2019, available at gfis.bcaresearch.com. 4 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Special Report, “The Great White North: A Framework For Analyzing Canadian Corporate Bonds”, dated August 28, 2019, available at gfis.bcaresearch.com. 7 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.bcaresearch.com. Appendix 2: US Bottom-Up CHMs For Selected Sectors The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Portfolio Strategy Depressed technicals, compelling valuations, macro tailwinds, improving operating fundamentals and the messages from our relative profit growth models and relative Cyclical Macro Indicators all signal that the time is ripe to initiate a long energy/short utilities pair trade. Pricey valuations, overbought technicals, the sell-off in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. Recent Changes Initiate a long S&P Energy/short S&P Utilities pair trade today. Table 1 Feature Equities propelled to uncharted territory, celebrating an easy Fed and the US/China détente with a hint of a tariff rollback, overcoming the seasonally difficult months of September and October. Historically, investors chase performance during the end of the year and seasonality will likely favor further flows into equities in the last two months of the year. On the economic front, while manufacturing remains in recession, a resilient labor market is providing a significant offset allaying fears of recession gripping the broad economy. Drilling deeper on the labor front is revealing. The unemployment rate ticked higher to 3.6% last month based on the household survey as the participation rate increased. However, according to the Sahm Rule Recession Indicator (SRRI), courtesy of Fed economist Claudia R. Sahm,1 were the unemployment rate to average 4% for three consecutive months by September 2020, the US economy will enter recession. In other words, based on empirical evidence the SRRI shows that when the three-month average unemployment rate has jumped by 50bps compared with previous twelve month low, the US has entered recession 100% of the time since the end of WWII (Chart 1). Chart 1Watch The Sahm Rule Recession Indicator Meanwhile, the parallels drawn with the mid-to-late 1990s and the current market backdrop have mushroomed, but our view is that the differences could not be wider. Since the history of our reconstructed SPX data going back to the late-1920s, there has never been a five-year period when the S&P 500 rose by at least 20% every year except for the 1995-1999 era. In that five-year period the SPX soared more than threefold, increasing annually by 34%, 20%, 31%, 27% and 20%, respectively. Investors forget that those were manic markets and despite a high and rising fed funds rate that peaked at 6.5% in early 2000 (real rates were over 4%), the forward P/E multiple went to the stratosphere ignoring theory and defying logic (Chart 2). Putting the late-1990s exuberance into perspective is instructive: if 1995 is similar to 2016 (and 1998 is similar to 2019) then the SPX should spike to over 6000 by the end of next year! Moving over to economic green shoots, we turn our attention to the signal the emerging markets are emitting. While both the EM and the Chinese manufacturing PMIs are expanding smartly, leading indicators suggest that the recovery may be running on empty. Chart 2One Of A Kind Chart 3Mixed Signals Chart 3 shows that the Chinese credit impulse is contracting, weighing on EM FX momentum and also signaling that the CAIXIN China manufacturing PMI, that has opened the widest gap with the official China NBS manufacturing PMI since the history of the data, will likely suffer a setback in the coming quarters. In the transportation sector, the Baltic Dry Index is down 33% since the early-September peak and is also losing steam on year-over-year basis, warning that a global trade recovery is skating on thin ice. Moreover, EM sentiment is downbeat. Investor flows into EM equities, according to the most liquid iShares MSCI EM ETF, have been drifting lower since the 2018 peak and have more recently gapped down (bottom panel, Chart 3). Thus, the recent green shoots may prove fleeting. This week we are initiating a new market-neutral pair trade and reiterate our negative view on a niche defensive sector. With regard to US liquidity, that we have been inundated with client requests recently, we highlight our simple liquidity indicator: industrial production (IP) growth versus M2 money supply growth. In other words, we gauge how fast a unit of currency is translated into IP. Chart 4 highlights that IP/M2 is contracting at an accelerating pace, heralding further earnings growth pain for the S&P 500. US dollar based liquidity is also contracting as we showed in last week’s US Equity Strategy Webcast slides. Chart 4Clogged Pipelines Weighing On Profit Growth Other SPX profit indicators we track continue to suggest that the earnings soft patch is not out of the woods yet (we use forward EBITDA estimates to gauge trend growth, which excludes the one time fiscal easing boost to net EPS). Net forward EBITDA revisions are below zero, the ISM manufacturing new orders-to-inventories ratio has fallen 40% from the 2018 peak and is hovering near parity, momentum in the key ISM manufacturing new orders subcomponent is contracting and BCA’s boom/bust indicator continues to deflate. All of this, suggests that a turnaround in profits remains elusive and is a first half of 2020 outcome, at the earliest (Chart 5). Already, Q4/2019 profit growth estimates have now sunk into negative territory according to the latest FactSet data.2 Finally, the Fed released the last Senior Loan Officer Survey of the year in the past week and demand for C&I loans collapsed. This data series has broken below the 2016 trough and warns that C&I credit origination will continue to contract. Chart 5No Pulse Chart 6Capex Contraction Dampens Need For Credit Such a souring backdrop makes intuitive sense as animal spirits have died down courtesy of the Sino-American trade war. CEO’s are still voting with their feet and are canceling/postponing capital outlays. Absent capex, C&I credit demand runs aground (Chart 6). It remains unclear if a US/China “phase one” trade deal including tariff rollbacks can reverse the ongoing global trade contraction, signaling that caution is still warranted on the prospects of the broad equity market for the next 9-12 months. This week we are