Financial Markets
Highlights At 50% Trump’s reelection odds are too high, flagging a risk to equity markets of policy discontinuity. The virus, unemployment, and wages will weigh on him over the year. Trump’s polling is firm because the crisis is still acute. If it remains firm when the dust settles then we will reassess. Trump is competitive in swing states, but not clearly leading. The stock market, as a single variable, is an excellent gauge of reelection odds for ruling parties in US elections going back to 1896. It gives Trump a 16% chance as of today. This is too low, but unemployment and wages also suggest he is an underdog. Michelle Obama and Justin Amash are potential spoilers flying under the radar. The Senate will follow the White House, signaling an understated risk of a total policy reversal and hard left turn in US policy. Massive stimulus motivates our long run risk-on trades: cyber security, infrastructure, Fed-backed corporate bonds, and China reflation plays. Europe and European industrials stand to benefit on a relative basis if Biden wins. Feature Chart 1Recent Poll Shows Trump Leads In Swing States President Donald Trump’s reelection bid is holding up better than we expected so far this year. Trump leads former Vice President Joe Biden in swing states by 52% to 45%, according to a poll taken by CNN from May 7-10 (Chart 1). Our poll of polls below are not as supportive, but this is a strong sign of competitiveness for a sitting president in the midst of a pandemic, recession, social unrest, and controversy over reopening the economy. Naturally several clients have pushed back against our decision to downgrade Trump’s chances of victory from 55% to 35% back in March. We don’t mind the heat – we took the heat for two years while we favored Trump for reelection. Moreover we are not dogmatic. If the facts change, we will change our minds. So far, we are sticking to our view. It is a view that implies risk to corporate earnings and hence supports a tactically bearish or short positioning on the S&P 500. If Trump maintains and builds on his popular support, particularly by August when the Republican and Democratic parties hold their conventions, then we will upgrade his odds, assuming that the economy is improving and the pandemic is abating. At present the market is underrating the challenges facing the president, as we outline in this report. Reopening Poses Downside Risks To Trump Chart 2US Follows The Swedes So far reopening is helping Trump, but it poses a major risk to him down the line this year. The election is five months away – a world away. The new “whistleblower’s complaint” against the Trump administration argues that America faces its “darkest winter in modern history” due to the impending second wave of the virus. However, we rely on the testimony of Anthony Fauci to the Senate this week. Fauci said that states can continue to reopen as long as they adhere to federal guidelines that require 14 days of declining cases in the first phase. June 1 is an acceptable time for most states to open. The trajectory of US deaths per million is deviating from the path of the European Union and moving toward the path charted by Sweden. Swedes have adhered strictly to looser guidelines; Americans have adhered loosely to stricter guidelines. The US death count per million people, a lagging indicator, will rise or at least remain flat in the coming months if states and individuals are not vigilant and compliant (Chart 2). One should assume, however, that governments and individuals will alter their behavior for the sake of self-preservation and in light of new information. Interior American states – those not included in the “COVID confederacy” of western and eastern Democratic states – have seen a tentative drop in deaths (Charts 3A & 3B). While looser restrictions will lead to higher deaths than otherwise, it is not a foregone conclusion that it will be unmanageable for the health system. Chart 3AInterior US Sees Rising COVID Cases … Chart 3B… And Deaths Could Rise From Here From an Electoral College perspective – an absurd way to look at a pandemic, but such are the times – the red states will see an accelerating case count and death toll if they do not actively manage the reopening process (Charts 4A & 4B). This is a political liability. Chart 4ARed States Stable In Case Count … Chart 4B… Yet Deaths Could Tick Up Expectations that Trump is a slam dunk for reelection neglect the obvious fact that interior states shut down before they suffered the full brunt of the pandemic. If new outbreaks spiral out of control, it will have a negative political ramification for those pushing for a quick reopening. That will eventually accrue to the president, with whom the buck stops. A resurgence of infections, whether this summer or this fall, will be met with better preparedness, in terms of non-pharmaceutical intervention (social distancing) and likely pharmaceutical intervention as well (anti-virals, probably not yet a vaccine). But the virus is now underrated as a political risk since President Trump is fully identified with the decision to “liberate” the states yet his polls are firm and online gamblers on sites like PredictIt are giving him a roughly 50% chance of winning reelection. Bottom Line: If outbreaks spiral out of control in swing states then the incumbent president and ruling party will be punished. The evolution of cases and deaths is critical in the near term. Uncertainty over reopening, and understated risks of political change, call for a higher equity risk premium and hence more downside for share prices. Trump’s Approval Gains Are Slight Americans are hitting “peak polarization” this year and the coming years. It is well known that partisanship is affecting voters’ views on objective reality. But notice that all consumers are getting more optimistic about the future, not just Republicans (Chart 5). Chart 5Sentiment Is Polarized But Everyone Sees Improvements On Horizon Uncertainty over reopening and understated risks of political change, call for more downside for share prices. There is a clear bifurcation in voter’s opinions of Trump’s handling of the economy as against the pandemic. Voters approve less and less of his pandemic response; they disapprove less and less of his handling of the economy (Charts 6A & 6B). Chart 6ATrump’s Approval Falling On COVID-19 … Chart 6BYet Supported On Economy Chart 7Voters Wary Of Reopening Too Fast The implication is that if the economy is the single biggest issue in November, then Trump made the right electoral call to reopen fast and focus on presiding over the biggest stimulus in history. Yet a clear majority feels the country is lifting restrictions too quickly. Only a slight majority of Republicans agree with him (Chart 7). Recent Emerson and Marist polls reinforce the point that the economy is the most important issue. Biden is leading Trump on the coronavirus – and notably leading older voters on both issues (Charts 8A & 8B). Chart 8AVoters Still Most Concerned About The Economy Chart 8BYet One Poll Says Biden Gaining Lead On Both Economy And Pandemic Trump’s national approval rating remains underwater, but it has gradually converged with the average of American presidents (Chart 9). A major incident of social unrest – which is possible given active protest movements amid high polarization – would hurt him. The lowest point in his approval rating occurred in August 2017 during the Charlottesville, Virginia protests against taking down a statue of Confederate General Robert E. Lee that turned bloody. Incidents of social unrest will be exploited by both political extremes, but a rise in unrest in general would cause anxiety among middle-of-the-road voters and tend to hurt the ruling party. Chart 9Trump Rising – But Social Unrest A Risk Chart 10Trump Not Yet Clearly On Obama Trajectory Chart 11Trump Gaining Among Hispanics, But Slight Dip Among Elderly Comparing Trump’s approval rating to his immediate predecessors is more realistic because general presidential approval has declined over time due to polarization. On this front, Trump is falling short of President Obama at this stage in 2012. Of course, he could still rally in the lead-up to the campaign, as is typical of sitting presidents (Chart 10). An important caveat is that Trump is making headway in unexpected voting groups. His support is surging among Hispanics, who are disproportionately hurt by economic lockdowns due to the sectoral concentration of their labor, yet less likely to die of COVID-19 (most likely because they are a younger cohort relative to blacks and whites). Moreover this trend began before the coronavirus and coincides with a rise in approval among electorally vital Midwesterners, as well as young people (Chart 11). The implication is that Democrats’ decision to impeach Trump has helped him, just as we argued it would last year, and yet COVID-19 has not reversed his gains. Older people, as mentioned, are a very important exception. They are the critical voting bloc and most susceptible to the virus. They are tentatively becoming less approving of the president. This is according to this Gallup poll, to the CNN poll highlighted at the top of this report, and the aforementioned poll in Chart 8 above. The right-leaning pollster Rasmussen – a proxy for those trying to avoid anti-Trump skews in polling due to any self-censorship or methodological biases – shows that Trump’s approval rating bottomed at a slightly lower level than it did when the Zelensky call appeared last fall, but not as low as during the market plunge and political controversies of late 2018 (Chart 12). This is good news for Trump. Chart 12Trump Reviving From Virus Hit, Shows Rasmussen Polling Chart 13Trump’s Polling Bounce Small Relative To Peers Yet Trump’s polling “bounce,” as the nation rallies around his leadership amid crisis, is small at two percentage points. Other leaders have gotten bigger boosts (Chart 13). More importantly, Trump’s polling bounce is miniscule compared to the average bounce for American presidents during crises that assail the US from the outside (Table 1). Table 1Trump’s Crisis Polling Bounce Compared To Previous Presidential Bounces Bottom Line: Trump is holding up surprisingly well with voters amid the crisis given his past polling. This is an important signal. But it is important to see if it is sustained after the acute phase passes. His polling gains are small relative to US history and contemporary peers. His consistent strong marks on the economy only matter if the economy is the chief issue of the election, but the pandemic creates a major risk that this election could be one of the unusual elections in which a non-economic issue is the most salient. Trump Isn’t Winning In Head-To-Head Polls Earlier we highlighted Trump’s lead in swing states, according to the latest CNN poll. But in our aggregate of polls, Biden is leading in all swing states except Ohio (Chart 14A). Chart 14ABiden Leads Swing State Poll-Of-Polls Except Ohio The lead is within the margin of error in Wisconsin, Florida, and Arizona, meaning the candidates are effectively tied. But that reflects negatively on the sitting president, since incumbents have an advantage over challengers, and Biden is widely known to be a deeply flawed challenger. Trump has taken a big hit in head-to-head polls in critical states. Moreover the year-to-date change in these head-to-head polls suggests that Trump has taken a big hit in critical states: Florida, Arizona, and even Ohio, which should be rock solid for him (Chart 14B). Chart 14BTrump Suffered Blow From Virus In Swing State Poll-Of-Polls The consolation for Trump is that Biden, “Sleepy Joe in the basement,” who is fending off mounting accusations of sexual misconduct against Tara Reade, has either lost ground or made negligible gains. Clients often tell us they do not trust the polls. But post-WWII history shows that polls are fairly accurate and more accurate for sitting presidents than their challengers. Incumbents have averaged 55% of the popular vote, versus 49% for challengers, a clear indication of the incumbent advantage (Chart 15A). Chart 15ASitting Presidents Usually Win The Popular Vote Voter intentions in October and November ahead of the election are usually only 0.8% lower than the sitting president’s actual vote share. However, the same polls tend to underrate challengers by 2.2% (Chart 15B). Chart 15BPolling Is Accurate – Yet Underrates Challengers More Than Incumbent Presidents Chart 16Trump’s Favorability Less Negative, Biden’s Turns Negative Favorability polling is of limited relevance, given that the candidates for president in 2016 and 2020 are the least favorable of all politicians. Polarization makes it so that being hated by the other party is an asset. But it is notable that Trump’s net favorability is not half as negative as it was in 2016, and that he is tied with Biden, whereas Biden has fallen a great distance since the last economic crisis, when he had greater favorability than Barack Obama (Chart 16). Bottom Line: The candidates are virtually tied in the swing states and Biden’s slight lead in our poll-of-polls has not benefited from the crisis. Incumbents tend to outperform their polling by one point, but challengers tend to outperform by two. Biden is manifestly a weak challenger but taking all the evidence together he has a slight lead at present in the swing states. Stock Market And Recession Are Worrisome For Trump Table 2Trump’s Odds 50% At Most Based On Historic Recession/Election Probabilities US elections are a referendum on the incumbent party. Recessions tend to destroy sitting presidents. This is true, but there are important exceptions. A close look at the odds of sitting presidents, as well as sitting parties, and the timing of when the economy resumes expansion, suggests that Trump’s odds of winning are at best 50/50 (Table 2). Our own quantitative election model shows the same thing, and has hovered at 51% all along, although it will flip key states against him once state-level data are updated for the collapse in the economy. Fernando Crupi, of BCA Research Commodity & Energy Strategy, shows what a simple and straightforward look at the S&P 500 implies about Trump’s odds. Together we looked at two variables in elections since 1896: the market performance year to date on October 31 of the election year, and the result of the election for the incumbent party, i.e. victory if the incumbent party is reelected or loss if the new president hails from the opposing party. To estimate the probability of victory we use a logistic model, a widely used statistical tool designed to predict probabilities which can only range between zero and one, never hitting them.1 It is virtually impossible for an election outcome to be certain. The results are as follows: The year-to-date