Financial Markets
The corporate sector’s ability to expand at the expense of labor has now come to an end. An increasingly tight labor market is rekindling wage growth. As a result, the labor share of income bottomed at the end of 2017 and the capital share peaked. The…
Highlights Duration: The U.S. economic data show few signs of restrictive monetary policy, despite the fact that the market is now priced for an end to the Fed’s rate hike cycle. Investors should position for further rate hikes this year. Practically, this means keeping portfolio duration low and avoiding the 5-year/7-year part of the Treasury curve. Corporate Spreads: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield bonds offer adequate compensation for default losses, in line with the historical average. Corporate Defaults: A simple model using gross nonfinancial corporate leverage pegs fair value for the 12-month speculative grade default rate at 4.1%. This fair value estimate should decline slightly in the months ahead, as long as pre-tax profit growth stays above 7%, the approximate rate of debt growth. Feature Fed rate hikes have been completely priced out of the curve. As of last Friday’s close, the overnight index swap market was priced for 2 basis points of rate hikes during the next 12 months and 9 bps of cuts during the next 24 months (Chart 1). The sharp drop in rate hike expectations is an overreaction, and investors should position for a near-term rise in rate expectations. The Fed’s rate hike cycle still has room to run before interest rates peak. Chart 1Market Says "No More Hikes" In this week’s report we survey the recent economic data, searching for any signal that interest rates are high enough to choke off the recovery. We conclude that monetary conditions remain accommodative, and that the Fed’s rate hike cycle will re-start in the second half of this year. Searching For Signs Of Tight Money Policymakers frequently talk about the concept of the neutral (or equilibrium) fed funds rate. In essence, the neutral rate is the interest rate that is consistent with trend economic growth and stable inflation. If the fed funds rate is set above neutral, then we should expect growth to slow and inflation to fall. Conversely, if the fed funds rate is set below neutral, we should expect growth to accelerate and inflation to rise. The slope of the yield curve can help distill this concept for bond investors. An inverted yield curve signals that the market is priced for interest rate cuts in the future. This is what we would expect to see in an environment where the fed funds rate is above neutral and monetary conditions are restrictive. Conversely, a very steep yield curve means that investors expect rate hikes in the future. This is usually consistent with accommodative monetary policy and an interest rate well below neutral. We find the neutral rate to be a useful concept, though like Fed Chairman Powell we think it is unwise to place too much stock in point estimates of its level.1 Such estimates are very difficult to make in real time, and tend to be heavily revised with hindsight.2 For investors, a wiser strategy is to look for signs in the economic data that interest rates are too high, and to use those signs to decide when interest rates have peaked for the cycle. We review a few of those potential signs below. Nominal GDP Growth One simple signal of restrictive monetary policy is when interest rates rise above the year-over-year growth rate in nominal GDP. In the last cycle, Treasury returns versus cash didn’t move materially higher until after year-over-year nominal GDP growth was below both the 10-year Treasury yield and the 3-month T-bill rate (Chart 2). At present, year-over-year nominal GDP growth is running at 5.5%. Though it is very likely to slow during the next few quarters, it still has a long way to go before it falls below 2.76%, the current 10-year Treasury yield. Chart 2GDP Growth Suggests That Monetary Policy Remains Accommodative Verdict: An assessment of nominal GDP growth shows that monetary policy remains accommodative. The Housing Market Given that the mortgage market provides the most direct link between interest rates and real economic activity, it makes sense that signs of tight money might show up first in the housing data. Empirical investigation backs up this claim. As was observed by Edward Leamer in his 2007 paper, of the ten post-WWII U.S. recessions, eight were preceded by a significant slowdown in residential investment.3 Our own reading of the data is consistent with this message. Downtrends in the 12-month moving averages of both single-family housing starts and new home sales preceded inflection points higher in excess Treasury returns in each of the past two cycles (Chart 3). Chart 3No Signal From Housing While these housing metrics certainly deteriorated during the past nine months, it appears that the worst is now behind us. The recent moderation in mortgage rates has already led to a significant bounce in mortgage purchase applications and a pop in homebuilder confidence (Chart 4). This will translate into increased housing starts and new home sales during the next few months. Chart 4Housing Rebound Underway Verdict: The housing data are most likely consistent with still-accommodative monetary policy. However, if single-family housing starts and new home sales do not respond as expected to the recent drop in the mortgage rate, then we will be forced to re-visit this view. The Labor Market Of all the available labor market statistics, initial unemployment claims tend to be the most leading and have historically provided the best signal of tight monetary conditions. In each of the past two cycles a significant increase in jobless claims has coincided with the inflection point higher in Treasury excess returns (Chart 5). While there was some concern toward the end of last year that claims were trending up, this has now been dashed and claims actually fell below 200k last week. Notice in Chart 5 that the 13-week change in claims remains negative. In prior cycles it rose above zero around the same time that Treasury returns started to improve.. Chart 5No Signal From Labor Market Verdict: The labor market data remain consistent with accommodative monetary policy. Bottom Line: It seems very likely that U.S. monetary policy remains accommodative. Nominal GDP growth and the labor market both strongly support this claim. The housing data have been weaker, but are already showing signs of rebounding. The implication for bond investors is that the Fed is not done lifting interest rates, even though the market is priced for exactly that outcome. Investors should maintain below-benchmark portfolio duration on the view that rate hikes will re-start in the second half of this year. The 5-year/7-year part of the Treasury curve is especially vulnerable to an increase in rate hike expectations. Investors should avoid this part of the curve, focusing on the very long and short maturities.4 The Weakness Is Global The analysis in the above section begs the question: If the economic data do not suggest that monetary policy is restrictive, then why is the market priced for an end to the Fed’s rate hike cycle? The answer is that everything is not rosy in the economic outlook. Specifically, we have already seen a significant slowdown in non-U.S. economic growth that weighed significantly on financial markets near the end of last year and is starting to impact the most externally-exposed segments of the U.S. economy. Chart 6 shows that a slowdown in the Global ex. U.S. Leading Economic Indicator (LEI) is now dragging the U.S. LEI down with it. Chart 6Global Weakness Infects U.S. Not surprisingly, the components of the U.S. LEI that have weakened are those related to financial markets and the corporate sector. Given that corporate profits are determined globally, a slowdown in global growth often shows up first in downward revisions to investors’ corporate profit expectations. This weighs on equity prices and causes business owners to re-assess their future investment plans. Consistent with this narrative, we have seen significant downward moves in ISM New Orders and NFIB Capital Spending Plans, shown averaged together in the top panel of Chart 7. Capital spending plans as reported in regional Fed surveys have also moderated (Chart 7, panel 2), and CEO confidence has plunged (Chart 7, bottom panel). All of these indicators suggest that weaker global growth will weigh on the nonresidential investment component of U.S. GDP during the next few quarters. Chart 7Weaker Nonresidential Investment... But while corporate investment is poised to weaken, the U.S. consumer is in rude health (Chart 8). Core retail sales are growing strongly, though the most recent data only extend through November. For more timely data we can look at the Johnson Redbook measure of same-store sales which has accelerated into the New Year (Chart 8, top panel). The University of Michigan survey of consumers shows that expectations dipped last month (Chart 8, panel 2), but also that consumers still view current conditions as extremely positive (Chart 8, bottom panel). Chart 8...And Resilient Consumer Spending The overall picture is reminiscent of 2015/16. The U.S. consumer and labor market are in good shape, but slowing foreign growth and a strong U.S. dollar are weighing on the corporate profit outlook and U.S. corporate investment spending. As in 2016, the solution is for the Fed to temporarily pause its rate hike cycle. This will allow the dollar’s uptrend to moderate and will take some pressure off the corporate profit and investment outlooks. With a Fed pause discounted in the market, the conditions are already in place for renewed optimism on the corporate sector. It is for this reason that we upgraded our recommended allocation to corporate bonds two weeks ago.5 We expect this optimism will cause financial conditions to ease during the next few months, allowing the Fed to resume