initiating a new market-neutral pair trade and reiterate our negative view on a niche defensive sector. Long/Short Idea: Buy Energy/Sell Utilities There is an exploitable opportunity in going long the S&P energy sector/short the S&P utilities sector and we recommend initiating this market-neutral trade today. The top panel of Chart 7 shows that energy stocks have come full circle and are trading at levels last seen two decades ago when WTI oil was fetching less than half of today’s $55/bbl price. Encouragingly, there seems to be long-term support for relative share prices at the current overly depressed level. While utilities have been making headlines all year long given their outperformance, when put in proper perspective this niche defensive sector with a mere 3% weight in the SPX looks like a shipwreck (bottom panel, Chart 7). Taken together, this battle between two diminishing sectors presents a tradable opportunity by favoring energy stocks at the expense of utilities. In fact, this ratio trades at more than two standard deviations below the historical uptrend, and thus offers a lucrative risk/reward profile (Chart 8). Chart 7Buy Energy… Chart 8…At The Expense Of Utilities Beyond depressed technicals and compelling overall valuations with an alluring relative dividend yield (investors are paid an unprecedented 100bps in dividend yield carry to put on this trade, Chart 9), macro tailwinds, improving operating fundamentals, and the messages from our relative profit growth models and relative Cyclical Macro Indicators (CMI), all signal that the time is ripe to initiate a long energy/short utilities pair trade. On the macro front, inflation expectations have tentatively troughed and if oil rebounds further, as our Commodity & Energy Strategy service expects, then given their tight positive correlation with oil prices, rising inflation expectations should put a definitive floor under the relative share price ratio (Chart 10). Chart 9Unloved And Oversold Chart 10Return Of Inflation… However, the real interest rate component (i.e. growth) also explains roughly half of the selloff in the 10-year Treasury yield since early September, which also moves in lockstep with relative share price momentum (bottom panel, Chart 10). Were this budding global growth recovery to gain steam into the first half of 2020, then energy profits would outshine utility sector profits. As a reminder, oil is a global growth barometer and rises with increasing global growth while defensive utilities flourish when growth sputters (Chart 11). The US dollar’s recent appreciation has also dealt a blow to this trade and a grinding lower currency which is synonymous with a modest global growth recovery would also reverse this pair trade’s fortunes (top two panels, Chart 12). Chart 11…And Green Shoots Beneficiary Chart 12Operating Metrics Also… Zooming into the relative operating outlook, the bottom panel of Chart 12 shows that oil price inflation is outpacing natural gas selling prices. This relative underlying commodity backdrop is important as energy stocks move with the ebbs and flows of the oil market, whereas the marginal price setter for utility services is natural gas prices. The upshot is that heading into 2020, bombed out relative share prices should play catch up to the firming relative commodity backdrop. Capital spending outlays also favor energy shares over utilities stocks (top two panels, Chart 13). Surprisingly, the utilities sector net debt-to-EBITDA ratio is above 5x, waving a red flag, but energy indebtedness is coming down fast in the aftermath of the early 2016 oil price collapse and the energy sector’s net debt-to-EBITDA ratio is close to 2x (bottom panel, Chart 13). Our relative CMIs and relative profit growth models do an excellent job capturing all these moving parts and are unanimously sending a bullish message that an earnings-led recovery is in store for the relative share price ratio (Chart 14). Chart 13…Favor Energy Over Utilities Chart 14Green Light From US Equity Strategy Models Bottom Line: Initiate a long S&P energy/short S&P utilities pair trade today. Out Of Power Warning Utilities stocks have been all the rave this year, but given their small weighting in the SPX they only explain a very small part of the broad market’s run (in contrast, the heavyweight tech sector explains most of the S&P 500’s rise as we highlighted in recent research).3 We reiterate our underweight stance in this small defensive sector that has run way ahead of soft profit fundamentals. Worrisomely, utilities trade with a 20 forward P/E handle and command a 20% premium to the broad market, but their forecast EPS growth rate at 5% trails the SPX by 350bps (not shown). Chart 15 shows that our composite relative Valuation Indicator has surged to one standard deviation above the historical mean, a level typically associated with recession. Technicals are also extended (bottom panel, Chart 15), warning that this crowded trade is at risk of deflating, especially if the breakout in bond yields gains steam. Chart 15Overbought And Overvalued In sum, pricey valuations, overbought technicals, the selloff in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. The top panel of Chart 16 shows that relative share prices and the 10-year Treasury yield are closely inversely correlated. Now that the risk free asset is having a more competitive yield, investors will likely start to abandon this niche defensive sector. Similarly, the recent selloff in the total return bond-to-stock ratio also warns that buying up expensive utilities at the current juncture is fraught with danger (second panel, Chart 16). The jury is still out on the final outcome of the Sino-American trade war. However, there has been a decisive change of heart in US exporters and the ISM manufacturing survey’s new export orders subcomponent reflects an, at the margin, improvement in the US/China trade relationship. This bodes ill for safe haven utilities stocks (new export orders shown inverted, bottom panel, Chart 16). Chart 16Budding Recovery Weighing On Utilities Chart 17Sell The Strength Turning over to the sector’s operating metrics reveals that investors piling into utilities is unwarranted. Natural gas prices are contracting at the steepest pace of the past four years (middle panel, Chart 17) and signal that the path of least resistance is lower for relative share price momentum. Meanwhile, electricity capacity utilization is in a multi decade downtrend, warning that the relative profitability will remain under pressure in the coming quarters (bottom panel, Chart 17). In sum, pricey valuations, overbought technicals, the sell-off in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. Bottom Line: Shy away from the expensive S&P utilities sector. The ticker symbols for the stocks in this index are: BLBG – S5UTIL– PPL, PNW, ATO, PEG, FE, EIX, AEE, SO, SRE, AEP, XEL, DTE, EVRG, WEC, AES, CMS, LNT, ED, NRG, D, AWK, DUK, ETR, EXC, NEE, CNP, NI, ES. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/econres/claudia-r-sahm.htm 2 https://insight.factset.com/sp-500-now-projected-to-report-a-year-over-year-decline-in-earnings-in-q4-2019 3 Please see BCA US Equity Strategy Insight Report, “Deciphering Sector Returns” dated August 30, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