performance of the S&P 500 is a statistically significant variable (at the 5% level) in determining the fate of an incumbent party and has a positive correlation with it. Out of 31 elections, the model correctly predicted the outcome of 77% of the elections in-sample. While this is far from perfect it is remarkable given that we are using the market performance as the only explanatory variable. The effect of an additional percentage point of stock market performance is not linear on the incumbent party’s re-election odds, so two numbers are worthwhile expressing. At the mean S&P 500 YTD performance of the 31 elections, an additional percentage point increase in the market would increase the incumbent party’s odds of winning by 2.8 percentage points, and a decrease would decrease it by the same. By comparison, for all possible values of market performance, the average effect of an additional percentage point increase (or decrease) of the market would increase (or decrease) the probability of an incumbent party re-election by 2.1 percentage points. Chart 17 helps to visualize the model – for any percentage of market performance YTD as of October 31, it shows Trump’s odds of reelection this fall. With the S&P down by 13% this year, Trump’s odds would be 16%. A 10ppt recuperation in the S&P 500 from here would increase his chances to 40% and a 15ppt recuperation would bring him to 55%. Chart 17The Stock Market Says Trump’s Reelection Odds Are 16% Obviously the stock market is likely to rally or sell off for various reasons, for instance, if it thinks that the economy will get worse and the incumbent will lose. A change of government introduces policy uncertainty. Our own electoral model, explained in previous reports, is more robust than this back-of-the-envelope experiment and produces a more favorable outcome for Trump. So while the S&P may be low-balling Trump at 16%, we have no basis either in history or in formal modeling to give him more than a 50% chance as things stand today. And subjectively we think 50% is too high. Presidential approval follows the unemployment rate in the final innings of the campaign. Trump is doomed by this measure. Lastly, to reiterate and update key points we have made in the past: Presidential approval tends to follow the unemployment rate in the final innings of the campaign. Trump is obviously doomed by this measure, as it is the net change over time that matters most (Charts 18A & 18B). Chart 18AUnemployment Rate A Huge Chart 18B… And Tends To Predict Voter turnout is one of the hardest variables to predict, but it follows pretty closely with the change in unemployment over the preceding four years in the swing states. High turnout amid a deep recession is negative for the incumbent president (Chart 19). Chart 19Surge In Unemployment Positive For Turnout, Yet Hurts Incumbent Our subjective probability of reelection, at 35% as of March 24, holds up pretty well in this light. We will adjust this as new evidence comes to light. Bottom Line: To claim that Trump’s odds of reelection are substantially higher than 50% is to argue that “this time is different.” The market should keep falling from its April 29 peak around 2950 not only because of uncertainty about the pandemic and economy but also because of the risk that Trump’s troubles lead to market-negative outcomes. Michelle And Justin As Spoilers With multiple overlapping crises and high polarization, we have highlighted the high potential for extreme events, black swans, and spoilers. These do not include any move of the election date – that would make Trump look weak and would require House Democrats to agree to change a key 1845 statute.2 But they include almost everything else: violent incidents, disputes over voting methods amid the virus, vote recounts, judicial interventions, Electoral College irregularities, congressional intercession, refusals to concede, you name it. We would not be surprised if the Supreme Court took an opportunity currently before it to rule in favor of punishments against “faithless electors” or even to prohibit electors from voting contrary to the popular will in general. On a much less important note, we would also not be surprised if the high court enables President Trump’s personal accounts and tax records to be subpoenaed. Another possible spoiler: Michelle Obama. Chart 20Michelle Obama Objective Best Pick For Vice President Biden is currently mulling his pick for the vice presidential candidate. None of the candidates are magical: Senator Amy Klobuchar makes the most sense of the conventional options as she could improve his standing among women, Midwesterners, white voters, and suburbanites. She hails from Minnesota, he from Pennsylvania, creating a potential pincer movement in the Electoral College. Klobuchar’s favorability is stronger than that of Senators Elizabeth Warren and Kamala Harris, neither of whom can help bring a swing state (Chart 20).3 Yet Warren is well known and could help mend the gap with the progressive wing of the party. Picking her highlights the understated risk to the market of a progressive turn in Biden’s platform. Stacey Abrams could help bring over the black vote but she is sorely lacking in credentials and is reminiscent of the GOP’s desperate and failed bid to reconnect with its base by nominating Sarah Palin in 2008. The obvious choice is Michelle Obama. She has the highest favorability by far, including when her detractors are netted out. She solidifies Biden’s connection with Barack Obama, helps energize progressives, women, and minorities who are needed to turn out. And her power base is in the Midwest. One little problem … Michelle has repeatedly said she does not wish to run. Others have confirmed she has no interest. And a Machiavellian political adviser could advise her to wait until later when there is no incumbent president and then run directly for the top job, free of Biden’s baggage. We held the latter view, until the corona crisis. Trump was heavily favored prior to recession. Now the tables have turned. And a vice presidential role would improve her chances of being the first woman president later. The fact that she apparently does not want to run is obviously a huge problem. But her party needs her and this fact may become increasingly evident as Biden’s weaknesses are exposed. Vice presidential picks seldom make a difference in the campaign. At best they can help bring a swing state. But this election is different. Biden would turn 78 immediately after being elected; he is more likely than the average president to depend upon his VP while ruling, and to pass the baton to the VP early. COVID-19 underscores this risk. In other words, this year is the rare case where the Veep pick is important enough to matter and a charismatic candidate exists who could materially improve the odds of the opposition party’s victory. Would Michelle really help? An argument could be made that the Obama legacy is tarnished and that Trump would relish the chance to run against the Obama brand. However, our reasoning is based on Electoral College scenarios drawn from the best demographic data available, which suggest that the strongest challenge the Democrats can mount in 2020 is to reproduce the 2012 Obama/Biden ticket (Chart 21). Chart 21Electoral College Scenarios Say Biden/Obama 2012 Redux Best Shot For Dems To Beat Trump Chart 22Amash Is Small, But Significant Another important potential spoiler is Justin Amash. Amash is a former Republican who defected from the party due to his opposition to Trump and has since become the nation’s first congressman of the Libertarian Party. Amash could be important because he hails from Michigan, a key swing state, and is a splinter from the right-wing rather than the left-wing, thus potentially threatening President Trump’s thin margins in the battleground states. Currently Amash is winning 3%-5% of the popular vote, according to polls (Chart 22). Historically an extremely elevated third party vote is a threat to the incumbent president and ruling party, regardless of ideological affiliation. This is because it bespeaks general popular discontent, which in turn reflects negatively on the status quo and ruling party. However, so far Amash is not popular enough to hit the extremely elevated threshold. Looking at third party candidacies that have drawn more than 2% of the vote over history, the incumbent party wins 50% of the time. So the historical results are indecisive, but they do show potential for Amash to play the spoiler (Table 3). Table 3How Do Sitting US Presidents And Their Parties Fare When Voters Turn To Third Parties? Furthermore a larger group of Democrats and Democratic-leaning voters are determined not to vote for Biden than Republican and Republican-leaning voters are determined not to vote for Trump (Chart 23). The Republican Party rank and file support Trump enthusiastically, more so than Democrats support Biden, especially in the swing states (Chart 24). This suggests that Amash will fail to get traction among Republicans. Chart 23Left-Leaners Reject Biden More Than Right-Leaners Reject Trump Chart 24GOP More Zealous For Trump Than Dems For Biden We would not rule him out, however. The context of pandemic, deep recession, and extreme polarization is fertile for a third party candidate, as was the case in 2016. If support for Trump wanes due to the mounting death toll and unemployment rate, the weakness of Biden might point to defections from Trump’s camp to Amash. Again, this could be particularly relevant in swing states. Amash may not garner more votes than Gary Johnson, his Libertarian predecessor in 2016, since that year saw an “open election” favorable to third parties, whereas this year there is an incumbent running. But Amash has flown entirely under the radar. He is therefore underrated by markets. And his impact, in the final analysis, will likely prove more negative for the ruling party than Biden, who is very far from a libertarian. Bottom Line: Peak polarization and a historic national crisis will produce black swans. But some spoilers are identifiable. Biden picking Michelle Obama, and a small but significant margin of Republicans defecting to Amash in swing states, are non-negligible risks to Trump’s reelection odds. What About The Senate? Democrats are likely to retain the House of Representatives, unless the positive trends for Trump that we have highlighted start to snowball into massive momentum. Hence the Senate will be decisive to the legislative success of the next administration. It is especially relevant if a Democrat wins, since the implication would be single party control of both legislative and executive branches. By contrast, Trump’s reelection would imply a continuation of today’s balance of power. Online gamblers have finally come around to our long-held view that the Senate will go the way of the White House: currently PredictIt gives the Democrats a 52% chance, up substantially from last year. Republican Senate leaders have openly aired their fears as the election cycle picks up. The risk to Republican control is not merely because the crisis has erased the uptick in Republican Party affiliation (Chart 25), nor is it due to the break in Republican momentum in generic voter party support (Chart 26), though these developments are unwelcome to Republicans. Chart 25Republican Affiliation Of Voters Rolls Over Chart 26Democrats Tick Up Slightly In Generic Congressional Ballot Rather, politics have increasingly become nationalized and more Republican senators are at risk than Democrats due to the windfall Republican senate victory in 2014. Current polling reinforces that the Senate stands on a knife’s edge, as all races are virtually tied, except Colorado, which is a likely shoo-in for Democrats. Arizona is almost as good for them (Chart 27). Democrats need to take four seats plus the White House to win the chamber. Chart 27Close Races In Senate Will Follow The White House Bottom Line: The Senate will go the way of the White House, which means the market is not only underrating a Biden victory but also underrating the probability that he is unconstrained. With peak polarization, and full Democratic control, Biden would not prove a center-left president in office. He would end up governing to the left of the Obama administration. Investment Takeaways Why does the election matter? If Trump loses, the United States will most likely see another total reversal of national policy, as in 2016 and 2008. Yet this time the macroeconomic, political, and demographic backdrop will make it harder for Republicans to stage as effective of resistance as in 2010-16. This is positive for aggregate demand, due to fiscal policy, but negative for corporate earnings. Biden will be pushed to the left by the progressive wing of his party and will face relatively few legislative or judicial constraints. The Democrats will also surprise the market with a tough stance toward China to steal back the mantle of fighting for American workers. Big business will face higher taxes, sweeping re-regulation, and trade restrictions, all at the same time. The S&P 500 has fallen 4% since we recommended investors step back from the rally. We see more downside due to sluggish recoveries, viral outbreaks, hiccups in providing stimulus, and political and geopolitical risks. The S&P’s next support levels are at 2670 and 2250. Chart 28China Faces Protectionism Either Way, But Europe Only With Trump In the short term, Trump’s odds are overrated. We will upgrade him if the stock market, economy, and political indicators improve substantially from what we are seeing today by August when the two parties hold their conventions. What about our view that Trump will crack down on China? A crackdown will cause the S&P to sell. Yet a dramatic selloff that destroys his reelection hopes, or a rally based on massive stimulus, both encourage him to escalate the crisis. Politically, confronting China is positive for him and he cannot let Biden outmaneuver him on workers, trade, and China. This entire dynamic leaves us inclined to be risk-averse. For investors with a long time horizon we recommend selective risk-on investments such as cyber-security, infrastructure, China reflation plays, and investment grade corporate bonds, the latter now backed by the Federal Reserve. A parting thought on industrials. Gargantuan stimulus is positive for cyclical stocks over the long run. But Trump’s reelection raises the prospect of trade war not only with China but also with Europe. It also increases the substantial risk of an expanding conflict with Iran that sows unrest in the Middle East over the next five years. Whereas Biden would seek a united front with Europe against China and would reduce Middle Eastern risks to Europe. Hence over the long run European industrials can benefit disproportionately from a Biden win, on a policy-oriented basis, compared to a Trump win (Chart 28). Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Fernando Crupi Research Associate fernandoc@bcaresearch.com Footnotes 1 Compared to a simple regression line, the effect of the explanatory variable on the predicted probabilities varies along the curve. An increase (or decrease) in our explanatory variable by one unit has a smaller and smaller effect on the probability of victory as we approach our upper and lower probability bounds of 0 and 1. Obviously this model cannot fully explain the outcome of an election nor establish causality, but it gives us a good indication of how important the market performance is for an incumbent party to be re-elected. 2 Please see Acts of the Twenty-Eight Congress of the United States, Statute II, Library of Congress. www.loc.gov. 3 The only superior scenario mathematically, in which Biden aims solely at winning back the Democrats’ old blue collar white voter base, is much less likely to succeed given that these voters have drifted to the GOP in recent decades and have been galvanized by Trump.