its rate hike cycle in the second half of this year. Corporate Bond Valuation Update As mentioned above, we increased our recommended exposure to corporate credit (both investment grade and junk) two weeks ago, partly due to valuations that had become too attractive to pass up. The Breakeven Spread One of our preferred valuation techniques is to look at 12-month breakeven spreads for each corporate credit tier as a percentile rank versus history.6 We like this method for three reasons: First, focusing on each individual credit tier controls for the fact that the average credit rating of bond indexes can change over time. Second, using the breakeven spread instead of the average index option-adjusted spread allows us to control for the changing average duration of the bond indexes. Finally, we find that the percentile rank is often a better representation of credit spreads than the spread itself. This is because credit spreads often tighten to very low levels and then remain tight for an extended period of time. By showing us the percentage of time that a given spread has been tighter than its current level, the percentile rank gives a better sense of this pattern than the actual spread. At present, Baa-rated debt and all junk credit tiers have 12-month breakeven spreads at or above their historical medians. Aa and A rated bonds have breakeven spreads that rank near the 40th percentile, and Aaa-rated debt remains expensive with a 12-month breakeven spread below the 10th percentile since 1989. To appreciate how cheap these spreads are, especially for Baa-rated and junk credits, consider that the current 12-month breakeven spread for a Baa-rated corporate bond is 24 bps (Chart 9). In our analysis of the different phases of the economic cycle, we determined that in an environment where the slope of the 3/10 Treasury curve is between 0 bps and 50 bps (it is 18 bps today), the 12-month Baa-rated breakeven spread averages 18 bps.7 Chart 9Attractive Baa Valuation Given current index duration, if the 12-month Baa-rated breakeven spread returned to the 18 bps level that is typical for this stage of the cycle, it would imply a tightening in the option-adjusted spread from 169 bps to 129 bps – a 40 bps tightening! Default-Adjusted Spread Another valuation measure to consider is our high-yield default-adjusted spread. This is the excess spread available in the high-yield index after subtracting expected default losses. To determine expected default losses we use Moody’s baseline forecast for the 12-month default rate and our own forecast for the 12-month recovery rate. At present, this gives us a default-adjusted spread of 237 bps, right in line with the historical average (Chart 10). In other words, if default losses during the next 12 months match those embedded in our calculation, then investors should expect an excess return that is in line with the historical average, assuming also no capital gains/losses from spread tightening/widening. Chart 10In Line With Historical Average But how likely is it that default losses fall in line with that expectation? In its last Monthly Default Report, Moody’s revised its baseline 12-month default rate forecast up to 3.4%, from 2.6% previously. The new 3.4% forecast seems reasonable to us. A simple model of the 12-month trailing default rate based only on our measure of gross leverage for the nonfinancial corporate sector puts fair value for the 12-month default rate at 4.1% (Chart 11). Our measure of gross leverage is simply total debt divided by pre-tax profits. This measure fell during the past year because pre-tax profits grew by 17% and total debt grew by only 7%. Chart 11Default Expectations Going forward, profit growth will almost certainly moderate during the next 12 months, driven by the combination of weaker global growth and rising wage pressures. However, it needs to fall a long way, to below 7%, before our measure of leverage starts to rise. In other words, a further slight decline in our measure of gross leverage is a reasonable expectation at the current juncture, which would bring the fair value from our simple default rate model close to the current Moody’s projection. All in all, our default-adjusted spread tells us that high-yield bonds offer historically average compensation given reasonable default expectations. Bottom Line: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield valuation is in line with the historical average, given a reasonable expectation for default losses. Overall, we conclude that corporate spreads are attractive at current levels and we recommend an overweight allocation to both investment grade and high-yield corporate debt in a U.S. bond portfolio. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Powell Doctrine Emerges”, dated September 4, 2018, available at usbs.bcaresearch.com 2 Chairman Powell cites a few examples of this in his Jackson Hole address from last fall. https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm 3 http://www.nber.org/papers/w13428 4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 The 12-month breakeven spread is the spread widening required on a 12-month investment horizon for a corporate bond to break even with a duration-matched position in Treasury securities. It can be quickly approximated by dividing the bond’s option-adjusted spread by its duration. 7 For a more complete analysis of the economic cycle based on the slope of the yield curve please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy We highlight our top seven reasons of why it pays to initiate a long materials/short utilities pair trade this week. Enticing long-term residential real estate prospects, a vibrant labor market, the recent improvement in house affordability, encouraging industry operating metrics and rock bottom valuations, all signal that a durable advance looms for the S&P homebuilding index. Recent Changes Initiate a long S&P Materials/short S&P Utilities pair trade today on a tactical (3-6 month) horizon. Table 1 Feature The S&P 500 pierced through the 50-day moving average last week and managed to hold the line above this key technical level. Stocks are still absorbing the December shock, and our sense is that it may take a while before the SPX clears 2,800 where it faced stiff resistance all last year (Chart 1). This is a ripe trading environment. Chart 12,800 Is Stiff Resistance However, in order for a breakout to materialize, we reiterate the three potential positive catalysts we identified last week: A continuation of the earnings juggernaut A positive U.S./China trade resolution A definitively more dovish Fed, which would help restrain the greenback On the earnings front, Charts 2 & 3 update our GICS1 sector EPS growth models with one caveat: due to a lack of data we continue to show telecom services instead of communications services. While most sectors are projected to decelerate following 2018’s fiscal easing-related profit growth boost, the energy sector is the one that clearly stands out. Chart 2Sector EPS Growth... Chart 3...Models Update Last week we highlighted that sell-side analysts are anticipating energy profits to contract in 2019;1 this is in line with our S&P energy EPS growth model that continues to point toward EPS contraction (third panel, Chart 2). Nevertheless, we expect upward surprises in this deep cyclical sector given BCA’s Commodity & Energy Strategy service bullish oil forecast for the year. With regard to the three profit heavyweight sectors, tech, financials and health care, our EPS growth models are more or less in line with the street’s estimates (please refer to Table 2 in last week’s Weekly Report). Tech profits in particular are kissing off the zero growth line according to our regression model (top panel, Chart 3), and we continue to recommend a barbell positioning approach, overweighting the S&P software (high-conviction) and tech hardware, storage & peripherals indexes at the expense of the S&P semiconductors index. As a reminder we are neutral the broad S&P tech sector. Beyond profit growth, looking at our S&P 500 GICS1 sector Valuation Indicator (VI) and Technical Indicator (TI) provides a more complete sector positioning picture. Chart 4 is a valuation versus technical map of the 11 sectors, using our proprietary VI and TI as inputs. The map plots the VI on the y-axis and the TI on the x-axis. Both indicators depict Z-scores (please look forward to our upcoming Cyclical Indicator Update report that will highlight long-term GICS1 sector time series of our VI and TI). The S&P utilities sector is the most stretched and simultaneously very expensive sector. Real estate is just behind utilities and we continue to dislike both of these niche interest rate-sensitive sectors. The S&P consumer discretionary sector also makes it in this top right quadrant and is the most expensive GICS1 sector; we remain underweight this early cyclical sector. On the flip side, energy, materials and financials populate the bottom left quadrant; as a reminder we are overweight all three sectors. The S&P energy sector is the most undervalued and unloved of all GICS1 sectors. Netting it all out, we continue to prefer deep cyclical to defensive sectors as we still see the most opportunity in this tilt on all three fronts: earnings, valuations and technicals. Importantly, most of the bad/negative China slowdown news is likely reflected in the downtrodden cyclical/defensive ratio and a slingshot recovery is looming (China slowdown story count shown inverted, bottom panel, Chart 5). Chart 5China Slowdown Baked In The Cake In that light, this week we are initiating a new cyclical/defensive pair trade that is primed to generate alpha, and also update a niche early cyclical group. Buy Materials/Sell Utilities A playable market-neutral opportunity has resurfaced to buy materials at the expense of utilities stocks. Below we outline our top seven reasons why investors should put on this pair trade on a tactical (3-6 month) horizon. Chart 6The