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Highlights All the steps in the earnings dance are well known: Company management teams guide Wall Street analysts to lower their expectations in the weeks leading up to the beginning of earnings season, and their companies’ results then comfortably clear the lowered bar. Given the lack of true suspense, the S&P 500 largely ignores quarterly results: In the near term, moves in the S&P 500 have little to no relationship with either earnings growth or the magnitude of earnings beats. Over time, however, index prices and earnings move together: If earnings multiples mean-revert, earnings and prices have to converge over the long run. The equity bull market isn’t finished yet: The monetary policy backdrop will support earnings growth well into 2021, though it will not promote multiple expansion for much more than a year. Feature Chart 1We've Seen This Movie Before Taking a turn chairing BCA’s daily meeting last week, we duly updated our colleagues on the progress of earnings season. At the time, over 75% of the S&P 500’s constituents had reported, and the index was on its way to surpassing consensus analyst expectations by a few percentage points. We then showed charts tracking the course of expectations across each of this year’s three quarters to show that the “surprise” wasn’t actually very surprising (Chart 1). We included the charts to add a bit of levity, but a fellow strategist asked an incisive question: If earnings season follows the same pattern every quarter, why pay attention to it at all? Earnings season surely has its elements of Kabuki theater, but earnings are the fundamental basis for purchasing an ownership stake in a company. A share of stock is a claim on a company’s aggregate future earnings. To the extent that quarterly earnings reports provide a window into the trajectory of a company’s future earnings path, they contain relevant information about the fair value of its shares. Quarterly earnings offer more insight at the individual stock level than at the index level, as individual stocks are subject to idiosyncratic factors, while index earnings tend to reflect overall economic performance, and we therefore view them as a check on the other real-time indicators we examine to gauge the health of the economy. A review of how S&P 500 prices interact with S&P 500 earnings suggests that earnings have little to no impact on near-term index performance. They do move together in the long term, though, as they must if earnings multiples are a mean-reverting series. In the near term, when multiples are oscillating, anticipating stock market moves is a function of anticipating earnings growth and swings in multiples, which move independently of one another. The fed funds rate cycle has historically provided a good high-level guide to earnings and multiples trends. S&P 500 Performance During Earnings Season To test the S&P 500’s sensitivity to earnings surprises, we dug through weekly earnings updates going back to the beginning of 2012 (4Q11 earnings season) to compare expected index earnings per share (EPS) with reported index EPS.1 I/B/E/S has long been recognized as the earnings-estimates authority, so we use its estimates in conjunction with its compilation of reported earnings to ensure our analysis really is apples-for-apples.2 We track S&P 500 performance in three-month segments, beginning with the Monday following the second Friday of the new quarter, since that is the week that the banks typically get earnings season rolling. Earnings beats are stable and predictable, but the S&P 500's reaction to them is anything but. The empirical record over the last 31 quarters supports our colleague’s intuition. Over the 13 weeks following the major banks’ releases, S&P 500 performance exhibits no consistent link with earnings surprises (Chart 2). The best-fit line through a simple scatterplot shows that the relationship, such as it is, has been inverse and weak (Chart 3). The link with the year-over-year change in S&P 500 earnings is even weaker (Charts 4 and 5). Chart 2Earnings Surprises Don't Move The S&P 500 … Chart 3… Which Is Slightly Negatively Correlated With Them Chart 4Earnings Growth Doesn't Move The S&P 500 … Chart 5… Which Has No Short-Term Relationship With It Earnings data support our colleague’s contention that earnings season, at least as it relates to expectations, is something of a charade. Companies, which heavily influence analyst estimates with their guidance, have beaten expectations every quarter for at least eight years. As Charts 2 and 3 show, earnings beat expectations by an average of 3.7%, nearly the midpoint of the 1-6% range. The S&P 500 shouldn’t be expected to react to “surprises” that are more or less pre-ordained. Bottom Line: Earnings season has no observable impact on the S&P 500. Earnings attract a lot of attention, but they do not influence index-level performance in the near term. The S&P 500 And Earnings Over Longer Periods Anything can happen over short periods, but stock prices have to track earnings over the long term. If the idea that an ownership share represents a proportional stake in company earnings is too abstract, consider the equity equation. Equity prices, P, can be viewed as the product of earnings, E, and the multiple investors are willing to pay for each dollar of earnings, P/E. P = E * (P/E) The market P/E ratio is subject to mean reversion, making changes in earnings the key long-term driver of S&P 500 performance. Since 1966, the S&P 500 index (Chart 6, top panel) has appreciated