The SPX 12-month forward P/E climbed to a new near two-decade high recently, as it almost kissed off the 21 handle (bottom panel). While investors begin to worry about lofty valuations, keep in mind that calendar 2020 profits are far from trend EPS. Peering across the valley to calendar 2021 and 2022 profits reveals that there is still more room for valuations to expand. Our sense is that the SPX some time next year can reclaim our trend EPS estimate near $162, and thus bring down the forward multiple to a more reasonable level (middle panel). The Fed’s ultra-dovish stance is a key driver behind the multiple expansion phase of late. Tack on the recent dip in fed funds futures below the zero lower bound, and factors have fallen into place for a sustained valuation overshoot phase. Bottom Line: We remain constructive on the prospects of the broad equity market on a cyclical 9-12 month time horizon.
Dear Client, In lieu of our regular report next week, we will be sending you a Special Report on China from Matt Gertken, BCA Research’s Chief Geopolitical Strategist. Matt will discuss whether China’s President Xi Jinping is losing his political mandate. Best regards, Peter Berezin, Chief Global Strategist Highlights The pandemic is likely to have a more severe impact on Main Street than Wall Street, which helps explain why stocks have rallied off their lows even as bond yields have remained depressed. Equity investors are hoping that central banks will keep rates lower for longer, while fiscal easing will revive demand. The end result could be lower bond yields within the context of a full employment economy – a win-win for stocks. In the near term, these hopes could be dashed, given bleak economic data, falling earnings estimates, and rising worries about a second wave of the pandemic. Longer term, an elevated equity risk premium and the likelihood that the pandemic will not have a significantly negative effect on the supply side of the economy argue for overweighting stocks over bonds. Negative real rates will continue to support gold prices. A weaker dollar later this year will also help. Divergent Signals Chart 1Conflicting Signals Global equities have rallied 24% off their March lows. The S&P 500 is down only 12% year-to-date and is trading close to where it was last August. In contrast, bond yields have barely risen since March. The US 10-year note currently yields 0.63%, down from 1.92% at the start of the year. The yield on the 30-year bond stands at a mere 1.3%. While crude oil and industrial metal prices have generally tracked bond yields, gold prices have rallied alongside equities (Chart 1). It would be easy to throw up one’s hands and exclaim that markets are behaving schizophrenically. Yet, we think it is possible to reconcile these seemingly divergent price patterns in a way that sheds light on where the major asset classes are likely to go in the months ahead. Two important points should be kept in mind: Bonds and industrial commodities tend to reflect the outlook for the real economy (i.e., Main Street) whereas stocks reflect the outlook for corporate earnings (i.e., Wall Street). The two often move together but can occasionally diverge in important ways. Stock prices and bond yields will tend to move in tandem when deflationary pressures are intensifying; however, the two often move in opposite directions when monetary policy is becoming more accommodative. The former prevailed in early March whereas the latter has been the dominant force since central banks have opened up the monetary spigots. The Real Economy Is Suffering The current economic downturn will go down as the deepest since the Great Depression. The IMF expects global GDP to contract by 3% this year, compared with a flat reading in 2009. GDP in advanced economies is projected to fall by 6%, twice as bad as in 2009 (Chart 2). Chart 2Severe Damage To The Global Economy This Year Unemployment rates are also likely to reach the highest levels since the 1930s. The US unemployment rate spiked to 14.7% in April. Even that understates the true increase in joblessness. The labor force has shrunk by 8 million workers since February. If everyone who had left the labor force had been considered unemployed, the unemployment rate would have jumped to nearly 19% (Chart 3). Unemployment among less-skilled workers rose more than among the skilled. Joblessness also increased more among women than men (Chart 4). Chart 3Increase In Joblessness Is Understated Chart 4Unemployment Has Risen More For Less Skilled Workers And Women The one silver lining is that unlike in past recessions, temporary layoffs have accounted for the vast majority of job losses (Chart 5). This suggests that the links between firms and workers have yet to be severed. As businesses reopen, the hope is that most of these workers will be able to return to their jobs, fueling a rebound in spending. Chart 5Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Risks Of A Second Wave Will that hope be realized? As we discussed last week, the virus that causes COVID-19 is highly contagious – probably twice as contagious as the one that caused the Spanish flu.1 While some social distancing measures will persist even if governments relax lockdown orders, the risk is high that we will see a second wave of infections. Even if a second wave ensues, we do not expect stocks to take out their March lows. In many places, the second wave could come on top of a first wave that has barely abated. This is precisely what happened during the Spanish flu pandemic (Chart 6). Stock prices and credit spreads have closely tracked the number of Google queries about the coronavirus (Chart 7). If the number of new infections begins to trend higher, concern about the pandemic will deepen. This makes us somewhat wary about the near-term direction of risk assets. Chart 6The Lesson From The Spanish Flu: The Second Wave Could Be Worse Than The First Chart 7Joined At The Hip March Was The Bottom In Equities Nevertheless, even if a second wave ensues, we do not expect stocks to take out their March lows. This is partly because the cone of uncertainty around the virus has narrowed. We now know that the fatality rate from the virus is around 1%-to-1.5%, which makes COVID-19 ten times more deadly than the common flu, but still less lethal than SARS or MERS, let alone some avian flu strains which have mortality rates upwards of 50%. A few treatments for the virus are on the horizon. Gilead’s remdesivir appears to be effective in treating COVID-19. Blood plasma injections also look promising. A vaccine developed by researchers at the University of Oxford has been shown to be safe on humans and effective against COVID-19 on rhesus monkeys. Production of the vaccine has already begun, and if it works well on humans, the Oxford scientists expect it to be widely available by September.2 The Stock Market Is Not The Economy Then there is the issue of Main Street versus Wall Street. US equities account for over half of global stock market capitalization. Tech and health care are the two largest sectors in the S&P 500. The former has benefited from the shift towards digital commerce in the wake of the pandemic, while the latter is a highly defensive sector that has gained from the flurry of interest in new treatments for the disease (Chart 8). Chart 8AUS Equity Sectors: Winners And Losers From The Pandemic (I) Chart 8BUS Equity Sectors: Winners And Losers From The Pandemic (II) Even within individual sectors, the impact on Wall Street has been more muted than on Main Street. For example, spending on consumer discretionary goods and services has plummeted across the real economy over the past few months. Yet, this has not hurt equity investors as much as one might have expected. Amazon accounts for 55% of the retail sector’s market capitalization. Home Depot is in second place by market cap. Home Depot’s stock is trading near an all-time high, buoyed by increased spending on home improvement projects by people stuck at home. McDonald's, which is benefiting from the shift to take-out ordering, is the largest stock in the consumer services sector (followed by Starbucks). Contrary to the claim that the stock market is blissfully ignorant of the mounting economic damage, those sectors that one would expect to suffer from a pandemic-induced downturn have, in fact, suffered. Airline stocks, which account for less than 2% of the industrials sector, have plunged. The same is true for cruise ship stocks. Bank stocks have also been beaten down, reflecting fears of heightened loan losses. Likewise, lower oil prices have undercut the stocks of energy exploration and production companies (Chart 9). At the regional level, non-US stocks, with their heavy weighting in deep cyclicals and financials, have underperformed their US peers. Small caps have also lagged their large cap brethren, while value stocks have trailed growth stocks (Chart 10). Chart 9Sectors Expected To Suffer From A Pandemic-Induced Downturn Have, In Fact, Suffered Chart 10Non-US Stocks, Small Caps, And Value Stocks Have Underperformed Tech stocks are overrepresented in growth indices, which helps explain why growth has outperformed value. Tech companies also tend to carry little debt while sporting large cash holdings. Companies with strong balance sheets have greatly outperformed companies with weak ones since the start of the year (Chart 11). Chart 11Firms With Strong Balance Sheets Have Excelled Relative To Weak Ones Chart 12Real Rates Have Come Down This Year In addition, growth companies have disproportionately benefited from the dramatic decline in real interest rates (Chart 12). A drop in the discount rate raises the present value of a stream of cash flows more the further out in time those cash flows are expected to be realized. What Low Bond Yields Are Telling Us Doesn’t the decline in real long-term interest rates signal that future economic growth will be considerably weaker? If so, doesn’t this nullify the benefit to growth companies in particular, and the stock market in general, from a lower discount rate? Not necessarily! While lockdowns have led to a temporary drop in aggregate supply, they have not severely undermined the long-term productive capacity of the economy. Unlike during a war, no factories have been destroyed. And while heightened unemployment could lead to some atrophying of skills, the human capital base has remained largely intact. Chart 13 shows that output-per-worker eventually returned to its long-term trend following the Great Depression. Chart 13No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth What the pandemic has done is made some forms of capital obsolete. We probably will not need as many cruise ships or airplanes as we once thought. But these items are not a huge part of the capital stock. And while some brick and mortar stores will disappear, this was part of a long-term shift toward a digital economy – a shift that has been raising productivity levels, rather than lowering them. Demand Is The Bigger Issue So why have long-term real interest rates fallen so much? The answer has more to do with demand than supply. Investors are betting that the pandemic will force central banks to keep interest rates at ultra-low levels for a very long period of time. All things equal, such an extended period of low rates might be necessary if the pandemic causes households to increase precautionary savings and prompts businesses to cut back on investment spending for an extended period of time. All things are not equal, however. As discussed in greater detail in Box 1, if real interest rates fall by enough, aggregate demand could still return to levels consistent with full employment since lower interest rates would discourage savings while encouraging capital expenditures. What if interest rates cannot fall by enough because of the zero-lower bound? In that case, fiscal policy would have to pick up the slack. Either taxes would need to be cut so that the private sector becomes more eager to spend, or the government would need to undertake more spending directly on goods and services. When interest rates are close to zero, worries about debt sustainability diminish since debt can be rolled over at little cost. In the end, the economy could end up in a new post-pandemic equilibrium where real interest rates are lower and fiscal deficits are larger. Applying Theory To Practice Framed in this light, we can make sense of what has happened over the past few months. The drop in long-term bond yields in February and early March was driven by falling inflationary expectations and rising financial stress. Yields then briefly jumped in mid-March as panicky investors dumped bonds in a mad scramble to raise cash. Not surprisingly, stocks suffered during this period. The Federal Reserve reacted to this turmoil by cutting rates to zero. It also initiated large-scale asset purchases, which injected much needed cash into the markets. In addition, the Fed dusted off the alphabet soup of programs created during the financial crisis, while launching a few new ones in an effort to increase the availability of credit and reduce funding costs. Other central banks also eased aggressively. As Chart 14 illustrates with a set of simple examples, even a modest decline in long-term interest rates has the power to significantly raise the present value of future cash flows. To compliment the easing in monetary policy, governments loosened fiscal policy (Chart 15). The point of the stimulus was not to raise GDP. After all, governments wanted most non-essential workers to remain at home. What fiscal easing did do was allow many struggling households and businesses to meet their financial obligations, while hopefully having