Dollar's Trough While global growth is decelerating, this news is last year’s story, especially now that even the IMF came out and downgraded global output growth. This is contrarily positive as cyclical stocks have more than discounted a softer growth outlook. If anything, the surprise this year would be for global growth to pick up momentum on the back of a positive U.S./China trade dispute resolution. The top panel of Chart 6 shows our Global Trade Activity Indicator (GTAI) that is making an effort to trough. Historically, the GTAI has been an excellent leading indicator of the long materials/short utilities price ratio and the current message is that the latter has bottomed. As the Fed is backing off aggressively raising interest rates this year and this has dealt a modest blow to the U.S. dollar. As a reminder, a depreciating greenback is conducive to rising global growth and vice versa. Were the U.S. dollar to complete its reverse head and shoulders technical formation courtesy of a more dovish Fed, this will prove a boon for relative share prices (middle panel, Chart 6). Related to the softening currency is a pickup in commodity price inflation. In fact, already metal prices are outpacing natural gas prices. The latter is the marginal price setter for utilities. This relative pricing power gauge is signaling that the worst is behind this pair trade ratio and a relative profit-led advance is in the offing (bottom panel, Chart 6). While the China slowdown narrative is well telegraphed to the markets (Chart 5), there is increasing pressure on the Chinese to either strike a deal with the U.S. and resolve the trade tussle or put together a comprehensive fiscal package alongside the already easing monetary backdrop in order to aid their decelerating economy. Importantly, the V-shaped recovery in the Li Keqiang index is signaling that the opening of the monetary taps and up-to-now piecemeal fiscal easing are starting to pay dividends. The upshot is that materials have the upper hand versus utilities (Li Keqiang index shown advanced, Chart 7). Chart 7...Chinese Reflation... Domestic conditions are also fertile ground for the relative share price ratio. While the ISM manufacturing survey took a beating last month, the latest release of the Philly Fed manufacturing business outlook ticked higher (both current activity and six-month forecast), reversing last month’s downbeat sentiment reading (Chart 8). BCA’s view remains that there will be no recession in 2019, which underpins materials at the expense of utilities. Chart 8...No U.S. Recession... High-frequency financial market indicators also suggest that the path of least resistance is higher for this cyclicals vs. defensives share price ratio. Inflation expectations have rebounded following an over 50bps collapse late last year, and financial conditions have also started to ease, partially reversing December’s spike (Chart 9). At the margin, materials are an inflation beneficiary/hedge and also investors shed defensive utilities stocks when financial conditions start to ease (junk bond spread shown inverted, bottom panel, Chart 9). Finally, our EPS growth models do an excellent job in capturing all these relative macro drivers and underscore that a reversal in bombed out technicals and depressed valuations looms (Chart 10). Chart 9...Financial Market Indicators... Chart 10...And Compelling Valuations & Technicals Say Buy Materials/Sell Utilities In sum, a softer U.S. dollar, positive global/China growth surprises, commodity price inflation, an easing in financial conditions and no 2019 U.S. recession, all suggest that a relative earnings led advance will unlock excellent relative value and push the materials/utilities ratio higher in the coming months. Bottom Line: Initiate a new long S&P materials/short S&P utilities pair trade today on a tactical (3-6 month) horizon. Will Homebuilders Go Through The Roof? While we were admittedly a bit early in buying homebuilders in late-September, relative share prices have come full circle and are in the black since inception.2 We maintain our overweight stance in this niche consumer discretionary sub index and reiterate our long S&P homebuilding/short S&P home improvement retail pair trade that we initiated last week.3 Domestic long-term housing prospects remain compelling, especially given that the GFC wrung out all the residential real estate excesses. Currently, household formation is still running higher than housing starts and building permits (top panel, Chart 11). Similarly the homeownership ratio remains low by historical standards (it has yet to return to the long-term mean, not shown) and suggests that there is pent up housing demand. Chart 11Robust Long-term Housing Fundamentals Further, housing valuations are not pricey as both the price-to-rent and price-to-income ratios are a far cry from the 2005/06 peak (bottom panel, Chart 11). BCA’s view remains that wages will continue to rise this year and the economy will avoid recession. Historically, a vibrant labor market and residential construction are joined at the hip (unemployment rate and unemployment insurance claims shown inverted, Chart 12). Chart 12Labor Market And Residential Construction Move In Lockstep Tack on the recent fall in the 30-year fixed mortgage rate courtesy of a marginally more dovish Fed, and first-time home buyers will return this spring selling season (second panel, Chart 11). Already there is tentative evidence that potential home-owners have rushed to take advantage of the near 50bps drop in interest rates since the early November peak. The Mortgage Bankers Association's (MBA) mortgage applications purchase survey hit a multi-year high this month and signals that the there is a long runway ahead for the S&P homebuilding share price ratio (bottom panel, Chart 13). Chart 13Buyers Are Coming Back On the homebuilding operating front there are also some encouraging signs. Lumber prices, are down $300/tbf since mid-summer. This wholesale lumber liquidation phase provides profit margin relief to homebuilders given that framing lumber is a key input cost to housing construction (second panel, Chart 14). Chart 14Firming Operating Metrics Importantly, bankers are still willing extenders of residential real estate credit according to the latest Fed Senior Loan Officer survey. Indeed, mortgage credit is expanding at a healthy clip and there are high odds that this recent pick up in mortgage loan origination will remain upbeat owing to the decrease in the price of credit (third & bottom panels, Chart 14). Finally, sell-side analysts’ exuberance on homebuilding profits has returned to earth and now industry long-term profit growth is trailing the overall market. This significantly lowered profit hurdle coupled with depressed relative valuations suggest that investors seeking early cyclical equity exposure can still park capital in homebuilding stocks (Chart 15). Chart 15Homebuilders Are Still Cheap Adding it all up, enticing long-term residential real estate prospects, a vibrant labor market, the recent improvement in house affordability, encouraging industry operating metrics and rock bottom valuations, all signal that a durable advance looms for the S&P homebuilding index. Bottom Line: Maintain the overweight stance in the S&P homebuilding index. The ticker symbols for the stocks in this index are: BLBG: S5HOME – PHM, LEN, DHI. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Indurated” dated September 24, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights We believe 2019 and 2020 will be a tale of two markets; … : The latter stages of the long post-crisis party may be rewarding, but the inflection points that will herald a bear market and a recession are not too far off. … the first will be broadly favorable for investors in risk assets, … : The combination of ample monetary accommodation and the indiscriminate fourth-quarter markdown in risk assets provides the springboard for one last advance. … but the second will mark the end of the post-crisis bull market, … : Nothing lasts forever, and we wouldn’t be overweight risk assets at this stage were it not for last quarter’s selloff. … as the Fed pulls the plug on the expansion: Our base-case scenario does not call for a deep or lengthy recession, but once Fed policy transits from accommodative to restrictive, the going will become much rougher for stocks, corporate bonds and the economy. Feature We spent the week of January 14th meeting with clients in South Africa. It is always good to exchange views with investors, especially when they are at a distant remove from the echo chamber which inevitably colors our perspective, no matter how much we try to resist it. It was also a pleasure to swap a week of winter at home for summer abroad, where our clients’ golf talk helped boil our views down to a simple analogy. We see the next twelve to twenty-four months as a double-breaker putt. 2019-20’s Double Breaker The undulating terrain of some golf-course greens sets up putts that break one way and then the other on their path to the hole. That is the way we view the next twelve-plus months, following the fourth quarter’s sharp, sudden tightening in financial conditions (Chart 1). The selloff pulled hard on the financial-condition reins, checking some of the pressure on the economy to overheat, and allowing the Fed to pause its rate-hiking campaign. Relieved investors immediately bid stocks higher, and corporate-bond spreads tighter, retracing nearly half of the tightening in financial conditions, but we expect the Fed to remain on the sidelines until June anyway. Chart 1A Swift Tightening In Financial Conditions A Fed pause delays the date when monetary policy will turn restrictive by a few months. We see the monetary policy inflection point as the key event presaging all of the inflection points that matter most to investors: the transition from an equity bull market to a bear market; the point at which credit performance deteriorates, and