at the same rate as its trailing four-quarter operating earnings (Chart 6, middle panel), given that its trailing multiple is not far from where it started (Chart 6, bottom panel). Growth in forward earnings expectations (Chart 7, middle panel) has lagged S&P 500 growth (Chart 7, top panel) since expectations data began to be compiled in 1979 because the forward multiple has more than doubled from late ‘70s trough levels (Chart 7, bottom panel). In any extended period not bookended by an outlier multiple, however, one should expect S&P 500 appreciation to track earnings estimate growth. Chart 6S&P 500 Earnings And Prices Will Converge Over Time ... Chart 7... As Long As The Starting Or Ending Multiple Isn't An Outlier Bottom Line: Stock price gains and earnings growth will converge over the long run as long as the earnings multiple mean-reverts. Earnings do matter in the long run. Where Do We Go From Here? There are several earnings growth models within BCA. Like all regression models, they often work well in stretches, but are susceptible to unanticipated inflections and changes in correlations. Since the crisis, the difference between year-over-year growth in industrial production and year-over-year growth in the money supply has aligned closely with earnings growth (Chart 8). If we (and global equity markets) are correct in sniffing out a bottoming in global manufacturing activity, and loan growth is unlikely to accelerate much as banks are pulling in their horns in commercial real estate and selected consumer categories, earnings growth could pull out of its funk. Chart 8Earnings Growth Will Revive Once Global Manufacturing Pressure Abates We have found that earnings growth and multiple re-rating or de-rating is reliably influenced by the monetary policy backdrop. While the level of the fed funds rate goes a long way to explaining overall index moves, earnings growth and multiple expansion/compression are a function of its direction. Broadly, forward estimates grow at a rapid rate when the Fed is hiking rates (the economy is expanding) and slump when it’s cutting them (the economy needs a hand). Forward multiples are the mirror image of earnings estimates, contracting when the Fed is hiking and expanding at a robust clip when the Fed is cutting. Earnings grow at a rapid clip when the Fed is leaning against a too-strong economy, but they slump when the Fed is trying to nurse it back to health. Viewed through the lens of the fed funds rate cycle (Figure 1), policy had been in Phase I from December 2015, when the Fed began hiking rates, until the end of July, when the Fed began cutting, transitioning into Phase IV. Phase IV has been characterized by solid multiple expansion and, ex-2008-9, decent earnings growth. It will remain in force until the Fed returns to hiking rates, which we do not expect until the second half of 2020 at the earliest. Once the Fed does resume hiking, it will likely take some time for it to raise the fed funds rate above its equilibrium level (Phase II). Figure 1The Fed Funds Rate Cycle Our base case is that the Fed will not turn restrictive until 2021. Easy monetary policy is a tailwind for earnings growth, which remains strong in Phase II, so we expect that earnings growth will shake loose of 2019’s doldrums across the next two years. Stocks should benefit from re-rating until the Fed resumes hiking rates (Phase I), cutting off multiple expansion. They will de-rate once monetary policy becomes restrictive (Phase II), as it must once the Fed perceives a need to cool the economy. The bottom line is that the monetary policy backdrop should be earnings-friendly well into 2021, even if multiple expansion isn’t likely to persist beyond the next nine to twelve months. Investment Implications Investors should not look to quarterly earnings reports to inform asset allocation decisions. Quarterly releases may be telling for individual companies’ longer-run profit potential, but they do not shed much light on the S&P 500’s future earnings. The long-run index earnings profile is much more likely to be influenced by broad themes than real-time data points. We devote our focus to the cyclical forces affecting asset-class-level returns, and find that the monetary policy cycle offers useful insight into future moves in earnings and multiples. The Fed's dovish pivot will help keep the expansion going, ... That insight is favorable for equities, and for spread product as well. We are in the latter stages of both the business cycle and the credit cycle, but new injections of monetary accommodation and the postponement of the shift to restrictive monetary policy settings will extend the longevity of the expansion and the period over which credit generates positive excess returns. Investors have different objectives and risk tolerances, but we think all of them should remain at least equal weight equities in balanced portfolios, and overweight spread product (and underweight Treasuries) within fixed-income sleeves. It is too soon to de-risk investment portfolios. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 All data cited in this section comes from Refinitiv’s (formerly Thomson Reuters’) This Week in Earnings publication. 2 Earnings estimates compiled by other vendors may differ from I/B/E/S estimates, and other measures of reported earnings, like Standard & Poor’s, regularly diverge from I/B/E/S’.
Feature Chart I-1Lebanese Bond Yields Have Surged To Precarious Levels In a May 2018 Special Report, we warned that a devaluation and government default were only a matter of time in Lebanon. The country's sovereign US dollar bond yields have now reached a whopping 21% and local currency interest rates stand at 18% (Chart I-1). On the black market, the Lebanese pound is already trading 12% below its official rate. A public run on banks and bank deposit moratorium, as well as public debt default and a massive currency devaluation are now unavoidable. A Classic Case Of EM Bank Run And Currency Devaluation… The current state of Lebanon’s balance of payments (BoP) is disastrous: The current account (CA) deficit has oscillated between 10% and 20% of GDP in the past 10 years (Chart I-2). This wide CA deficit has been funded by speculative portfolio flows into local currency government bonds, sovereign bonds and bank deposits. However, since the middle of 2018 these inflows have dried up. In turn, to defend the currency peg to the US dollar and