enough income left over to generate some pent-up demand for when businesses did reopen their doors. Chart 14What Happens To Earnings During A Recessionary Shock? Chart 15Will It Be Enough? Ultimately, equity investors are hoping for an outcome where fiscal policy is eased by enough to eventually restore full employment while interest rates stay low well beyond that point in order to induce the private sector to keep spending: A win-win combination for stocks. Chart 16Gold Prices Move In The Opposite Direction To Real Rates The discussion above can also explain the divergent moves in commodity prices. Most industrial metals are consumed not long after they are produced. This makes industrial metal prices highly sensitive to the state of the global business cycle. In contrast, almost all of the gold that has ever been unearthed is still around. This makes gold an anticipatory asset whose price reflects expectations about future demand. Since owning gold does not generate any income, the opportunity cost of holding gold is simply the interest rate (Chart 16). When real interest rates rise, as they did briefly in early March when deflationary fears intensified, gold prices tend to fall. When real interest rates decline, as they did after central banks slashed rates and restarted large-scale QE programs, gold prices tend to rise. Investment Conclusions The current environment bears a passing resemblance to the one that prevailed in late 2008. Following the stock market crash in the wake of Lehman’s bankruptcy, the S&P 500 rallied by 24% between November 20, 2008 and January 6, 2009 to reach a level of 935. Had you bought stocks on that day in January, you still would have made good money over a 12-month horizon. However, you would have lost money over a 3-month horizon since the S&P 500 ultimately dropped to as low as 667 on March 6. During that painful first quarter of 2009, the economic surprise index remained firmly below zero, while earnings estimates continued to drift lower, just like today (Chart 17). As noted above, we do not expect stocks to take out their March 2020 lows, but a temporary sell-off would not surprise us, especially against a backdrop where a second wave of the pandemic looks increasingly likely. Chart 17Is Today A Replay Of Late 2008/Early 2009? Chart 18Favor Equities Over Bonds Over A 12-Month Horizon Despite our near-term concerns, we continue to think that stocks will outperform bonds over a 12-month horizon. The equity risk premium remains elevated, particularly outside the US (Chart 18). While non-US stocks do not have as much exposure to tech and health care, they do benefit from very cheap valuations. European banks are trading at washed out levels (Chart 19). The cyclically-adjusted PE ratio for EM stocks is near record lows (Chart 20). Investors should consider increasing exposure to non-US equities if global growth begins to reaccelerate this summer. Chart 19European Banks Are Trading At Washed Out Levels Chart 20EM Stocks Are Very Cheap Given our view that central banks want real rates to stay low and will refrain from tightening monetary policy even if inflation eventually begins to rise, investors should maintain above-average exposure to gold. A weaker US dollar later this year will also help bullion. Box 1The Role Of Monetary And Fiscal Policy Following Savings Shocks Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Risks To The U,” dated May 7, 2020. 2 Charlie D’Agata, “Oxford scientists say a vaccine may be widely available by September,” cbsnews (April 30, 2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights Treasuries: Despite surging issuance, long-dated Treasury yields will move only slightly higher this year, driven by a modest recovery in global demand. There is also a risk that a second wave of COVID infections will send yields to new lows. We recommend keeping portfolio duration close to benchmark while hedging the risk of higher yields by entering duration-neutral curve steepeners. Negative Rates: The Fed will not cut rates into negative territory any time soon. Investors who are able to do so should go short fed funds futures contracts that are priced for negative rates. EM Sovereigns: US bond investors should avoid USD-denominated EM sovereign debt and focus instead on US corporate credit rated Ba and higher. Of the EM countries with large USD bond markets, Mexican debt looks most attractive on a risk/reward basis. Don’t Expect A Taper Tantrum The big announcement in bond markets last week was the Treasury department detailing its plans for note and bond issuance in the second and third quarters. Of course, with the CARES act injecting $2.8 trillion into the economy, investors were already prepared for a big step up in issuance.1 But the numbers are striking nonetheless, particularly at the long-end of the curve. Overall note and bond issuance will reach $910 billion in Q3, roughly equal to the 2010 peak as a percent of GDP (Chart 1). Issuance beyond the 10-year point of the curve (i.e. the 30-year bond and new 20-year bond) will far exceed its financial crisis highpoint (bottom panel). Many bond investors are understandably worried that surging issuance will put significant upward pressure on yields in the coming months. Long-maturity Treasury yields jumped after the Treasury’s announcement on Wednesday before reversing all of that bounce the following day. But despite the mild market reaction, many bond investors are understandably worried that surging issuance will put significant upward pressure on yields in the coming months, especially with the Fed paring its pace of Treasury purchases (Chart 2). Chart 1Gross Treasury Issuance Chart 2Fed Buying Fewer Treasuries Our base case outlook is that Treasury yields will be marginally higher by the end of the year, and the yield curve will be steeper.2 However, we do not foresee a Taper Tantrum-style bond market rout. Treasury supply will continue to expand in the months ahead. But on the flipside, the Fed’s forward rate guidance will remain very dovish. If investors believe that short-dated interest rates will stay pinned near zero for a long time, fear of significant losses will remain low and Treasury demand will keep pace with supply, even at the long-end of the curve. Chart 3No Taper Tantrum In 2020 Yes, the Fed has scaled back its pace of Treasury purchases during the past few weeks, removing a significant source of demand from the market. However, it has also given no indication that it intends to lighten up on monetary stimulus broadly speaking. Based on the Fed’s dovish posture, we can be sure that if surging issuance leads to undesirably high term premiums at the long-end of the Treasury curve, the Fed will quickly ramp purchases back up to squash them. In general, our view is that all dramatic bond sell-offs are caused by the market suddenly pricing in a much more hawkish Fed reaction function. This can be driven by surprisingly strong economic growth and inflation, or by investors collectively changing their assessments of how the Fed will react. In this regard, the 2013 Taper Tantrum is an interesting case study. The Treasury curve bear-steepened dramatically in 2013 after Fed Chair Ben Bernanke laid out the Fed’s plan for winding down asset purchases. But this is not a simple story of bond yields rising because the market reacted to less demand in the form of Fed purchases. Rather, yields rose so much because Bernanke signaled to investors that the overall stance of monetary policy was much less accommodative than they had previously thought. Notice that gold fell sharply during this period (Chart 3), not because of less direct demand for Treasuries but because a more hawkish Fed meant less long-run inflation risk. The dynamic is illustrated very clearly by the CRB Raw Industrials / Gold ratio (Chart 3, bottom panel). The ratio is highly correlated with long-dated Treasury yields, meaning that for yields to shoot higher we need to see either a surge in global demand (i.e. CRB commodity prices) or a hawkish shift in the Fed’s reaction function (i.e. a drop in the gold price). If, as we expect, global demand improves only modestly this year and the Fed remains steadfastly dovish, upside in both the CRB/Gold ratio and long-maturity Treasury yields will be limited. Bottom Line: Despite surging issuance, long-dated Treasury yields will move only slightly higher this year, driven by a modest recovery in global demand. There is also a risk that a second wave of COVID infections will send yields to new lows. We recommend keeping portfolio duration close to benchmark while hedging the risk of higher yields by entering duration-neutral curve steepeners. Don’t Bet On Negative Rates Table 1Fed Funds Futures The massive amount of new issuance was not the only exciting development in fixed income markets last week. Short-dated yields also started to price-in the possibility of negative interest rates in the US! Table 1 shows the price of different fed funds futures contracts (as of Monday morning) and what funds rate those prices imply for each contract’s maturity month. We also show the return you would earn by taking an unlevered short position in each contract and holding to maturity, assuming that the actual fed funds rate remains unchanged. We assume that the fed funds rate will stay at its current level (0.05%) because the Fed has made it very clear that a negative policy rate is not an option that will be considered. As evidence, we present some excerpts from recent Fed communications. Fed Chair Jerome Powell from his March 15 press conference:3 So, as I’ve noted on several occasions, really, the Committee – as you know, we did a year-plus-long study of our tools and strategies and communications. And we, really, at the end of that, and also when we started out, we view forward guidance and asset purchases – asset purchases and also different variations and combinations of those tools as the basic elements of our toolkit once the federal funds rate reaches the effective lower bound – so, really, forward guidance, asset purchases, and combinations of those. You know, we looked at negative policy rates during the Global Financial Crisis, we monitored their use in other jurisdictions, we continue to do so, but we do not see negative policy rates as likely to be an appropriate policy response here in the United States. The Fed staff’s assessment of negative interest rates from the October 2019 FOMC minutes:4 The briefing also discussed negative interest rates, a policy option implemented by several foreign central banks. The staff noted that although the evidence so far suggested that this tool had provided accommodation in jurisdictions where it had been employed, there were also indications of possible adverse side effects. Moreover, differences between the US financial system and the financial systems of those jurisdictions suggested that the foreign experience may not provide a useful guide in assessing whether negative interest rates would be effective in the United States. FOMC participants’ assessment of negative interest rates from the October 2019 minutes:5 All participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States. Participants commented that there was limited scope to bring the policy rate into negative territory, that the evidence on the beneficial effects of negative interest rates abroad was mixed, and that it was unclear what effects negative interest rates might have on the willingness of financial intermediaries to lend and on the spending plans of households and businesses. Participants noted that negative interest rates would entail risks of introducing significant complexity or distortions to the financial system. In particular, some participants cautioned that the financial system in the United States is considerably different from those in countries that implemented negative interest rate policies, and that negative rates could have more significant adverse effects on market functioning and financial stability here than abroad. Notwithstanding these considerations, participants did not rule out the possibility that circumstances could arise in which it might be appropriate to reassess the potential role of negative interest rates as a policy tool. It is always possible that the Fed’s view of negative interest rates will change in the future. However, this won’t happen any time soon. The Fed still has other zero-lower-bound policy options it can deploy before it gets desperate enough to re-consider negative rates. The Fed still has other zero-lower-bound policy options it can deploy before it gets desperate enough to re-consider negative rates. For example, one logical next step would be to bring back the Evans Rule. That is, specify economic targets (related to unemployment and inflation) that must be met before the Fed will consider lifting rates. If that sort of forward guidance is deemed insufficient, the Fed could adopt a plan recently advocated by Governor Lael Brainard and start to cap short-maturity bond yields.6 If it wants more stimulus after that it could gradually move further out the curve, capping bond yields for longer and longer maturities. According to the FOMC minutes, this sort of Yield Curve Control policy had more support among participants at the October 2019 FOMC meeting than did negative interest rates:7 A few participants saw benefits to capping longer-term interest rates that more directly influence household and business spending. In addition, capping longer-maturity interest rates using balance sheet tools, if judged as credible by market participants, might require a smaller amount of asset purchases to provide a similar amount of accommodation as a quantity-based program purchasing longer-maturity securities. However, many participants raised concerns about capping long-term rates. Some of those participants noted that uncertainty regarding the neutral federal funds rate and regarding the effects of rate ceiling policies on future interest rates and inflation made it difficult to determine the appropriate level of the rate ceiling or when that ceiling should be removed; that maintaining a rate ceiling could result in an elevated level of the Federal Reserve’s balance sheet or significant volatility in its size or maturity composition; or that managing longer-term interest rates might be seen as interacting with the federal debt management process. By contrast, a majority of participants saw greater benefits in using balance sheet tools to cap shorter-term interest rates and reinforce forward guidance about the near-term path of the policy rate. Bottom Line: The Fed will not cut rates into negative territory any time soon. Investors who are able to do so should go short fed funds futures contracts that are priced for negative rates. For example, a short position in the June 2021 fed funds