spreads widen, in earnest; and the transition from expansion to recession. The delay, and the lower entry points provided by the selloff, set the stage for a last hurrah in risk assets over the next six to nine months. With the Fed in the background, investors will be able to focus on the above-trend growth driven by the remaining fiscal thrust (Chart 2) and what we expect will be better calendar 2019 S&P 500 earnings than investors currently anticipate. Chart 2Fiscal Fuel Will Keep 2019 Growth Above Trend Better-than-expected conditions will ultimately prove to be self-limiting, however. The more momentum the economy gathers while the Fed is on hold, the more budding inflation pressures will become evident. The more that inflation pressures reveal themselves, the more forcefully the Fed will have to act to counter them. The upshot for investors is that the last burst of the good times will necessarily bring forth a slowdown, and they therefore confront a putt that will break twice over the next year or two: equities and spread product will outperform Treasuries and cash over the first stretch, but underperform over the next.1 Inflation Pressure Our oft-repeated view that the fiscal stimulus will promote inflation pressures is not at all controversial. Force-feeding stimulus into an economy already operating at capacity should lead to inflation. Businesses and other investors, recognizing that the above-trend boost in aggregate demand is temporary and unsustainable, will not expand capacity to meet it. Imports may relieve some of the pressure, but prices should nonetheless rise as aggregate demand exceeds aggregate supply. Inflation pressures emanating from the labor market provoke much more pushback. Investors, tired of hearing that a pickup in wages is right around the corner, harbor considerable doubts about the Phillips Curve, which posits that there is an inverse relationship between the unemployment rate and wage growth. We acknowledge that the 1960s belief in a mechanical tradeoff between inflation and unemployment – policymakers could have lower inflation if they were willing to tolerate higher unemployment, or lower unemployment if they were willing to tolerate higher inflation – was shattered by the stagflation of the 1970s. We further acknowledge that the relationship between unemployment and compensation is not linear. We continue to believe, however, that the laws of supply and demand apply, and that the relationship between compensation and unemployment has been slow to assert itself this time around because the Phillips Curve is kinked. That is to say that the sensitivity of wage growth to a drop in unemployment is a function of the level of the unemployment rate itself. A decline in unemployment from 10% to 9%, 9% to 8%, or 8% to 7% does not exert upward pressure on wages because there are many more qualified candidates than there are openings at such elevated unemployment rates (Chart 3, top panel). When the unemployment rate is 5% or less, on the other hand, wages do respond to unemployment declines because the lack of labor market slack ensures that employers have to compete to attract qualified candidates (Chart 3, bottom panel). Estimates of the United States’ natural rate of unemployment in recent years have typically hovered around 5%. Over the 50-plus years covered by the average hourly earnings (AHE) series, real AHE growth has tended to peak (Chart 4, bottom panel) following unemployment’s sub-natural-rate trough (Chart 4, top panel). It has not yet reached an elevated level, but wages did begin accelerating sharply a year after the unemployment gap turned negative in early 2017. With the unemployment rate on track to continue to fall throughout 2019 (it only takes about 110,000 net new jobs a month to hold it in place), we expect that real AHE growth has further to run. Chart 4Don't Count Dr. Phillips Out Just Yet Taking the analysis a step further to consider real wage growth relative to productivity growth exhibits an even stronger link with the unemployment gap. From the early ‘70s through 2001, when productivity and real wages grew at the same rate (Chart 5, middle panel), real wages fell behind productivity when the unemployment gap was positive and caught up when it was negative (Chart 5, bottom panel). Capital has seized a disproportionate share of the gains in productivity since 2002, with the real-wages-to-productivity ratio able to stabilize only when the unemployment gap turned negative from 2006 to 2008. Chart 5Productivity-Adjusted Real Wages Rise When Unemployment Bottoms We expect that the coming cyclical trough in the unemployment gap will be consistent with past troughs, which have been associated with cyclical peaks in compensation gains. The linkage between compensation and consumer prices isn’t firmly established, but investors don’t have to sweat it. As long as the Fed perceives a connection, which it clearly does, it can be counted upon to respond to higher wages by tightening policy. A swift recovery in oil prices – our Commodity & Energy Strategy service sees Brent crude averaging $80/barrel, and WTI averaging $74, across 2019 – will also help keep the Fed’s attention squarely focused on price stability after ten years of full-employment fixation. Bottom Line: Unnecessary fiscal stimulus will continue to exert upward pressure on prices, while an extremely tight labor market will place steady upward pressure on wages. The Fed will respond by removing accommodation, pushing the fed funds rate above the neutral level, and bringing down the curtain on the record-long expansion sometime in 2020. Upgrading Corporate Bonds We noted two weeks ago that the spread-widening in high-yield corporate bonds was extreme, and that overweighting spread product would mesh well with our renewed equity overweight. Our U.S. Bond Strategy colleagues have since upgraded credit,2 and we are following their lead. We now recommend that investors overweight equities, underweight fixed income and equal-weight cash. Within fixed income, we recommend that investors significantly underweight Treasuries while overweighting both investment-grade and high-yield corporate bonds. Consistent with our above-consensus inflation expectations, we prefer TIPs to nominal Treasuries. We harbor no illusions that a new credit cycle has begun. It is late in an already lengthy cycle, and we view the projected near-term decline in high-yield default rates as a final unwind of the default spike that accompanied the shale-drilling rout in 2016 (Chart 6). We do not expect a recession in 2019, but the next one is likely not too far off, and defaults begin to pick up well ahead of a recession. Our spread-product upgrade is an opportunistic short-term move, not a change in our cyclical view. Chart 6A New Credit Cycle Has Not Begun High-yield spreads widened so much in the fourth quarter, relative to their history, that their capital-gain prospects have flipped. We had been at equal weight, anticipating an eventual move to underweight, because spreads were unusually tight. The capital-gain stretch of the cycle was long gone, and excess returns over Treasuries were limited to coupon spreads that were likely to be eroded by capital losses as spreads widened ahead of an approaching recession. The lurch in spreads from the 25th percentile to the 75th percentile in double-B, B and triple-C bonds (Chart 7) restores potential capital gains as a cushion that should protect the coupon spread against unanticipated economic weakness. Chart 7Irrational Gloom The Fed’s newly conciliatory stance should support spread product just as it should support equities. All three monetary-policy elements of our bond strategists’ peak-spread checklist are issuing the all-clear signal: twelve-month fed funds rate hike projections have collapsed (Chart 8, second panel), gold has revived (Chart 8, third panel), and the dollar’s relentless upward march has finally been halted (Chart 8, bottom panel). Chart 8Monetary Policy Argues For Lower Spreads ... The jury is still out on the global-growth elements of our bond team’s peak-spread checklist. Our China Investment Strategy service’s Market-Based China Growth Indicator looks spry3 (Chart 9, third panel), and industrial mining stocks may be in the midst of bottoming (Chart 9, bottom panel), but the CRB raw industrials index is still scuffling (Chart 9, second panel). A blowout in spreads accompanied by a less-hawkish Fed and rebounding global growth would be a no-brainer reason to own spread product, but two out of three ain’t bad, and spreads would not have blown out in the first place if global growth were poised to surge. The biggest threat to our constructive economic and market views is a slowdown in China, and its uncertain direction is a risk to overweighting credit. On balance, though, we believe the current level of option- and default-adjusted spreads adequately compensate credit investors over the next three to six months, especially after factoring in the Fed’s benign turn. Chart 9... But The Jury's Still Out On Global Growth Bottom Line: We are upgrading spread product to take advantage of its fourth-quarter selloff and a Fed pause that may last until June, despite uncertainty around the global growth outlook. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com Footnotes 1 The wise men and women gathered at the Barron’s annual roundtable foresee a similar setup, but with the direction reversed. They expect markets and the U.S. economy to encounter rough going in the first half of 2019 before conditions become more hospitable in the second half and in 2020, ahead of the next election. “Goodbye to Gloom,” Rublin, Lauren R., Barron’s, January 14, 2019, pp. 21-34. 2 Please see the January 15, 2019 U.S. Bond Strategy Weekly Report, “Buy Corporate Credit,” available at usbs.bcaresearch.com. 3 Please see the November 21, 2018 China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem,” available at cis.bcaresearch.com.