avoid a currency depreciation in the face of the BoP deficit, the Central Bank of Lebanon (BDL) has been depleting its foreign exchange (fx) reserves, i.e., the central bank has been financing the BoP deficit (Chart I-3). Chart I-2Lebanon's Chronic Current Account Deficit Chart I-3Lebanon: The BoP Has Been Deteriorating Substantially BDL’s gross fx reserves – including gold – have dropped from $48 billion in 2018 to its current level of $43 billion. We estimate that BDL’s net foreign exchange reserves excluding commercial banks’ US dollar deposits at BDL are at just $26 billion. This amount is insufficient in light of the panic-induced outflows the country and the banking system are experiencing.1 As a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon. Chart I-4Depositors’ Are Heading For The Exit Worryingly, as a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon.2 Moreover, after opening their doors, Lebanese commercial banks are now imposing unofficial capital controls – they are paying US dollar deposits in local currency only and are no longer providing dollar-denominated credit lines to businesses and importers. This will only intensify the panic among depositors. Chart I-4 illustrates that local currency deposits have already been declining while US dollar deposits have been slowing, and will likely begin contracting soon. In short, capital outflows will intensify in the coming weeks as people and businesses quickly realize that banks cannot meet their demand for deposits. Critically, we suspect Lebanese commercial banks are short on US dollars to meet people’s demand for the hard currency. Commercial banks’ net foreign currency assets stand at negative $70 billion or 127% of GDP. They hold, roughly, somewhere around $20 billion worth of US dollars in the form of liquid and readily available deposits (in banks abroad and deposits in the central bank) versus $124 billion worth of dollar deposits. Over the years, Lebanese commercial banks have been an attractive place for investors and residents to park their US dollars given the high interest rate paid by the banks. In turn, Lebanese commercial banks have been converting these US dollar deposits into local currency in order to buy government bonds. With domestic bonds yielding well above the rates on US dollar deposits - and given the exchange rate peg to the dollar - commercial banks have been de facto playing the carry trade. In addition, commercial banks also lent some of these dollars directly to the private sector. With the economy collapsing and the widening dollar shortage, banks will not be able to either collect their dollar loans or purchase dollars in the market. Without new dollar funding – which is very likely to persist – banks will fail to meet the demand for dollars. As a result, a bank run is imminent. At this point, the sole option is for the central bank to keep pushing local interest rates higher to discourage capital flight and a run on the banks. Yet, at 18% and surging, interest rates will suffocate the Lebanese economy and the property market. This will dampen sentiment further and cause a bank run. Bottom Line: A bank run is brewing and bank moratorium as well as currency devaluation are inevitable. …As Well As Public Debt Default Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Chart I-5Public Debt Dynamics Are Toxic Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Commercial banks own 37% of outstanding government debt. This will come on top of skyrocketing private-sector non-performing loans and will push banks into outright bankruptcy. Lebanon’s fiscal and public debt dynamics have reached untenable levels. The fiscal deficit stands at 10% of GDP and total public debt stands at 150% of GDP (Chart I-5). Surging government borrowing costs will push interest payments as a share of government aggregate expenditures to extremely high levels. These are unsustainable fiscal and debt arithmetics (Chart I-6). Meanwhile, government revenues will decline as growth falters (Chart I-6, bottom panel). The pillars of the Lebanese economy – private credit growth and construction activity – have been already collapsing (Chart I-7). Chart I-6Surging Interest Rates Will Make Public Debt Servicing Impossible Chart I-7Lebanon: Domestic Economy Has Been Collapsing Bottom Line: The Lebanese government will be forced to default on both local currency and dollar debt. This will be the final nail in the coffin of the Lebanese banking system. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1 BDL does not publish its holding of net foreign exchange reserves. However, other estimates of BDL’s net fx reserves are even lower. Please refer to the following paper: Financial Crisis In Lebanon, by Toufic Gaspard and the following article: Lebanon Warned on Default and Recession as Its Reserves Decline. 2 Banks shut down allegedly as a result of the ongoing civil disobedience that was sparked by the government’s reckless decision to tax WhatsApp's call service. The protests quickly escalated to a country-wide uprising, causing the government to resign on October 29.
Highlights Lebanon and Iraq – the two countries most entrenched in Iran’s sphere of influence – are experiencing mass unrest. Protesters in both states are calling for the dismantling of sectarian based political systems, economic reforms, and reduced foreign interference. The unrest in Iraq is of greater consequence due to its role as a major global oil supplier. The widening rift between the rival Iraqi Shia blocs implies that any détente will be temporary. We remain tactically long spot crude oil on the back of the geopolitical risks to supply amid an expected revival in global demand. Feature A wave of popular uprisings has swept over Lebanon and Iraq. While the riots are to a large extent a product of long-standing economic and governance failures, the timing is consequential. The Middle East is experiencing a paradigm shift. With the US reducing its strategic commitment to the region, most recently evidenced by the withdrawal of its troops from northeast Syria, a power vacuum has emerged. This opens up the necessity for foreign actors – Russia – as well as regional powers – Saudi Arabia, Iran, and Turkey – to fill the void. The evolution of power could be unsettling given that it will likely generate greater instability in a region that is fertile ground for unrest. Iran has so far emerged a winner in this dynamic. It