futures contract will earn an unlevered 6.5 bps if the fed funds rate remains unchanged and the position is held to maturity. No Buying Opportunity Yet In EM Sovereigns When assessing the outlook for the US dollar denominated sovereign debt of emerging markets we consider two main factors: Valuation, relative to both US Treasuries and US corporate credit. The outlook for EM currencies versus the dollar. Ideally, we want to move into EM sovereign debt when spreads look attractive relative to the domestic investment alternatives and when EM currencies are on the cusp of rallying versus the dollar. Valuation At first blush, value looks like it has improved considerably for EM sovereigns. The average spread on the Bloomberg Barclays EM Sovereign index is 167 bps wider than it was at the beginning of the year and the spread differential with the duration-matched Ba-rated US corporate bond index is elevated compared to the recent past (Chart 4). However, widening has been driven by a select few distressed countries (e.g. Ecuador, Argentina and Lebanon). When we strip those out and look only at the investment grade EM sovereign index (Chart 4, panels 3 & 4), the average spread looks relatively tight compared to a duration-matched position in Baa-rated US corporate credit. Chart 4Only A Few EMs Look Cheap Because country-specific trends often exert undue influence on the overall index, we find it helpful to look at value on a country-by-country basis. Chart 5A shows the average option-adjusted spread for major countries included in the Bloomberg Barclays EM Sovereign index. This chart makes no adjustments for credit rating or duration, and as such we see the lower-rated nations (Turkey, South Africa, Brazil) offering the widest spreads. Chart 5B shows each country’s spread relative to a duration and credit rating matched position in US corporate credit. Viewed this way, the most attractive opportunities lie in Mexico, Saudi Arabia, UAE, Colombia, Qatar and South Africa. Chart 5AUSD-Denominated EM Sovereign Debt By Country: Spread Versus Treasuries Chart 5BUSD-Denominated EM Sovereign Debt By Country: Spread Versus US Credit Currency Outlook Chart 6EM Currencies Are Linked To Global Growth Currency is important for EM sovereign spreads because a stronger local currency literally makes US dollars cheaper for the EM nation to acquire. This, in turn, makes its USD-denominated debt easier to service, leading to tighter spreads. Chart 6 shows that EM Sovereign excess returns versus US Treasuries closely track EM currency performance. We also observe a strong link between EM currencies and high-frequency global growth indicators like the CRB Raw Industrials commodity price index (Chart 6, bottom panel). Based on this, we would only expect EM currencies to strengthen when global demand starts to pick up. Further, as our Emerging Market strategists wrote in a recent report, EM central banks are behaving differently during this recession than they have in past downturns.8 In the past, EMs would often run relatively tight monetary policies in order to fend off currency depreciation in the hopes of preventing capital outflows. This time, EM central banks are cutting rates aggressively, allowing their currencies to depreciate but supporting domestic demand. This is bearish for EM currencies and sovereign spreads in the near-term, but will probably lead to stronger economic recovery down the road. At the country level, we assess how vulnerable each country’s currency is to further depreciation by looking at its ratio of exports to foreign debt obligations.9 This ratio is a measure of US dollars coming in over a 12-month period relative to 12-month US dollar debt obligations. It has a relatively tight correlation with the dollar-denominated sovereign spread (Chart 7A). Low-rated countries, like Turkey and South Africa, have relatively low export coverage of foreign debt obligations, while Russia and South Korea have relatively strong debt coverage. Combining Valuation & Currency Outlook Chart 7B shows the same measure of currency vulnerability on the horizontal axis, but shows EM spreads relative to duration and credit rating matched US corporate credit on the vertical axis. Here, we see that Russia offers poor valuation, but a relatively safe currency. Meanwhile, Colombia offers an attractive spread but has a poor currency outlook. In this chart, Mexico stands out as the most attractive on a risk/reward basis. Chart 7AEM Sovereign Spread Versus Currency Vulnerability Chart 7BEM Sovereign Spread Over US Credit Versus Currency Vulnerability You will notice that the three Middle Eastern countries that stood out as having attractive spreads in Chart 5B are not shown in Charts 7A and 7B. This is because some data are unavailable, and also because those countries operate with currency pegs. Despite attractive spreads in those countries, we would not advise long-run positions in the USD-denominated sovereign debt of Saudi Arabia, Qatar or UAE. As our EM strategists wrote in a recent Special Report, if oil prices remain structurally low in the coming years (~$40 range), pressure will grow for Saudi Arabia to break its currency peg and allow some depreciation.10 The same holds true for Qatar and UAE. A bet on those countries’ sovereign spreads today amounts to a bet on higher oil prices. Despite attractive spreads, we would not advise long-run positions in the USD-denominated sovereign debt of Saudi Arabia, Qatar or UAE. Bottom Line: US bond investors should avoid USD-denominated EM sovereign debt and focus instead on US corporate credit rated Ba and higher. Of the EM countries with large USD bond markets, Mexican debt looks most attractive on a risk/reward basis. Appendix: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. Right now, that means we are overweight corporate bonds rated Ba and higher, Aaa-rated Agency and non-agency CMBS, Aaa-rated consumer ABS and municipal bonds. We are underweight residential mortgage-backed securities and corporate bonds rated B and lower. The below Table tracks the performance of these different bond sectors since the Fed’s March 23 announcement. We will use this Table to monitor bond market correlations and evaluate our strategy's success. Table 2Performance Since March 23 Announcement Of Emergency Fed Facilities Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the size and potential efficacy of the CARES act please see Bank Credit Analyst Special Report, “The Global COVID-19 Fiscal Response: Is It Enough?”, dated April 30, 2020, available at bca.bcaresearch.com 2 Please see US Bond Strategy Portfolio Allocation Summary, “The Policy-Driven Bond Market”, dated May 5, 2020, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20200315.pdf 4 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 5 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 6 https://www.federalreserve.gov/newsevents/speech/brainard20191126a.htm 7 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 8 Please see Emerging Markets Strategy Weekly Report, “EM Domestic Bonds And Currencies”, dated April 23, 2020, available at ems.bcaresearch.com 9 For more information on this ratio please see Emerging Markets Strategy Special Report, “EM: Foreign Currency Debt Strains”, dated April 22, 2020, available at ems.bcaresearch.com 10 Please see Emerging Markets Strategy Special Report, “Saudi Riyal Devaluation: Not Imminent But Necessary”, dated May 7, 2020, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy The Fed’s unorthodox monetary policy is aimed at quashing volatility, lifting asset prices and debasing the currency, all of which are equity market bullish. Grim, but backward looking, macro data are already reflected in the significant restaurant relative share price correction. Upgrade to neutral. Book profits in the underweight S&P rails portfolio position and lift exposure to neutral on the back of: a.) already reflected grim ISM services data, b.) resilient industry pricing power, c.) firming railroad profit margin backdrop and d.) encouraging signs from our EPS growth model. Recent Changes Augment the S&P restaurants index to neutral, today. Upgrade the S&P railroads index to a benchmark allocation, today. Table 1 Feature The SPX made a fresh run to recovery highs last week, cheering forward looking news of reopening of the economy and neglecting backward looking downbeat employment and PMI releases. Extremely easy fiscal and monetary policies remain the dominant macro themes, and underpin our sanguine equity market view for the coming 9-12 months. While Bill Martin’s infamous 1955 portrayal of the Fed as “the chaperone who ordered the punch bowl removed just when the party was really warming up”,1 the Jay Powell led Fed has done the opposite, and rightly so: it has ordered and delivered a bottomless punchbowl. The Fed’s unorthodox monetary policy is aimed at quashing volatility (Chart 1), lifting asset prices and debasing the currency, all of which are equity market bullish. According to Leo Krippner’s shadow short rates (SSR) estimate, the shadow fed funds rate is negative and should continue to support the SPX (SSR shown inverted, Chart 2). Chart 1Vol Will Melt Chart 2Crumbling Shadow Rates Underpin The SPX… In fact, there are two distinct avenues that declining interest rates underpin equities: First, falling interest rates are a boon to equities via a rising price-to-earnings multiple (SSR shown inverted, Chart 3). While the 12-month forward multiple is above a 20 handle, the highest point since the dotcom bubble era, using second and third fiscal year sell-side profit estimates – which better resemble trend EPS – results in a more tame forward P/E multiple with more upside (Chart 4). Second, while the Fed would never admit to it, it is trying to devalue the US dollar and reflate the global economy, which will indirectly boost S&P 500 revenues. As a reminder, 40% of SPX sales are internationally sourced and thus a falling greenback is a boon to S&P 500 turnover (bottom panel, Chart 5). Chart 3…Via Higher Valuations Keep in mind that most of global trade is conducted in USD and when trade collapses it creates a US dollar shortage (i.e. fewer US dollars are circulating around) that lifts the value of the reserve currency and vice versa. Cognizant of that, the Fed is trying to provide ample US dollar liquidity and aid in pushing the greenback lower (top panel, Chart 5). Chart 4Peer Across The EPS Valley, And Valuations Have Room To Rise Chart 5Depreciating USD Is A Boon For SPX Sales Drilling beneath the SPX’s surface, early-cyclical consumer discretionary equities are the primary beneficiaries of negative SSR. The top panel of Chart 6 shows that over the past three decades relative share prices are the mirror image of interest rates. This cycle, household finances are in order and coupled with generationally low interest rates signal that consumer spending will recover smartly as the economy opens up in coming quarters. Thus, consumer discretionary stocks should sustain their outperformance (middle & bottom panels, Chart 6). A small digression with regard to the reopening of the economy is in order. Pundits have been discussing and showing the three distinct waves of the Spanish flu as the closest parallel with the current pandemic. Chart 7 shows these three waves using UK data, but the UK equity market (and the DOW for that matter) did not really budge back then. Keep in mind this was in the midst of a recession as the Great War was about to end on November 11, 1918 (Remembrance Day). Chart 6Stick With Consumer Discretionary Exposure Chart 7The 1918 UK Parallel, Including Equities While no one really knows how in the long-term this pandemic will affect the economy, the stock market, society in general and consumer behavior in particular, our sense is that uncertainty will continue to recede in the coming months irrespective of the second and third likely waves. Why? Because not only do governments know more about this invisible enemy, but they (and hospitals) will also be more prepared to deal with any future outbreaks. Moreover, given that there is a race to get a novel coronavirus vaccine (and treatment) the world over, a breakthrough will soon materialize; MRNA’s recent FDA phase II clinical trial for their vaccine candidate is a case in point. Receding uncertainty is great news for stock investors. Meanwhile, in recent research we highlighted that early-cyclical interest rate-sensitive equities do in fact lead the GICS1 sector pack in recessionary recoveries based on empirical evidence.2 As a reminder, in mid-April we lifted the S&P consumer discretionary sector to overweight and this week we are updating our views on a hard hit subindex. We are also upgrading a deep cyclical services industry to neutral. Preparing To Dine Out It no longer pays to be underweight the S&P restaurants index; upgrade to neutral today. Not only the reopening of the economy will, at the margin, bring back diners (take out mostly) to restaurants, but the two heavyweights that comprise 80% of the market cap of the S&P restaurants group are anything but discretionary. In our view, MCD is defensive and SBUX has become a staple. Thus, as the economy slowly reopens and store traffic picks up, these bellwether stocks will lead this index higher. Relative share prices have corrected to the twenty-year uptrend line and hover near the previous two breakout points in 2011/12 and 2015/16 where they should find enough support (top panel, Chart 8). With regard to macro data, most of the restaurant-relevant releases are looking in the rear view mirror. In other words, the trouncing in restaurant retail sales and employment, food-away-from-home PCE and even the collapse in the Restaurant Performance Index were “known knowns” (Chart 8). Therefore, all of this grim news is already reflected in the 30% drubbing in relative performance from peak-to-trough. Chart 8Grim Data Priced In Chart 9Dollar The Reflator Domestic restaurant sales should stabilize in the coming months. If the Fed manages to devalue the US dollar (please see discussion above), then even international revenues in general and Chinese sourced sales in particular will rekindle overall industry turnover (Chart 9). Keep in mind that China’s economy reopening is leading the global economy by about six weeks. Importantly, construction spending on restaurants is falling like a stone and this decline in supply and industry capex will provide a much needed offset to free cash flow generation (middle panel, Chart 10). Nevertheless, three key concerns keep us at bay and prevent us from turning outright bullish. First, net debt-to-EBITDA has taken a steep turn for the worst of late, and while it is mostly driven by the shortfall in cash flow, it is still quite unnerving (bottom panel, Chart 11). Second, there is margin trouble that restauranteurs