Our commodity strategists remain convinced OPEC 2.0 member states will once again have to embark on a strategy to backwardate the Brent forward curve, as they did in 1H18. Reducing production in the short term will force refiners to draw on inventories in…
For the European stock market, the negative space is technology, a sector in which European equities have a near-zero exposure. But there is another factor to consider: the currency. The technology sector’s global profits are mostly translated into shares…
Brazilian stocks have lately exhibited a low correlation with the overall EM equity index. Thus, even if our negative view on EM risk assets pans out, Brazilian domestic equity plays will likely suffer moderate downside in absolute terms, and will certainly…
Highlights Excess dollar liquidity is still deteriorating. The U.S. economy’s robustness suggests this trend will continue. Elevated EM-dollar debt and declining dollar liquidity point to lower global growth and a stronger dollar. Despite these cyclical forces, a tactical dollar correction is unfolding. Slowdowns do not evolve in straight lines, and deep investor pessimism is setting the stage for a temporary bout of positive surprises. DXY could correct to 93, EUR/USD could rebound to 1.17-1.18, and USD/CAD could fall to 1.27. Buy NOK/SEK. Feature Investment legend Stanley Druckenmiller often refers to the primacy of liquidity trends when making investment decisions. BCA is highly sympathetic to this view, as our DNA is rooted in the analysis of global liquidity trends. Under this lens, a peculiar trend has caught our attention: U.S. commercial and industrial (C&I) loans are currently accelerating, and easing lending standards point to further gains (Chart I-1). This is in sharp contrast with the 2015-2016 market riots and subsequent slowdown – an episode where banks tightened lending standards and loan growth decelerated sharply. While this represents a good omen for the U.S. economy, it is a dangerous evolution for the rest of the world. Chart I-1Resilient Corporate Sector Credit Growth Growing credit is good for the U.S. because it points to robust domestic demand. However, it is problematic for the rest of the world for two reasons. First, if U.S. credit growth is more robust today than in 2016, it also implies that the Federal Reserve is unlikely to pause its rate-hike campaign as much as it did back then. Thus, U.S. rates, the key determinant of the global cost of capital, may have additional upside as interest rate markets anticipate a year-long pause. This is not yet a problem for the U.S. economy, but it is one for rest of the world, which is exhibiting poorer growth trends. Second, U.S. credit growth is already outpacing the expansion of U.S. money supply by 7%, pointing towards a decline in dollar liquidity available for international financial markets. The reduction in the Fed’s balance sheet will contribute to a continuation of this trend. The fall in the amount of dollars available for the international financial system creates a brake on growth. Over the past 10 years, each time money supply growth fell below the loan uptake of the U.S. corporate sector, our Global Industrial Activity Nowcast, BCA’s Global Leading Economic Indicator, Korean exports, and global export prices all deteriorated considerably (Chart I-2). Chart I-2Deteriorating Excess Liquidity Hurts Global Growth The large dollar debt of emerging markets lies behind this relationship. If less dollars are available outside the U.S. financial system, EM borrowers have to bid more for these greenbacks, raising their cost of capital. Additionally, borrowers are likely to hoard any dollars they access in order to repay their liabilities instead of using these greenbacks to finance economic transactions. As Chart I-3 shows this problem is particularly acute today: relative to EM GDP and various measures of U.S. money supply, EM dollar debt stands at record highs, highlighting deep vulnerabilities if liquidity conditions deteriorate. Chart I-3The Sensitivity To Dollar Liquidity Stems From The Large Stock Of Dollar Debt The problem extends beyond the capacity of the U.S. economy to generate deposits in excess of non-bank liabilities. Despite a meaningful slowdown in non-U.S. industrial production, official reserves are contracting relative to global industrial activity (Chart I-4). This further suggests that the global economy is experiencing some form of liquidity crunch, where the growth of monetary aggregates is insufficient to support economic activity. This is a deflationary environment. Chart I-4High-Powered Money Lagging Sagging Activity Another factor is at play: We have often argued in these pages that carry trades are a key component of global liquidity, as they allocate funds from economies where savings are excessive (i.e. borrowing in funding currencies) to economies that need those savings to generate growth (i.e. carry currencies).1 This is why the performance of high-octane carry trades is often a very reliable leading indicator of global economic activity. However, as Chart I-5 demonstrates, EM carry trades funded in yen continue to perform execrably, a poor signal for global liquidity and growth. Chart I-5Underperforming Carry Trades Add To The Global Liquidity Woes The impact of the deterioration in dollar liquidity, in FX reserves growth and in carry trade liquidity is evident in EM monetary aggregates. EM M1 growth has sharply decelerated. Since decelerating EM money supply presages weaker growth, it also points to stronger counter cyclical currencies like the dollar and the yen, especially against the very growth-sensitive commodity currencies (Chart I-6). The dollar bull market is unlikely to be over this year. Chart I-6Ominious Signal From EM Money Supply This risk is reinforced by the tight inverse correlation between the dollar and U.S. commercial banks’ liquidity. When U.S. banks curtail their holdings of securities, a key source of dollar liquidity in international markets, a dollar rally follows (Chart I-7). Not only does last year’s fall in securities in bank assets point to a firming greenback, but if banks also expand their loan books they will also further curtail their securities holdings. Chart I-7Contracting Liquidity On U.S. Commercial Banks Balance Sheets Support The Dollar The much-higher real rates offered by U.S. Treasurys relative to other DM bonds magnifies these dollar positive trends (Chart I-8). Hence, not only will global growth and money quantity considerations prove tailwinds for the greenback, but so will more well-known drivers of exchange rates. Chart I-8Real Rates Differentials Still Favor The Dollar Bottom Line: The deterioration in global liquidity conditions continues to argue in favor of the dollar. Since U.S. credit growth is still managing to accelerate, the Fed is unlikely to pause on the rate-hike front for too long, implying that excess dollars will further vanish from the international financial system. Consequently, global monetary conditions will tighten again, and global growth has not hit its nadir this cycle. On a 9 to 12 month basis, the dollar will benefit in this environment, especially against cyclical commodity currencies. How Fast Can Investors Price In Bad News? Due to the tightening in global liquidity conditions, global growth has suffered. However, the global and U.S. stock-to-bond ratios, two financial market metrics finely tuned to global economic gyrations, have already fallen in line with our Global Economic and Financial Diffusion Index that tallies the improvement and deterioration among more than 100 key global variables (Chart I-9). This implies that asset prices already reflect much of the deterioration in the economic outlook. Chart I-9The Global Economy Is Soft, But Financial Markets Already Reflect This Reality The problem for bears is that economic cycles rarely play out in a straight line. Now that asset prices are incorporating poor expectations, any positive surprises, even if modest, could lift asset prices. And there is room for improvement in global economic surprises (Chart I-10), particularly as Sino-U.S. trade relations are improving, global financial conditions are easing and China is trying to manage its slowdown. In fact, China’s fiscal and monetary stimulus already points to a rebound in growth-sensitive currencies, and to a correction in the dollar (Chart I-11). Chart I-10Scope For A Rebound In Economic Surprises Chart I-11Chinese Reflation Points To A Dollar Correction, Even If Only A Small One EM breadth confirms this message. Chart I-12 shows that the breadth of EM equities has not been this poor since early 2009. However, it has begun to rebound. Rebounds in EM breadth from such levels are historically associated with a weaker dollar, stronger commodity currencies and a weaker yen. Chart I-12Deep Oversold Conditions In EM Stocks Further Support The Case For A Dollar Correction Flows paint a similar picture. Global investors tend to buy Japanese bonds when global growth conditions deteriorate. Foreigners buying of Japanese fixed-income products now stands near record levels – something normally