has expanded its influence in Iraq since the US pullout, it has played a critical role in saving the Assad regime, and it has seen Saudi initiatives fail in Syria, Yemen, Lebanon, and Qatar. It is making progress toward building its ‘land bridge’ to the Mediterranean (Map 1).1 Map 1Iran’s Aspirational ‘Land Bridge’ To The Mediterranean The tensions brought about by the US withdrawal from the JCPOA further illustrate Iran’s growing regional sway. It has hardened its stance. Meanwhile the US and its allies have been vacillating. The Saudi coalition – mired in a war in Yemen and confronting domestic risks – is reluctant to engage in a full-scale confrontation. Even though Iran has a higher pain threshold, it stands on shaky ground. Just last year it was rocked by domestic protests demanding less foreign adventurism. Lebanon and Iraq are the two countries most entrenched in Iran’s sphere of influence. Protesters in both countries are calling for greater national unity – demanding an overhaul of the political system, and arguing that the sectarian set-up has failed to meet their most basic needs. What occurs in Beirut and Baghdad will be of great consequence for Tehran. Deadlock In Iraq “Out, out, Iran! Baghdad will stay free!” - Chants by Iraqi protesters While both the grievances and demands of the protesters in Lebanon and Iraq are similar, the unrest in Iraq is of much greater consequence from a global investor’s perspective. The trigger was the removal of the highly revered Lieutenant General Abdul-Wahab al-Saadi from his position in the Iraqi army by Prime Minister Adel Abdul-Mahdi.2 The popular general was unceremoniously transferred to an administrative role in the Ministry of Defense. The sacking of al-Saadi – considered a neutral figure – was interpreted as evidence of Iranian influence and the greater sway of the Iran-backed Popular Mobilization Forces (PMF), an umbrella organization of various paramilitary groups. Iraqis all over the country responded by attacking the Iranian consulate in Karbala and offices linked to Iranian-backed militias. Chart 1AFertile Ground For Unrest In Iraq The protesters are also united in their economic grievances, frustrated at a political and economic system that is unwilling to translate economic gains to improved livelihoods for its people. The May 2018 parliamentary elections, which ushered in Prime Minster Abdul-Mahdi, failed to generate much improvement. The country continues to be plagued by high unemployment, corruption, and an utter lack of basic services (Charts 1A & 1B). This has ultimately resulted in a lack of confidence in Iraqi leadership who are being increasingly perceived as benefiting from the status quo at the expense of the populace. Chart 1BFertile Ground For Unrest In Iraq Most importantly, the ruling elite has failed to respond to key trends that emerged in last year’s parliamentary elections. The extremely low voter turnout reveals that Iraqis are disenchanted with the government's ability to meet their needs. Meanwhile the success of Shia cleric Moqtada al-Sadr’s Sairoon coalition – running on a platform stressing non-sectarianism and national unity – in securing the largest number of seats highlights the desire for a reduction of foreign interference (both Iranian as well as US/Saudi) in domestic politics. Where the election results failed to translate into real change for Iraq is in the appointment of the Prime Minister. Abdul-Mahdi – a technocrat – was a compromise candidate that surfaced as a result of a five-month long political standstill between the two rival Shia blocs, each claiming to have gained a majority of seats in parliament. On one end is the Iran-backed bloc led by Hadi al-Amiri head of both the Fatah Alliance and the PMF, and Nouri al-Maliki leader of the State of Law Coalition. On the other end is al-Sadr’s Sairoon coalition, which joined forces with Ammar al-Hakim of the Wisdom Movement, and champions greater unity and less foreign interference. The result has been a weak prime minister who is perceived to be incapable of pushing back against Iraq’s ruling elites and ushering in structural reforms. Instead the Prime Minister is seen as benefiting from a corrupt system. The rift between Iraq’s rival Shia blocks is deepening. Thus, the ongoing protests are to a great extent the result of the new government’s failure to heed the warnings brought about by the 2018 election and protests. They have served to deepen the rift between the rival Shia blocs. Last week Abdul–Mahdi responded to calls by al-Sadr and former Prime Minister Haider al-Abadi to resign by arguing that it is up to the main political leaders to agree to put forward a vote of no confidence in the Iraqi parliament. He agreed to resign, on condition that political parties jointly approve of a replacement. For now, that appears improbable. In a move that has been interpreted as a display of Iranian interference, al-Amiri changed heart after a reported meeting with Iranian Quds Force leader Qassem Suleimani last week in Baghdad. He backed down on his agreement to support al-Sadr to bring down Abdul-Mahdi, and has instead stated Abdul-Mahdi’s resignation will only bring about more chaos. This interference on the part of Iran was likely induced by fears that a crisis-stricken Iraq would weaken its hegemony over the region. Iraq is in a state of deadlock. A vote of no confidence would require a majority of 165 in parliament and would require the support of various Sunni and Kurdish parties (Chart 2). Al-Sadr is likely calculating that a new election is in his best interest. He would be able to capitalize on the movement given that he has aligned himself with the protesters, and will gain seats in parliament. Chart 2A Shia Schism In Iraq’s Parliament This would allow the nationalist bloc to gain a majority and appoint a government that is acceptable to the protesters. However, this scenario would also entail greater meddling from Iran, as it is unlikely to stand by idly as its influence wanes. As a result, we are likely to witness greater unrest as the rift between the two Shia blocs intensifies. Neither the US nor Saudi Arabia have an appetite to step in and provide the support necessary to counteract Iran. Moreover, Iran and its proxies in Iraq will not back down easily. At the same time, the geographical spread of the protest movement demonstrates that Iraqis are fed up with the current system.3 Despite the