have yet to work out, and a rising wage bill will continue to weigh on profit growth (second panel, Chart 11). Finally, relative valuations are lofty for our liking. On a 12-month forward P/E basis the S&P restaurants index is trading at 53% premium to the SPX and 26% above the historical mean (third panel, Chart 11). Chart 10Supply Restraint Is Positive Chart 11Watch These Risks Netting it all out, grim but backward looking macro data are already reflected in the significant restaurant relative share price correction. Lift exposure to a benchmark allocation. Bottom Line: Lift the S&P restaurants index to neutral for a relative loss of 13.7% since inception. The ticker symbols for the stocks in this index are: BLBG: S5REST – MCD, SBUX, YUMB, CMG, DRI. Upgrade Rails To Neutral Over the past three years we have been mostly on the right side of rails both in bull and bear phases; today we recommend cementing relative gains of 6.4% since inception, and lifting exposure to neutral. Rails are the largest transports subgroup and this services industry is showcasing impressive resilience in times of adversity. True, the latest ISM non-manufacturing survey made for grim reading. Both the headline number and most of the key subcomponents of the survey were tough to digest: the overall survey fell near the GFC lows (bottom panel, Chart 12), the Business Activity Index collapsed to 26%, an all-time low. While this survey can fall anew next month, we deem that extreme pessimism reigns supreme, and as the US economy is slated to reopen some semblance of normality will return in coming months. Tack on the improving export data out of China, and we are cautiously optimistic that rail hauling services will soon stage a comeback (middle panel, Chart 12). Chart 12As Bad As It Gets Chart 13Green Shoots The defensive nature of rails is most evident in industry pricing power (third panel, Chart 13). Railroad selling prices are holding their own despite a sizable drop in volumes. Moreover, CEOs exercised caution and refrained from adding to headcount. Taken together, they are boosting our profit margin proxy, which can serve as a catalyst to lift relative share price momentum out of its recent funk (second panel, Chart 13). Similarly, our 3 factor S&P rail EPS growth model is heralding a pickup in profits in the back half of the year (bottom panel, Chart 13). Despite all these tailwinds, there are some powerful offsets that tame our optimism on railroards. Intermodal rail shipments are a major freight category and thus a key determinant of rail profitability. As consumer confidence remains in freefall, downbeat retail sales will cast a dark shadow on this essential rail freight category (Chart 14). Finally, the industry’s rising debt profile is still a primary concern. Rail executives neglected capex in recent years and instead raised debt in order to retire equity and enhance shareholder value. We continue to view this “investment” backdrop with skepticism and prior to further augmenting exposure to an overweight stance we would want to see an easing on the debt uptake directed at these shareholder friendly activities (Chart 15). Chart 14The Consumer Is A Sore Spot Chart 15Debt Burden Flashing Red In sum, we are compelled to take profits in our underweight S&P rails portfolio position and lift exposure to neutral on the back of: a.) already reflected grim ISM services data, b.) resilient industry pricing power, c.) firming railroad profit margin backdrop and d.) encouraging signs from our EPS growth model. Bottom Line: Lift the S&P railroads index to a benchmark allocation today booking a profit of 6.4% since inception. The ticker symbols for the stocks in this index are: BLBG: S5RAIL – UNP, NSC, CSX, KSU. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 https://fraser.stlouisfed.org/title/statements-speeches-william-mcchesney-martin-jr-448/address-new-york-group-investment-bankers-association-america-7800 2 Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018 Favor value over growth April 28, 2020 Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Chart 1 The SPX made a run for the technically important 200-day moving average and set it sights to fresh recovery highs. Three key drivers underpin stocks and dominate the news flow: First, surfacing of positive news on a coronavirus vaccine fast-track with the FDA approving MRNA’s candidate for a phase II trial. Second, the Fed reiterating its commitment to ZIRP and QE5 (Chart 1). And third, the quintuplet tech titans (MSFT, AAPL, GOOGL, AMZN & FB) reporting solid profits and April guidance, thus alleviating investors’ fears of a complete breakdown in tech revenues and EPS. Tack on the World War-like fiscal easing packages (Chart 2) and the path of least resistance remains higher for the S&P 500 in the coming 9-12 months. Please see this Monday’s Weekly Report for more details. Chart 2
Highlights Global stimulus efforts are sufficient thus far, but more will need to be done, especially by Europe and emerging markets. Hiccups will not be well-received by financial markets. The net public wealth of countries helps put debt constraints into perspective in a world of zero and negative interest rates. Insufficient fiscal policy is a bigger risk for Europe in the near term than any Germany-mandated withdrawal of ECB quantitative easing. European states remain locked in a geopolitical predicament that prevents them from abandoning each other despite serious differences over fiscal policy, which will persist. We are tactically long defensive plays and safe havens. Stay long JPY-EUR. Feature This week we focus on two questions: Will global stimulus be enough to fill the gap in demand? And will Germany impose a hard limit on European stimulus efforts? Our answers are yes to the first and no to the second. It is impossible for governments to replace private activity indefinitely, but the resumption of private activity is inevitable one way or another. Governments are continuing to provide massive fiscal and monetary support. The near term is cloudy, however, due to the mismatch between uncertain economic reopening and increasing impediments to new stimulus. Weak spots in the global fiscal stimulus efforts arise in Europe and emerging markets excluding China. Europe, at least, is a temporary catch – as Germany has no choice but to help the rest of the EU prop up aggregate demand. But fiscal policy is a greater near-term risk to peripheral European assets than any cessation of monetary support from the ECB. Will Global Stimulus Be Enough? Yes, Eventually Chart 1 shows the latest update of our global fiscal stimulus chart comparing the size of today’s stimulus to the 2008-10 period. Countries that make up 92% of global GDP are providing about 8% of global GDP in fiscal stimulus. Full calculations can be found in the Appendix. Chart 1US Still Leads In Fiscal Stimulus The chief difference between our calculation and that of others is that we include government loans while excluding government loan guarantees. If a government gives a loan to a business or household, funds are transferred to the receiver’s deposits and can be spent to make necessary purchases or pay fixed costs. A loan guarantee, by contrast, is helpful but does not involve a transfer of funds. Our colleague Jonathan LaBerge, has recently written a Special Report analyzing the size of global fiscal stimulus. He provides an alternative calculation in Chart 2, which focuses on “above the line” measures, i.e. only measures affecting government revenues and expenditures. Government loans, guarantees, and other “below the line” measures are left aside in this conservative definition of stimulus. Chart 2Japan Leads In IMF “Above The Line” Account Of Stimulus Chart 3 shows the discrepancies between Jonathan’s version and our own – they are not very large. The major differences are Japan, China, Germany, Italy, and South Africa. Of these only Germany, Japan, and China are significant.1 Chart 3Geopolitical Strategy Estimates Accord Less Stimulus To Japan, More To Germany And China, Than IMF Does In Japan’s case, we include the stimulus measures that Japan passed at the end of 2019 because even though they were not passed in response to the pandemic, they will take affect at the same time as those that were. We do not include private sector complements to government action, which Japan includes in its account, since private responses are hard to predict and we do not include them for other countries. In China’s case, official estimates underrate the easing of credit policy. Credit is a quasi-fiscal function in China since the Communist Party controls the banks. With a large credit expansion the overall stimulus impact will be larger than expected, as long as borrowers still want to borrow. Data thus far this year suggests that they do, if only to cover expenses and debt payments. Our assessment that China’s stimulus will reach about 10% of GDP follows BCA Research’s China Investment Strategy. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts … Is global stimulus “enough” to plug the gap in demand? Chart 4 shows our colleague Jonathan’s narrower definition of stimulus compared with estimates of the drop in demand from social lockdowns and spillover effects. It assumes a fiscal multiplier of 1.1. The result suggests that the US, China, and Australia are clearly doing enough; Germany, Japan, and Canada are arguably doing enough; other countries including Italy, France, and Spain will likely have to do more. Chart 4Which Countries Have Plugged The Gap In Demand So Far? The latest news confirms this assessment. The US Congress is negotiating another phase of stimulus that will provide a second round of direct payments to households, a third infusion of small business loans, and a large bailout of state and local governments. The current total is $2 trillion, and so far this year these totals are only revised upward. This tendency stems from the political setup: Trump needs to stimulate for the election, GOP senators’ fates ultimately hinge on Trump, while the House Democrats cannot withhold stimulus merely to undermine the Republicans. Similarly, there can be little doubt that China and Japan will provide more stimulus to maintain full employment – their different political systems have always demanded it. We are more concerned about Europe. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts, with the last three ranging from 2%-4% of GDP, according to Chart 4 above. They will add more stimulus, but might they still fall short of what is needed? Assuming that the ECB will provide adequate liquidity, and that low bond yields for a long time will enable debts to be serviced, these countries can service their debts for some time. But what then is the constraint? From a long-term point of view, the UK and peripheral European nations have relatively fewer national assets to weigh against their well-known liabilities. They are closer to their constraints in issuing debt, even if those constraints are nearly impossible to establish and years away from being hit. This is apparent from the IMF’s data series on net public wealth, i.e. total public sector assets and liabilities (Chart 5A). These data, from 2016, are a bit stale, but they are still useful because they take account of assets like natural resources, real estate, state-owned companies, and pension plans that retain value over the long run. It does no good to refer to the large debt loads of countries without considering the vast holdings that they command. By the same token, at some point the debt loads look formidable even relative to these huge realms. Chart 5ANet Public Wealth: A Fuller Picture Of The Debt Story These data tend to underrate the sustainability of developed markets, which are highly indebted but have reserve currencies, safe haven status, and large, liquid credit markets. They overrate the sustainability of emerging markets, with large resource wealth and low-debt, but vulnerable currencies and credit markets. This is not only true for emerging markets with the most negative net worth, like Brazil, or with unsustainable fiscal policies, like Turkey and South Africa. China would look a lot worse in net public wealth, if this could be calculated, than it does on the general government ledger (Chart 5B), due to the liabilities of its state-owned enterprises and local governments. It would look more like the US or Japan in net public wealth – yet without a reserve currency. Chart 5BNet Government Debt: Flatters EM, Not DM Nevertheless the European states have a problem that the other developed markets do not have: the Euro Area’s “constitutional” order is still unsettled. Questions are continually arising about whether countries’ liabilities are backstopped by a single currency authority and the entire assets of the Euro Area. These questions will tend to be settled in favor of European integration. But treaty battles in the context of upcoming elections – in the Netherlands, Germany, France, and likely Italy and Spain – will provide persistent volatility. Bottom Line: Fiscal stimulus passed thus far is only “sufficient” in a few economies; it is insufficient in southern Europe and emerging markets. Uncertainty about the pandemic, and the pace of economic reopening and normalization, combined with any hiccups in providing adequate stimulus will create near-term volatility. Will Germany Halt Quantitative Easing? No, Not Ultimately The questions about Europe highlighted above have come to the fore with the reemergence of the “German question,” which in today’s context means Germany’s and northern Europe’s willingness to conduct fiscal policy to help rebalance the Euro Area and monetary policy to ease conditions for heavily indebted, low productivity southern Europe. We have little doubt that Germany will provide more than its current 10.3% of GDP fiscal stimulus given that it has explicitly stated that state lender KfW has no limit on the amount of loans it can provide to small businesses. This accounts for the difference between our fiscal stimulus estimate and the IMF’s, but the fullest count, including “below the line” measures, would amount to nearly 35% of GDP. A sea change in the German attitude toward fiscal policy has occurred, which we have tracked in reports over the years. This shift gives permission for other European states to loosen their belts as well. We also have little doubt that German leaders will ultimately accept the ECB’s need to take desperate measures to backstop the European financial system: The “dirty little secret” of the Euro Area is that debt is already mutualized through the Target 2 banking imbalance, worth 1.5 trillion euros (Chart 6). As our Chief European Investment Strategist Dhaval Joshi has argued, Germany, as the largest shareholder in the ECB, holds a large quantity of Italian bonds, and Italians have deposited the proceeds of these bond purchases in German banks. All of this is denominated in euros. If Italy redenominates into lira, it can make bond payments in lira and the ECB and Germany will suffer capital losses. Germany would then face Italians withdrawing their deposits from German banks that would still be denominated in euros (or the deutschmark). The cause of this predicament is the ECB’s quantitative easing program (Chart 7). Chart 6Europe’s Gordian Knot Thus Chancellor Angela Merkel’s shift in tone to become more supportive of joint debt issuance belies the fact that European debt is already mutualized through the Gordian knot of Target2 imbalances. This is a politically unpalatable reality for Germans, but they generally accept it because it is in Germany’s national interest to maintain the monetary union and broader European integration. Chart 7Quantitative Easing Puts Germans On Hook For Italy However, the market may need reassurances about “the German question” from time to time, as EU institutional evolution is ongoing. Financial markets did not sell off on the German court’s ruling on May 5, which ostensibly gave the Bundesbank three months before withdrawing from the ECB’s quantitative easing program. Since the sovereign debt crisis, investors have come to recognize that there is more undergirding European integration than mere German preference. Namely, geopolitics – which we have outlined many times, originally in a 2011 Special Report. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. Still, there will be more consequences from this week’s ruling. At issue is the budgetary sovereignty of the European member states as well as Article 123 of the Treaty of Europe, which holds that neither the ECB nor the national central banks of member states can directly purchase public debts. The latter is a prohibition on the monetary financing of deficits. It became controversial in the wake of Mario Draghi’s 2012 declaration that the ECB would do “whatever it takes” to preserve the euro and the ECB’s 2015 Public Sector Purchase Program (PSPP) quantitative easing program, which the European Court of Justice deemed legal on December 11, 2018. The controversy is now implicitly shifting to the new Pandemic Emergency Purchase Program. The other principle concerned is that of “proportionality,” which requires that EU entities not take actions beyond what is necessary to achieve treaty objectives. If the ECB acted without regard to the limits of its mandate, the fiscal supremacy of the states, and the broader economic and fiscal consequences of QE, then its actions would violate the principle of proportionality and would require adjustment by EU authorities or non-participation from member state authorities. The German court did not attempt to overrule or invalidate the European court’s decision in favor of QE, or QE as a whole. Rather, it held that this ruling was not “comprehensible,” hence requiring an independent German ruling, and that the larger question of whether QE violates the prohibition against debt monetization is “not ascertainable.” The reason is that the ECB did not explain its actions adequately and the European Court of Justice did not demand an explanation. Presumably once this is done more decisive determinations can be made. Essentially the German court is demanding “documentation” by the ECB Governing Council that it weighed its monetary decisions against larger economic and fiscal consequences. So will the Bundesbank withdraw from the ECB’s QE operations in three months? Highly unlikely! The ECB, whether directly or indirectly, will provide an assessment of the proportionality of its actions to the Bundesbank and the German court will probably conclude, with limitations, that the ECB’s actions were largely within its mandate. If not, however, markets will plunge. Then the Bundestag or the Bundesbank will have to intervene to ensure that Germany does not in fact withdraw support from the ECB. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. How can we be sure? German opinion. Chancellor Merkel and her ruling Christian Democrats have not suffered this year so far from launching a wartime fiscal expansion and backing the ECB and EU institutions in their emergency actions. On the contrary, they have received one of the biggest bounces in popular opinion polls of any western leaders over the course of the global pandemic. While the bounce will deflate once the acute crisis subsides, this polling signals more than the average rally around the flag (Chart 8). Merkel’s approval rating started to rise when her party embraced more expansive fiscal policy in late 2019 in reaction to malaise revealed in the 2017 election. Germany’s handling of today’s crisis, both the pandemic and the expansive fiscal policy, has put the ruling party in the lead for the 2021 elections (Chart 9). Chart 8Germans See Popular Opinion ‘Bounce’ Amid COVID Chart 9Merkel's CDU Revives Amid Global Crisis Chart 10Germans Support Euro, But Lean On ECB Moreover Germans are enthusiastically in support of the euro and the EU relative to their peers – which makes sense because Germany has been the greatest beneficiary of European integration (Chart 10). The ECB, by contrast, does not have strong support – and is losing altitude. But a crisis provoked by the court and centered on the ECB would quickly become a crisis about the euro and European project as a whole. Opinion has broken in this direction despite Merkel’s and Germany’s many compromises over the years. Remember that Merkel’s capitulation to the Mediterranean states on the European Council in June 2011, which paved the way for Draghi’s famous dictum, was initially seen as a failure by her to defend German interests. Merkel and her party have also recovered from the hit they took when she insisted that Germany take in a huge influx of Syrian refugees in 2015. German popular opinion is relevant when discussing the judicial system and rule of law. No court can ignore popular opinion entirely, no matter how independent and austere, because every court ultimately needs public opinion to maintain its credibility. The European Court’s decision is final, as long as Germany remains committed to the EU. Yet German sovereignty still gives German institutions a say. If the German court persists in attempting to block Bundesbank participation in QE, the result will be a bond market riot that pushes up peripheral debt funding costs. This would eventually risk forcing peripheral states out of the Euro Area, which is against German interests. It is very unlikely things will go so far. Rather, the court will back down after receiving due attention and having its legitimate concerns addressed. The imperatives of European integration are as powerful today as they were in 2011. True, other court challenges will open up against the ECB, particularly the PEPP. But bear in mind that it will be even easier to show that ECB actions are proportional – that broader economic consequences have been weighed – in the case of the pandemic relief emergency than with respect to PSPP prior to COVID. Today it is households and small businesses that need protection from an act of God, not banks and bureaucracies that need protection from the consequences of their excesses. As for the size and duration of QE, the court will try to force some limitations to be acknowledged given the risk to fiscal sovereignty. In this sense, the ECB faces a new constraint, albeit one that we doubt will prove relevant in the near term. Ultimately, the consequence of imposing some limits on central bank policy is to restore authority to member state budgets and European fiscal coordination. In the short term, emergency provision can be provided via the European Stability Mechanism (ESM), whose lending conditions can be relaxed, and by the ECB’s Outright Monetary Transactions (OMT), which can buy bonds amid a market riot. But beyond the immediate crisis the clash over fiscal policy will persist because at some point countries will have to climb down from their extraordinary stimulus and the attempt to restore limits will be contentious. Germany has already made a huge shift in a more fiscally accommodative direction. Italy, Spain, and France are currently not providing enough, but they will add more. Future governments might demand more than even today’s more dovish Germany is willing to accept. Down the road, if these states do not provide more stimulus, then their recoveries will be weaker and political malaise will get worse. An anti-establishment outcome is already likely in Italy in the coming year or two, due to the ability of the League to capitalize on post-COVID voter anger. The big question after that is France in 2022. Macron’s approval rating is holding up, we expect him to win, but his bounce amid the pandemic is not remarkable. From our point of view the peripheral states have a license to spend, so spend they will. But then fiscal conflicts will revive later. Bottom Line: The German constitutional court is not going to try to force the Bundesbank to withdraw from QE, but it is attempting to lay a foundation for the imposition of at least some limits on this policy. The risk to European assets in the short run is not on the monetary side but the fiscal side. Over the long run, the “German question” will never be settled. But the imperatives of European integration are as powerful today as they were in 2011. Each new crisis exposes the weakness of the peripheral states, their need for European institutions. It also exposes Germany’s need to accommodate them when they form a united front. Investment Takeaways Financial markets have no clarity on economic reopening in the face of the virus or how governments will respond to resurgent outbreaks or a second wave in the fall. Taking into consideration the initial shock of the lockdowns plus spillover effects, the cumulative impact to annual GDP rises to 6%-8% by the end of this year for major economies. If another lockdown occurs, the level of GDP would be 10-12% lower at the end of the year depending on the region. This bare risk suggests that global equities face a relapse in the near term. Eventually economic reopening will proceed, as the working age population will demand it. But the path between here and there is rocky and any hiccups in providing stimulus will create even more volatility. Globally, we continue to argue that political and geopolitical risks are rising across the board as the pandemic and recession evolve into a struggle among nations to maintain security amid vulnerabilities and distract from their problems at home. Rumors that China is about to declare an air defense identification zone (ADIZ) in the South China Sea are unverified but we have long expected this to occur and tensions and at least some saber-rattling would ensue. We also expect the US to surprise the market with punitive tech and trade measures against China in the near term and to upgrade relations with Taiwan. We remain long JPY-EUR on a tactical 0-3 month horizon. We are converting our tactical long S&P consumer staples, which is up 6%, to a relative trade against the broad market. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Appendix Table 1The Global Fiscal Stimulus Response To COVID-19 Footnotes 1 In the case of Italy, we assume that parliament will pass the latest proposed increase in stimulus from 1.4% to 3.1% of GDP. In the case of South Africa, we expect the IMF to include these measures soon. Germany is discussed below.
Highlights Our baseline view foresees a U-shaped recovery, as economies slowly relax lockdown measures. There are significant risks to this forecast, however. On the upside, a vaccine or effective treatment could hasten the reopening of economies and recovery in spending. On the downside, containment measures could end up being eased too quickly, leading to a surge in new cases. A persistent spell of high unemployment could also permanently damage economies, especially if fiscal and monetary stimulus is withdrawn too quickly. In addition, geopolitical risks loom large, with the US election likely to be fought on who sounds tougher on China. Earnings estimates have yet to fall as much as we think they will, making global equities vulnerable to a near-term correction. Nevertheless, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon. Is It Safe To Come Down? We published a report two weeks ago entitled Still Stuck In The Tree where we likened the current situation to one where an angry bear has chased a hiker up a tree.1 Having reached a high enough branch to escape immediate danger, the hiker breathes a sigh of relief. As time goes by, however, the hiker starts to get nervous. Rather than disappearing back into the forest, the bear remains at the base of the tree licking its chops. Meanwhile, the hiker is cold, hungry, and late for work. Like the hiker, the investment community breathed a collective sigh of relief when the number of cases in Italy and Spain, the first two major European economies to be hit by the coronavirus, began to trend lower. In New York City, which quickly emerged as the epicentre of the crisis in the United States, more COVID patients have been discharged from hospitals than admitted for the past three weeks (Chart 1). Chart 1Discharges From New York Hospitals Have Exceeded Admissions For The Past Three Weeks Deepest Recession Since The 1930s Yet, this progress has come at a very heavy economic cost. The IMF expects the global economy to shrink by 3% this year (Chart 2). In 2009, global GDP barely contracted. Chart 2Severe Damage To The Global Economy This Year The sudden stop in economic activity has led to a surge in unemployment. According to the Bloomberg consensus estimate, the US unemployment rate rose to 16% in April. The true unemployment rate is probably higher since to be considered unemployed one has to be looking for work, which is difficult if not impossible in the presence of widespread lockdowns. Regardless, even the official unemployment rate is the worst since the Great Depression (Chart 3). Chart 3Unemployment Rate Seen Jumping To Levels Not Reached Since The Great Depression Unshackling The Economy A key difference from the 1930s is that today’s recession has been self-induced. Policymakers want workers to stay home as much as possible. The hope is that once businesses reopen, most of these workers will return to their jobs. How long will that take? Our baseline scenario envisions a slow but steady reopening of the global economy starting later this month, which should engender a U-shaped economic recovery. Since mid-March, much of the world has been trying to compensate for lost time by taking measures that would not have been necessary if policymakers had acted sooner. As Box 1 explains, some loosening