witnessed when credit spreads widen. However, positive economic surprises and the recent easing in global financial conditions suggest that these flows will reverse. When they do, the dollar will suffer (Chart I-13) and very pro-cyclical pairs like AUD/JPY will appreciate, even if only temporarily. Chart I-13Elevated Flows Into Japanese Bonds Suggest Overdone Pessimism, And Scope For A Dollar Correction It’s not just the commodity currencies that have upside: so does the euro. German bunds’ hedged yields have been rising relative to the U.S., which in recent years has often led to a rally in EUR/USD (Chart I-14). Chart I-14European Hedged Yields Imply A Euro Rebound How deep will this dollar down leg be? Our Intermediate-Term Timing Model suggests that the greenback’s weakness is likely to be limited. The dollar already trades below our fair-value estimate, but during corrective episodes it tends to trough at a 5% discount, implying that the DXY at 93 is a buy (Chart I-15). The euro, the dollar’s mirror image, could rebound to a roughly 5% overvaluation, implying that a countertrend move to 1.17-1.18 is also likely. Finally, the CAD may be able to rebound to USD/CAD 1.27. Chart I-15Gauging The Extent Of The Countertrend Moves At these levels, we would expect the countertrend moves to end. Ultimately, the aforementioned deterioration in global liquidity conditions means that positive surprises are likely to be transitory phenomena. Moreover, we doubt that Chinese stimulus, a key catalyst for a weaker dollar, will be very deep. Ultimately, our view remains that China is only trying to prevent a collapse of its economy and Beijing is extremely reluctant to stimulate enough to generate yet another boom – something needed to genuinely boost global growth if the Fed resumes its tightening campaign. Finally, while a trade deal between China and the U.S. is likely, investors should not get overly exuberant on its ramifications. Disagreements over intellectual property transfers will not be resolved anytime soon, and China remains the U.S.’s largest geopolitical challenger. Bottom Line: Global liquidity conditions may have deteriorated, suggesting a trough in global growth is not yet in the cards, but slowdowns do not evolve in straight lines. This means that oversold risk assets are likely to respond well to positive economic surprises. As a result, the countercyclical dollar will correct, probably to 93. The commodity currency complex should be the main beneficiary of this move, with downside in USD/CAD to 1.27. The euro could rebound toward 1.17-1.18. Buy NOK/SEK In June 29th, we closed our long NOK/SEK trade, expecting corrective action in this cross. A serious selloff ensued, and we are now buying this pair again.2 First, NOK/SEK is very sensitive to oil prices (Chart I-16), and BCA’s Commodity and Energy service anticipates a rebound in oil prices this year on the back of tightening supply conditions. Chart I-16BCA's Oil View Points To A NOK/SEK Rebound Second, the Norwegian economy is outperforming Sweden’s. As Chart I-17 shows, the Norwegian LEI continues to rise relative to Sweden’s, which historically implies a much stronger NOK/SEK. Beyond the LEIs, Norway’s PMIs and economic surprises have not only rebounded, but are also outpacing Sweden’s equivalent metrics. The Norwegian consumer is also participating in the good times. The three-month moving average of employment growth, retail sales and consumer confidence are stronger in Norway than in Sweden. Chart I-17Norwegian Growth Is Superior To Sweden's Third, after a long period of underperformance, Norwegian core inflation stands above that of Sweden, pointing to a potentially more hawkish Norges Bank than Riksbank. Fourth, NOK/SEK trades at a 5% discount to its fair value implied by our Intermediate-Term Timing model. Historically, a rebound in this cross follows such discounts Chart I-18). Chart I-18The ITTM Highlights An Attractive Entry Point To Buy NOK/SEK Finally, NOK/SEK is at a technically attractive spot. Our momentum oscillator shows deeply oversold conditions in the pair (Chart I-19). However, momentum has begun to roll over, suggesting that a reversal of those oversold conditions is starting. Moreover, the uptrend that began in the first quarter of 2016 has been confirmed. Had NOK/SEK not rebounded from where it did, that uptrend would have been seriously challenged, with potential greater downside ahead. Chart I-19Favorable Technical Setup To Buy NOK/SEK Bottom Line: We are re-opening our long NOK/SEK trade. We avoided the serious correction in this pair at the end of last year, but rebounding oil prices, an outperforming Norwegian economy, a potentially more-hawkish Norges Bank, a favorable valuation backdrop and positive technical developments argue in favor of buying this cross. Set a stop at 1.037 and a target at 1.120. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In the Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth", dated December 15, 2017. Both are available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "What Is Good For China Doesn’t Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Capacity utilization outperformed expectations, coming in at 78.7%. However, the Michigan Consumer Sentiment Index surprised to the downside, coming in at 90.7. Finally, existing home sales month-on-month grow also surprised negatively, coming in at 4.99 million. DXY has risen 0.2% this week. While we believe that DXY could experience some weakness in the next couple of months, we remain bullish on the DXY on a cyclical basis, as the strength in the U.S. economy will prompt the Fed to deliver more rate hikes than expected by market participants. Moreover, the sharp focus of Chinese policymakers on limiting indebtedness should continue to put downward pressure on global growth, helping the dollar in the process. Report Links: So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 2019 Key Views: The Xs And The Currency Market - December 7, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro has been negative: Both headline and core inflation came in line with expectations, coming in at 1.6% and 1% respectively. However, Markit Services PMI underperformed expectations, coming in at 50.8. Moreover, the Markit Manufacturing PMI also surprised negatively, coming in at 50.7. EUR/USD fell 0.4% this week. Thursday, ECB President Mario Draghi highlighted that downside risks to the European economy are building up. Overall, we agree with his assessment, and thus remain bearish on the euro on a cyclical basis. We believe that the Fed will eventually raise rates more than the market expects, widening the rate differentials between Europe and the U.S, which will hurt EUR/USD. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Import growth underperformed expectations, coming in at 1.9%. Moreover, driven by weak shipments to China, export growth also surprised to the downside, coming in at a 3.8% contraction. USD/JPY fell 0.1% this week. We remain bearish on the yen on a short-term basis, as the recent easing in global financial conditions and the improvement in sentiment towards risk assets will likely weigh on safe havens like the yen. Moreover, we believe that bond yields will start rising again. In light of the positive relationship between yields and USD/JPY, we remain bullish on this cross. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Retail sales yearly growth and retail sales excluding fuel yearly growth underperformed expectations, coming in at 3% and 2.6%, respectively. Moreover, the claimant count change also surprised to the downside, coming in at 20.8 thousand. However, average hourly earnings growth also outperformed, coming in at 3.4%. GBP/USD has rose 1.5% this week, lifted by motion by MPs to delay the implementation of Article 50, and news that Jeremy Corbyn may be moving more clearly in favor of a new referendum if Labour takes hold of Westminster. We are closing our short EUR/GBP trade today, after reaching our target of 0.87. At this point, we think that plenty of good news have been discounted by the pound. While it is true that GBP could go up on the back of positive political developments, we believe that the risk reward ratio of selling EUR/GBP is not as attractive anymore, especially if EUR/USD can rebound. That being said, we remain bullish on cable on a long-term basis due to its cheap valuation. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in the Australia has been mixed: The participation rate surprised to the downside, coming in at 65.6%. However, the unemployment rate surprised positively, coming in at 5%. Moreover, the change in employment also outperformed expectations, coming in at 21.6 thousand, however, this improvement was driven by part-time positions, not full-time ones. AUD/USD has fallen by 1% this week. We remain bearish on the AUD versus the USD on a cyclical basis given that we expect that Chinese authorities will remain reluctant to over-stimulate their economy while global dollar liquidity deteriorates. Thus, in light of the tight economic links between Australia and Chinese industrial activity, the Australian economy is likely to suffer, dragging the AUD down in the process. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The Q4 New Zealand inflation on a year–over-year basis remains at 1.9%, slightly surprised to the upside. December business NZ PMI has increased to 55.1. December credit card spending year over year growth dropped to 4.5%. NZD/USD appreciated by 0.3% this week. On a structural basis, we are negative on the kiwi. The new government is looking to lower immigration, and implement an unemployment mandate. Both of these developments would likely lower the neutral rate of interest for the RBNZ, which would imply a lower NZD/USD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Consumer price index year over year growth in December surprised to the upside, coming in at 2.0%. Core inflation year over year measure also increased to 1.7%, from the previous 1.5%. Retail sales in November month on month growth is lower than expected, dropping to -0.9% from the previous 0.2% in October. Year-on-year growth hit levels not seen since 2012. USD/CAD is now trading above 1.3354, after a small rebound by 0.5% this week following weak data releases. We are bearish on Canadian dollar in the long run, but are bullish on a tactical basis. Financial condition will stay easy, as suggested by Stephen S. Poloz’s interview with Bloomberg this Wednesday. Given the recent trade tensions, housing market and oil price plunge, there is less urgency for BoC to push for higher rate at this moment. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen 0.3% this week. We are bullish on this cross, given that the surge of the franc against the euro has caused a significant slowdown in Swiss inflation. The strong relationship between inflation and the currency means that any additional currency strength could severely impair the central bank’s objective of achieving 2% inflation. The SNB is very well aware of this developments, which means that it will likely intervene in the currency market in order to put a floor on EUR/CHF. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Norges Bank kept the key interest rate unchanged at 0.75%. Overall, we remain bullish on USD/NOK on a cyclical basis, given that this cross is very sensitive to real rate differentials. We expect the Fed to continue hiking rates this year at a faster pace than the Norges Bank, a development which will widen rate differentials and provide a tailwind for USD/NOK. That being said, we are positive on NOK/SEK. Not only is this cross attractive from a technical perspective, but also the expected rise in oil prices should help the Norwegian economy outperform the Swedish one. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has risen by 0.6% this week. We are bullish on the krona on a long-term basis, as we believe that the Riksbank’s monetary policy is too accommodative considering the strong inflationary pressures brewing in the Scandinavian country. The cyclical outlook for the SEK remains poor, as the krona displays the highest sensitivity to the dollar’s strength of any G10 currencies. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
OPEC 2.0 is building physical optionality, to deal with different possible moves the U.S. can make on Iranian oil export sanctions and waivers. This comes despite an apparent break in the sense of urgency Saudi Arabia and Russia feel re production cuts. The coalition’s market monitoring committee meets in April, followed by a full gathering in May, when U.S. waivers expire. If the U.S. extends waivers, OPEC 2.0 can extend production cuts; if it doesn’t, it can add supply as needed.1 On the demand side, markets appear to be overly concerned about a sharper-than-expected slowdown in China, which, if borne out, would restrain EM growth. We believe these fears are overdone, and expect a slight improvement in EM demand generally this year and next. In our new balances estimates, we see the OECD commercial oil inventory overhang clearing in 1H19, on the back of resilient demand, OPEC 2.0 discipline, and a more moderate level of growth in U.S. shale oil output. This keeps Brent on track to average $80/bbl this year and $85/bbl next year, with WTI trading $74/bbl this year, and $82/bbl next year. Highlights Energy: Overweight. Mandatory cuts of 325k b/d, coupled with additional exports of ~ 190k b/d due to additional train and pipeline capacity out of Canada, will drain the 35mm barrels of excess crude oil inventories targeted by the Alberta government in December by 1H19. The WCS – WTI spread narrowed to -$10/bbl from -$50/bbl on these mandatory cuts. By 2H19, we expect Canadian production cuts to average 95k b/d. Base Metals: Neutral. Aluminum output in China surged 11.3% y/y in December, hitting 3.05mm MT, according to Metal Bulletin. Total output for 2018 was 35.8mm MT, a 7.4% y/y increase. Precious Metals: Neutral. Gold is holding its recent gains, as markets become more comfortable with the Fed pausing on its rates-normalization policy until 2H19. Agriculture: Underweight. Hot and dry weather in Brazil is threatening crop yields there. The unfavorable weather is expected to affect three-quarters of cotton-growing regions, half of sugar areas, a third of first-crop corn acreage, and a quarter of soy regions. Feature The first signs of fraying in the relationship between the putative leaders of OPEC 2.0 – the Kingdom of Saudi Arabia (KSA), which cut production ~ 450k b/d m/m in December, and Russia, which raised output – are emerging, as world leaders meet in Davos. While this casts doubt on the leadership’s carefully cultivated amity, and their shared willingness to abide by the recently agreed output cuts, we do not believe it signals the end of the historic cooperation between these states. Total OPEC output – estimated by production-tracking sources outside the Cartel – stood at 31.6mm b/d in December, a prodigious 751k b/d reduction m/m. We expect continued oil production cuts from core OPEC states and decline-curve losses among non-Gulf OPEC and non-OPEC states within the coalition this year to remove at least 1.2mm b/d from the market, per the quotas agreed by members in December (Chart of the Week, Table 1). On top of this, mandatory Canadian production cuts of 325k b/d in 1H19 and 95k b/d in 2H19 will keep average production cuts at ~ 1.4mm b/d this year. Chart of the WeekOPEC 2.0 Will Resume Production CutsTable 1OPEC 2.0 Production Cuts Could Exceed Quotas OPEC 2.0’s cuts could persist into 2020, depending on how the U.S. deals with Iranian oil-export sanctions and waivers. Even though KSA and Russia apparently do not share the same sense of urgency re production cuts right now, we believe OPEC 2.0 is committed to draining oil inventories, particularly in the OECD.2 To do so, they’re increasing their operational flexibility – creating physical options, in a manner of speaking – to deal with a range of uncertain outcomes when U.S. waivers on Iranian export sanctions expire in May. Sanctions And OPEC 2.0’s Physical Options Despite the waivers granted to its eight top consumers shortly after U.S. sanctions took effect in November, Iranian exports plunged below 0.5mm b/d in December. As of December, China had substituted almost all of its Iranian imports for alternative barrels.3 This coincided with a production surge by OPEC 2.0 at the behest of the U.S. leading up to the November sanctions deadline of November 4, 2018, which swelled OECD inventories and took them above their rolling 5-year average level (Chart 2). India retained 30% of its May import levels from Iran, while Europe complied at 100% with U.S. sanctions (Table 2). Chart 3 shows the decrease in exports in preparation for the sanctions over the course of 2018. Chart 2OECD Inventory Overhang Will Draw As OPEC 2.0 Cuts and Losses Kick InTable 2Iran Exports By Destination 2018 (‘000 b/d) Whether or not the waivers are extended is anyone’s guess. It is possible waivers will be extended for 90 or 180 days, as a way to counter OPEC 2.0 production cuts, and to offset the lag between filling new pipeline takeaway capacity in the Permian. We expect importers to queue up for Iranian barrels as the market tightens in 1H19. OPEC 2.0’s market monitoring committee will meet in April, followed by a ministerial meeting in May, just ahead of the expiration of the waivers.4 If the U.S. extends them, OPEC 2.0 can extend production cuts after it meets in May; if waivers are not extended, the Cartel can calibrate an appropriate supply response. Either way, we expect OPEC 2.0 will closely align its production schedule with any U.S. action on the sanctions and waivers. This will, we believe, keep change in the overall market’s supply side relatively constant, except for the month or two required to adjust OPEC 2.0 output. Permian Will Drive OPEC 2.0 Policy The larger issue for OPEC 2.0 comes in 4Q19, when ~ 2mm b/d of new pipeline takeaway capacity comes on line in the Permian Basin in West Texas. With additional takeaway capacity due to come on in 2020, the Cartel will have its work cut out for it next year.5 Our models show a slight decrease then flattening in U.S. rig counts over the coming months, as