death of over 260 Iraqis, the protesters have yet to be deterred by the violence. This points to greater instability in Iraq as no side is backing down and the only foreign power willing and able to interfere is Iran. The impasse could be resolved if the main actors – the rival Shia blocs – agree to compromise. However, that is precisely what transpired last year and resulted in Abdul-Mahdi’s appointment. It ultimately led to only a temporary resolution of the unrest: a one-year deferral. If a similar compromise is reached in the current environment, it too will result in only a temporary détente. The grievances afflicting Iraqis cannot be resolved easily or swiftly. Iraq is in for an extended period of instability. Bottom Line: Iraqi protesters and authorities are in stalemate. The rift in the Shia bloc is deepening. There does not appear to be a clear path to bridge the demands and desires of the protesters and the leadership. Any détente will be temporary. Even if under a new election the protests translate to greater seats for the nationalist bloc, it will not translate to a de-escalation of domestic tensions. It may resolve the protests, but Iran-backed groups will retaliate. Iraq is in for an extended period of instability. Deadlock In Lebanon “All of them means all of them” “No to Iran – No to Saudi” - Chants by Lebanese protesters Just as Iraqi protesters are expressing national unity in calling for an end to sectarian politics and foreign interference, Lebanon’s protests stand out for crossing religious and regional divides. They have swept across the country, and include the Shia-dominated southern region where anger is even being directed at Hezbollah. Among the protesters’ demands is the removal of all three heads of the pillars of government – the Maronite Christian President Michel Aoun, the Sunni Prime Minister Saad Hariri, and the Shia Speaker of Parliament Nabih Berri. Rather than being a source of division, the unrest is a demonstration of unity among Lebanese of all ideologies against the entire political system. Since Prime Minister Saad Hariri’s resignation on October 29, the movement rages on. Protesters are claiming that they are unwilling to back down until all their demands are met, including a complete overhaul of the sectarian power-sharing system, which has defined the country’s politics since the end of the 1975-1990 civil war.4 Chart 3Economic Deterioration In Lebanon The movement and the protesters’ complaints are not surprising. The government has failed to prevent the economy from moving toward collapse. It has long been in decline, with Lebanese feeling the pinch of corruption, economic stagnation, high unemployment, and the effects of the massive influx of Syrian refugees (Chart 3).The trigger of the uprising, a tax on WhatsApp calls amid clear signs of a domestic liquidity shortage, is a delayed response to what citizens have already known and felt for some time: a deteriorating economic situation. While the protests were caused by these economic grievances, they persist due to a crisis of confidence between the political class and the masses. Neither concessions on the part of the government in the form of a list of reforms nor the prime minister’s resignation convinced protesters to halt the movement. The uprising appears set to remain steadfast so long as the current politicians remain in power. The challenge for Lebanon’s protesters – and political elite all the same – is that while the protesters are united in their demands, they have so far been headless. The protesters have refused to present a list of acceptable replacement leaders, insisting that it is the government’s role to propose potential alternatives to the people. This has led to deadlock and will be a hurdle for the government in negotiating with demonstrators. On the other side of the conflict, the current political class, including Hezbollah leader Hassan Nasrallah, has expressed warnings about the chaos that would ensue with a government resignation. According to the Lebanese constitution, following Hariri’s resignation President Aoun is now tasked with consulting Lebanon’s fractured parliament to determine the next prime minister – a role reserved for a Sunni Muslim. However, if history is any guide, this process could take months and protesters are not that patient. Given that Hariri has sidelined himself and – unlike Parliament Speaker Nabih Berri or Foreign Minister Gebran Bassil – he is not the core target of protesters’ ire, there is a possibility that he may once again be appointed to the post of prime minister. While the outgoing government will take on a caretaker role until a new one is formed, demonstrators are standing their ground. This has generated a political standoff causing Lebanese assets to bear the brunt (Chart 4). The emergence of competing rallies – in the form of support for President Michel Aoun – only complicates and possibly prolongs the situation. For now, the army is staying on the sidelines, allowing the protests to be – for the most part – a peaceful one. However, with Hezbollah also subject to the protesters’ wrath, odds of greater regional tensions have increased. Hezbollah may attempt to regain lost support by provoking Israel. The instability could also prompt Hezbollah to reassert its willingness to use force against domestic enemies, namely any new government that attempts to disarm it. In the meantime, Lebanon’s economy and financial markets will remain under pressure. The economy depends on capital inflows from citizens living abroad to finance the large twin deficit and maintain the dollar peg. Thus, the decline in sentiment will weigh on the economy (Chart 5). While the government has not implemented official capital controls, banks have independently tightened restrictions and raised transaction fees to reduce capital outflow. Chart 4Further Unrest Ahead Chart 5Weak Sentiment Weighs On Lebanon's Economy Bottom Line: Lebanese protesters and the political class are in deadlock. The prime minister’s resignation has done little to ease the tension, and demonstrators are refusing to back down until a new non-sectarian, technocratic government is formed. The domestic economy will remain frail. Earlier this week the central bank asked local lenders to boost their liquidity by raising their capital by 20% or $4 billion in 2020 in anticipation of potential downgrades. A stabilization of the political situation is