of lockdown measures could be achieved without triggering a second wave of cases once the infection rate has been brought down to a sufficiently low level. To the extent that economic activity tends to move in tandem with the number of interactions that people have, a relaxation of social distancing measures should produce a modest rebound in growth. New technologies and a better understanding of how the virus is transmitted should also allow some of the more economically burdensome measures to be lifted. As we have discussed before, mass testing can go a long way towards reducing the spread of the disease (Chart 4).2 Right now, high-quality tests are in short supply, but that should change over the coming months. Chart 4Mass Testing Will Help Increased mask production should also help. Early in the pandemic, officials in western nations promulgated the view that masks do not work. At best, this was a noble lie designed to ensure that anxious consumers did not deprive frontline workers of necessary safety equipment. At worst, it needlessly led many people astray. As East Asia’s experience shows, mask wearing saves lives. A recent paper estimated that the virus could be vanquished if 80% of people wore masks that were at least 60% effective, a very low bar that even cloth masks would pass (Chart 5).3 Chart 5Masks On! Recent research has also cast doubt on the merits of closing schools. The China/WHO joint commission could not find a single instance during contact tracing where a child transmitted the virus to an adult. A study by the UK Royal College of Paediatrics provides further support to the claim that children are unlikely to be important vectors of transmission. The evidence includes a case study of a nine year-old boy who contracted the virus in the French Alps but fortunately failed to transmit it to any of the more than 170 people he had contact with in three separate schools.4 Along the same lines, there is evidence that the odds of adults catching the virus indoors is at least one order of magnitude higher than outdoors.5 This calls into question the strategy of states such as California of clearing out prisons of dangerous felons in order to make room for beachgoers.6 Upside Risks To The U: Medical Breakthroughs While a U-shaped economic recovery remains our base case, we see both significant upside and downside risks to this outcome. The best hope for an upside surprise is that a vaccine or effective treatment becomes available soon. There are already eight human vaccine trials underway, with another 100 in the planning stages. In the race to develop a vaccine, Oxford is arguably in the lead. Scientists at the university’s Jenner Institute have developed a genetically modified virus that is harmless to people, but which still prompts the immune system to produce antibodies that may be able to fight off COVID. The vaccine has already worked well on rhesus monkeys. If it proves effective on humans, researchers hope to have several million doses available by September. On the treatment side, Gilead’s remdesivir gained FDA approval for emergency use after early results showed that it helps hasten the recovery of coronavirus patients. Hydroxychloroquine, which President Trump has touted on numerous occasions, is the subject of dozens of clinical trials internationally. While evidence that hydroxychloroquine can treat the virus post-infection is thin, there is some data to suggest that it can work well as a prophylactic.7 Research is also being conducted on nearly 200 other treatments, including an improbable contender: famotidine, the compound found in the heartburn remedy Pepcid.8 Downside Risk: Too Open, Too Soon Chart 6The Lesson From The Spanish Flu: The Second Wave Could Be Worse Than The First As noted above, once the number of new cases drops to sufficiently low levels, some relaxation of containment measures can be achieved without reigniting the pandemic. That said, there is a clear danger that measures will end up being relaxed too aggressively and too soon. This is precisely what happened during the Spanish Flu (Chart 6). It has become customary to talk about the risk of a second wave of infections; however, the reality is that we have not even concluded the first wave. While the number of cases in New York has been falling, it has been rising in many other US states. As a result, the total number of new coronavirus cases nationwide has remained steady for the past five weeks (Chart 7). It is the same story globally: Falling caseloads in western Europe and East Asia have been offset by rising cases in countries such as Russia, India, and Brazil (Chart 8). Chart 7The Spread Of COVID-19 Has Not Been Contained Everywhere (I) Chart 8The Spread Of Covid-19 Has Not Been Contained Everywhere (II) Chart 9Widespread Social Distancing Has Dampened The Spread Of All Flus And Colds At the heart of the problem is that COVID-19 remains a highly contagious disease. Most studies assign a Reproduction Number, R, of 3-to-4 to the virus. As a point of comparison, the Spanish flu is estimated to have had an R of 1.8. An R of 3.5 would require about 70% of the population to acquire herd immunity to keep the virus at bay.9 As discussed in Box 2, the “true” level of herd immunity may be substantially greater than that. At this point, if you come down with a cough and fever, you should assume you have COVID. As Chart 9 shows, social distancing measures have brought the number of viral respiratory illnesses down to almost zero in the United States. Up to 30% of common cold cases stem from the coronavirus family. Just like it would be foolhardy to assume that the common cold has been banished from the face of the earth, it would be unwise to assume that COVID will not return if containment measures are quickly lifted. Downside Risk: Permanent Economic Damage Chart 10No Spike In Bankruptcies For Now There are a lot of asymmetries in economics: It is easier to lose a job than to find one; starting a new business is also more difficult than going bankrupt. The good news so far is that bankruptcies have been limited and most unemployed workers have not been permanently laid off (Chart 10 and Chart 11). Thus, for the most part, the links that bind firms to workers have not been severed. Chart 11Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Unfortunately, there is a risk that the economy will suffer permanent damage if unemployment remains high and economic activity stays depressed. For some sectors, such as airlines, long-term damage is nearly assured. It took a decade for real household spending on airlines to return to pre 9/11 levels (Chart 12). It could take even longer for the physiological scars of the pandemic to fade. While businesses outside the travel and hospitality sectors will see a quicker rebound, they could still experience subdued demand for as long as social distancing measures persist. Chart 129/11 Was A Big Shock For US Air Travel There is not much that fiscal policy can do to reverse the immediate hit to GDP from the pandemic. If people cannot work, they cannot produce. What fiscal stimulus can do is push enough money into the hands of households and firms to enable them to meet their financial obligations, while hopefully creating some pent-up demand that can be unleashed when businesses reopen. For now and for the foreseeable future, there is no need to tighten fiscal policy. The private sector in the major economies is generating plenty of savings with which governments can finance budget deficits. Indeed, standard economic theory suggests that if governments tried to “save more” by reducing budget deficits, total national savings would actually decline.10 Nevertheless, just as fiscal policy was prematurely tightened in many countries following the Great Recession, there is a risk that austerity measures will be reintroduced too quickly again. Likewise, calls to tighten monetary policy could grow louder. Just this week, Germany’s constitutional court ruled that the EU Court of Justice had overstepped its powers by failing to require the ECB to conduct an assessment of the “proportionality” of its controversial asset purchase policy. The German high court ordered the Bundesbank to suspend QE in three months unless the ECB Governing Council provides “documentation” showing it meets the criteria of proportionality. Among other things, the ruling could undermine the ECB’s newly launched €750 billion Pandemic Emergency Purchase Programme (PEPP). Downside Risk: Geopolitical Tensions Had the virus originated anywhere else but China, President Trump could have made a political case for further deescalating the Sino-US trade war in an effort to shore up the US economy and stock market. Not only did that not happen, but the likelihood of a new clash between China and the US has gone up dramatically. Antipathy towards China is rising (Chart 13). As our geopolitical team has stressed, the US election is likely to be fought on who can sound tougher on China. With the economy on the ropes, Trump will try to paint Joe Biden as too passive and conflicted to stand up to China. Indeed, running as a “war president” may be Trump’s only chance of getting re-elected. Chart 13US Nationalism Is On The Rise Amid Broad-Based Anti-China Sentiment At the domestic political level, the pandemic has exacerbated already glaringly wide inequalities. While well-paid white-collar workers have been able to work from the comfort of their own homes, poorer blue-collar workers have either been furloughed or asked to continue working in a dangerous environment (in nursing homes or meat-packing plants, for example). It is not clear what the blowback from all this will be, but it is unlikely to be benign. Investment Implications Global equities and credit spreads have tracked the frequency of Google search queries for “coronavirus” remarkably well (Chart 14). As coronavirus queries rose, stocks plunged; as the number of queries subsided, stocks rallied. If there is a second wave of infections, anxiety about the virus is likely to grow again, leading to another sell-off in risk assets. Chart 14Joined At The Hip Chart 15Negative Earnings Revisions Will Weigh On Stocks In The Near Term Earnings estimates have come down, but are still above where we think they ought to be. This makes global equities vulnerable to a correction (Chart 15). Meanwhile, retail investors have been active buyers, eagerly gobblingup stocks such as American Airlines and Norwegian Cruise Lines that have fallen on hard times recently (Chart 16). They have also been active buyers of the USO oil ETF, which is down 80% year-to-date. When retail investors are trying to catch a falling knife, that is usually an indication that stocks have yet to reach a bottom. As such, we recommend that investors maintain a somewhat cautious stance on the near-term direction of stocks. Chart 16Retail Investors Keen To Buy The Dip Chart 17Favor Equities Over Bonds Over A 12-Month Horizon Chart 18USD Is A Countercyclical Currency Looking further out, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon (Chart 17). If global growth does end up rebounding, cyclicals should outperform defensives. As a countercyclical currency, the dollar will probably weaken (Chart 18). A weaker greenback, in turn, will boost commodity prices (Chart 19). Historically, stronger global growth and a softer dollar have translated into outperformance of non-US stocks relative to their US peers (Chart 20). Thus, investors should prepare to add international equity exposure to their portfolios later this year. Chart 19Commodity Prices Usually Rise When The Dollar Weakens Chart 20Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Box 1The Dynamics Of R Box 2Why Herd Immunity Is Not Enough Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Still Stuck In The Tree,” dated April 16, 2020. 2 Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 3 Philip Anfinrud, Valentyn Stadnytskyi, et al., “Visualizing Speech-Generated Oral Fluid Droplets with Laser Light Scattering,” nejm.org (April 15, 2020); Jeremy Howard, Austin Huang, Li Zhiyuan, Zeynep Tufekci, Vladmir Zdimal, Helene-mari van der Westhuizen, et al., “Face Masks Against COVID-19: An Evidence Review,” Preprints.org, (April 12, 2020); and Liang Tian, Xuefei Li, Fei Qi, Qian-Yuan Tang, Viola Tang, Jiang Liu, Zhiyuan Li, Xingye Cheng, Xuanxuan Li, Yingchen Shi, Haiguang Liu, and Lei-Han Tang, “Calibrated Intervention and Containment of the COVID-19 Pandemic,” arxiv.org (April 2, 2020). 4 “COVID-19 – Research Evidence Summaries,” Royal College of Paediatrics and Child Health; and Alison Boast, Alasdair Munro, and Henry Goldstein, “An evidence summary of Paediatric COVID-19 literature,” Don’t Forget The Bubbles (2020). 5 Hiroshi Nishiura, Hitoshi Oshitani, Tetsuro Kobayashi, Tomoya Saito, Tomimasa Sunagawa, Tamano Matsui, Takaji Wakita, MHLW COVID-19 Response Team, and Motoi Suzuki, “Closed environments facilitate secondary transmission of coronavirus disease 2019 (COVID-19),” medRxiv (April 16, 2020). 6 “Coronavirus: Arrests as California beachgoers defy lockdown,” Skynews (April 26, 2020); and “High-risk sex offender rearrested days after controversial release from OC Jail,” abc7.com (May 1, 2020). 7 Sun Hee Lee, Hyunjin Son, and Kyong Ran Peck, “Can post-exposure prophylaxis for COVID-19 be considered as an outbreak response strategy in long-term care hospitals?” International Journal of Antimicrobial Agents (April 25, 2020). 8 Brendan Borrell, “New York clinical trial quietly tests heartburn remedy against coronavirus,” Science (April 26, 2020). 9 In the simplest models, the herd immunity threshold is reached when P = 1-1/Ro, where P is the proportion of the population which has acquired immunity and Ro is the basic reproductive number. Assuming an Ro of 3.5, heard immunity will be achieved once more than 71.4% of the population has been infected (1-1/3.5). For further discussion on this, please refer to Global Investment Strategy, “Second Quarter 2020 Strategy Outlook: World War V,” dated March 27, 2020. 10 It is easiest to understand this point by considering a closed economy where savings, by definition, equals investment. Savings is the sum of private and public savings. Suppose the economy is depressed and the government increases public savings by either raising taxes or cutting spending. Since this action will further depress the economy, private investment will fall even more. But, since investment must equal total savings, private savings must decline more than proportionately with any increase in public savings. This happens because tighter fiscal policy leads to lower GDP. It is difficult to save if one does not have a job. To the extent that lower GDP reduces employment, it also tends to reduce private-sector savings. Global Investment Strategy View Matrix Current MacroQuant Model Scores