a result of the 4Q18 sell-off in WTI, with a rebound around mid-year (Chart 4). This is because rig count lags oil prices by ~4 months. Chart 4U.S. Shales Continue to Drive Lower 48 Production Growth (ex GOM) We are expecting production in the Big 5 shale basins to average 8.4mm b/d in 2019 and 9.0mm b/d next year, a somewhat higher level than projected by the EIA. Growth in the shales accounts for close to 80% of the 2.3mm b/d of growth in the U.S. over 2019 – 2020. Globally, U.S. shales will continue to provide the bulk of y/y crude oil production growth, accounting for 73% of the 2.5mm b/d of growth we will see over the next two years. Given the near-death experience OPEC 2.0 member states had in the price collapse of 2014 – 2016, we remain convinced OPEC 2.0 member states will once again have to embark on a strategy to backwardate the Brent forward curve as they did in 1H18, to moderate the growth of shale-oil production in the U.S. (Chart 5). Reducing production in the short term will force refiners to draw inventories to supply their units and produce products like gasoline, diesel, jet fuel and a wide range of petrochemicals. Chart 5OPEC 2.0 Needs Backwardated Brent Forwards This will backwardate the Brent forward curve – i.e., prompt-delivery barrels will be more expensive than deferred-delivery barrels. A backwardated forward curve means OPEC 2.0 member states with term contracts indexed to spot prices receive higher prices for their oil than shale producers hedging 2 years forward, all else equal. The trick for OPEC 2.0 will be to keep the Brent forwards backwardated when the Permian takeaway capacity starts to fill, and exports from the U.S. rise in the early 2020s, as deep-water harbors are brought on line. If OPEC 2.0 is successful in keeping the Brent forwards in backwardation, this will, over time, moderate the growth of shale production: Hedgers’ revenue is constrained by lower forward prices.6 We would not be surprised if OPEC 2.0 states started announcing final investment decisions on select investments in spare capacity to augment existing resources, so they are able to quickly bring production to market in the event of unplanned outages that could lift the entire forward curve and incentivize hedging at higher prices. Demand Still Looks Good Oil markets continue to fret over a possible hard landing in China – resulting either from an internal policy error or a ratcheting up of tensions in the Sino – U.S. trade war. This is causing markets to extrapolate into the wider EM space, and take oil-demand projections lower on an almost-daily basis. In a word, markets are overwrought. Chinese policymakers are sensitive to the tight financial conditions that prevailed in 2H18, which, along with the trade war with the U.S., slowed growth and fostered uncertainty among households and firms in China. We agree with our Geopolitical Strategy and China Investment Strategy groups that presidents Trump and Xi are pragmatists dealing with restive populations, and want to deliver a deal ahead of U.S. elections and the 100th anniversary of the founding of the Chinese Communist Party in 2021.7 We’ve been expecting the government to deploy a modest amount of stimulus in 1H19, which will begin having an effect on the Chinese economy in the second half of this year. Toward the end of the year and into 2020, we expect the larger stimulus to be deployed in the run-up to put a bid under industrial commodities – oil, base metals and bulks in particular. Overall, we are seeing signs global growth may be reviving over the next few months via an apparent bottoming in our Global LEI Diffusion index (Chart 6). The diffusion index measures the proportion of countries where Leading Economic Indicators (LEIs) are rising relative to those in which LEIs are falling. As is apparent in Chart 6, the diffusion index suggests the downturn in the global LEI has bottomed. The index leads the global LEI by a few months. Chart 6BCA's Global LEI Likely Bottoming In our latest supply-demand balances, we are expecting Chinese oil demand to average 14.3mm b/d this year, and 14.8mm b/d next year. Along with India – expected to consume 5.0mm b/d this year, and 5.2mm b/d next year – these two states account for 36% of the total 54.3mm b/d of EM demand we expect in 2019 and 2020 (Table 3).8 Table 3BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Overall EM demand, the powerhouse of global oil-demand growth led by China and India, is expected to increase 1.1mm b/d this year – slightly more than we estimated last month – and 1.3mm b/d in 2020. DM demand growth, as always, comes in lower, at 390k b/d this year and 280k b/d next year. Oil Supply-Demand Balances Will Tighten We expect global oil production to average 100.9mm b/d this year and 102.9mm b/d in 2020. Consumption is expected to average 101.8mm b/d this year and 103.4mm b/d next year, respectively (Chart 7). This puts OECD inventories back on a downward trajectory, as storage draws resume (Chart 2). Chart 7Global Oil Balances Will Resume Tightening On the back of these estimates, we expect Brent to average $80/bbl this year and $85/bbl next year, with WTI averaging $74/bbl and $82/bbl, respectively. Given our expectation for higher prices in Brent and WTI, we continue to favor being long crude oil exposure. We are long outright WTI spot futures; long July 2019 Brent vs. short July 2020 Brent; long call spreads along the 2019 forward Brent curve, and long the S&P GSCI. Bottom Line: Markets will continue to tighten as a combination of lower supply growth and rising consumption allows OECD commercial oil inventories to resume their downward trajectory. The apparent lack of a shared sense of urgency by OPEC 2.0’s leaders – KSA and Russia – will be resolved, in our view. OPEC 2.0 will once again focus on backwardating the Brent forward curve, in order to gain some control over the rate at which U.S. shale oil production grows. We continue to favor long exposures to the crude oil futures. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1 In last week’s Commodity & Energy Strategy we noted these upcoming meetings, and OPEC 2.0’s resolve to drain the market. Please see “Fed’s Capitulation Will Boost Oil,” published by BCA Research January 17, 2019. It is available at ces.bcaresearch.com. 2 Bloomberg reported this week KSA’s and Russia’s oil ministers cancelled a planned meeting in Davos, following al-Falih’s criticism of the pace at which Russian oil production is being cut. Please see “Saudi, Russian Energy Ministers Cancel Planned Davos Meeting,” published by bloomberg.com January 22, 2019. KSA cut its crude oil output 450k b/d m/m in December to 10.64mm b/d from 11.09mm b/d in November. Russia increased crude and liquids production to a record 11.65mm b/d in December, an 80k b/d increase m/m, according to OPEC Monthly Oil Market Report published January 17, 2019. OPEC expects Russian oil output to average 11.47mm b/d in 1H19, and 11.49mm b/d in 2019. We are carrying something close to this in our balances (11.51mm b/d) for 2019 and 2020. 3 China imported 10.3mm b/d of crude oil in December after posting a record 10.4mm b/d of imports in November 2018, just as sanctions were kicking in. 4 In our base case estimate, we assume Iran’s crude oil output will average ~ 2.8mm b/d, down ~ 1.0mm b/d from its 3.8mm b/d production level in 1H18, which was prior to the U.S.’s announcement it intended to re-impose export sanctions. One way or another, we expect OPEC 2.0 to adjust production to compensate for whatever production is lost due to sanctions. 5 Please see “Permian tracker: Production growth slowing as pipeline race still on,” published by S&P Global Platts July 2, 2018, for a discussion of the new takeaway capacity planned for the Permian Basin by midstream companies in 2019 and 2020. 6 The Permian basin is closely tied to hedging activity in the WTI futures market. It is the only basin for which WTI commercial short open interest is an explanatory variable for rig counts in our modeling. Commercial short open interest in the WTI futures also Granger causes Permian rig counts. 7 Please see the Special Report entitled “Is China Already Isolated,” published by BCA Research’s Geopolitical Strategy and China Investment Strategy January 23, 2019. It is available at gps.bcaresearch.com and cis.bcaresearch.com. 8 Our EM demand assumptions are driven by the IMF and World Bank EM GDP forecasts. This week the IMF lowered its global growth forecast for 2019 and 2020 by 0.2 and 0.1 percentage points to 3.5% and 3.6%, respectively. This is only slightly down from our lower estimate last month, but still above the World Bank’s expectation. We are using these variables directly in regressions to estimate prices and EM consumption. This replaced our earlier income-elasticity models used to calculate EM oil consumption. We proxy EM demand with non-OECD oil consumption. We discuss this in “Fed’s Capitulation Will Boost Oil,” published by BCA Research January 17, 2019. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 4q18 Commodity Prices and Plays Reference Table Insert table images here Summary Of Trades Closed In 2018