a necessary precondition to boost confidence and once again shore up capital inflows. Nevertheless, with the protest movement being largely headless, the path toward compromise with the government will be challenging, raising the odds of prolonged tensions. What Of Iran’s Sphere Of Influence? “Not Gaza, Not Lebanon, I Give My Life For Iran” - Chants by Iranian protesters, January 2018 Iran has a strong incentive to preserve the established systems in both Lebanon and Iraq. The protesters’ demands risk weakening its grip on power in the region. In both movements, pro-Iranian forces have taken a stance against the protests with Hezbollah in Lebanon advising against the resignation of Prime Minister Hariri while the Iran-backed bloc in Iraq voiced concern over the chaos that will ensue with the prime minister’s resignation. Meanwhile, Tehran’s position is hardening. Iran is taking further steps away from the nuclear deal, injecting uranium gas into centrifuges at its underground Fordow nuclear complex, making the facility an active nuclear site rather than a permitted research plant. Chart 6Popular Support For Iran’s Hardening Stance Chart 7US-Iran Détente Unlikely This reflects the loss of public support for the JCPOA and the loss of confidence that other countries will honor their obligations toward the nuclear agreement (Chart 6). In a speech on November 3 marking the fortieth anniversary of the 1979 US Embassy takeover, Supreme Leader Ayatollah Ali Khamenei renewed his ban on negotiations with the US. His stance mirrors public opinion, which is moving toward an increasingly unfavorable view of the US (Chart 7). However, this does not mean that President Hassan Rouhani’s administration is immune to popular discontent. Rather, with Iranians living through a continued economic deterioration and assigning the most blame to domestic mismanagement and corruption, there could be cracks forming in Iran as well (Chart 8). Chart 8A Case For Unrest In Iran? Bottom Line: The ongoing US withdrawal from the Middle East opens opportunities for Iran to increase its regional influence. It has been capitalizing on such opportunities by lending support to its proxies in Syria, Yemen, Iraq, and Gaza. However, the escalation of unrest in Lebanon and Iraq pose a risk to Iran’s grip on power in the region. On the one hand, if the movements there result in new governments, Iran will witness its wings clipped. This could incentivize retaliation and violence in Iraq, and provocations by Hezbollah along Lebanon’s southern border in an attempt to regain lost support. On the other hand, a prolonged standstill between protesters and the governments could result in greater Iranian influence over the long term. Other foreign powers are unwilling to wholeheartedly intervene to fill an emergent power vacuum. Investment Implications The risk of a decline in Iran’s control over its sphere of influence and the still unstable state of Iraqi domestic politics suggest that the geopolitical risk premium in oil prices should remain elevated. For now, President Trump is still enforcing sanctions and Iran’s oil exports have largely collapsed (Chart 9). The White House is continuing to add pressure by warning Chinese shipping companies – the largest remaining buyer of Iranian oil – against turning off their ships’ transponders. Chart 9The US Maintains Pressure On Iran News reports indicate that oil workers in Iraq’s southern region have started to join the government demonstrations. Moreover, reports on Wednesday indicate that the 30k b/d of production from the Qayarah oil field has been shut down due to road blockades in Basra that are preventing trucks from transporting crude to the Khor al-Zubair port. The geopolitical risk premium in oil prices should remain elevated. While the impact on the country’s oil production and exports have so far been minimal, a prolonged standoff between protesters and the government could result in supply outages. Today’s environment is notably different than that of the ISIS invasion of Iraq in 2014. Tensions then did not create a geopolitical risk premium in oil as they occurred amid an oil market share war, which kept supply abundant. Similarly, the September attack on Saudi Arabian oil facilities did not result in a lasting price spike as it occurred at a time of weak global demand. Moreover, Saudi Arabia possesses the technology and spare capacity that permitted it to swiftly restore output and maintain export commitments. The same cannot be said today about Iraq. A disruption there would be of greater consequence to oil markets, as illustrated by the 2008 Battle of Basra. Especially given Saudi Arabia's need to maintain high prices and amid the Aramco IPO and the tailwind created by a rebound in global growth. The fall in global economic policy uncertainty as the US and China move toward a trade ceasefire will weaken the dollar and support global demand for oil, which is overall bullish for oil prices. Moreover, US-Iran tensions remain unresolved which pose risks to production and shipping infrastructure in the region. We remain tactically long spot crude oil on the back of the geopolitical risks to supply as well as an expected revival in global demand. We are booking a 4.6% gain on our GBP-USD trade but remain long sterling versus the yen. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The ‘land bridge’ is an aspirational route by which Iran would create a strategic corridor to the Mediterranean, stretching through friendly territory. 2 Lt. Gen. Abdul-Wahab al-Saadi was recognized and respected among Iraqis for fighting terrorism and his role in ridding the country of the Islamic State. The Iran-backed Popular Mobilization Forces were uneasy with Saadi’s close relationship with the US military. His abrupt removal was likely a result of the Iraqi government’s growing concern over al-Saadi’s popularity and rumors of a potential military coup. 3 Protests are occurring in all regions in Iraq. They are supported by Grand Ayatollah Ali al-Sistani. This is a significant development from the 2018 protests which were mainly concentrated in Iraq’s southern region. 4 Under the current system, Lebanon’s president has to be a Maronite Christian, the parliament speaker a Shiite Muslim and the prime minister a Sunni. Cabinet and parliament seats are equally split between the two Muslims groups and Christians.
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