Financial Markets
Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. John Canally, Chief U.S. Investment Strategist Highlights Late in the business cycle, investors should remain overweight risk assets generally, as long as margins are still rising. A 2015-style deceleration in the Chinese economy cannot be ruled out if it suffers a serious shock to its external sector. The bar remains high for Q2 2018 EPS, but investors are already focused on 2019 and the impact of trade policy on corporate results. Economic surprise is rolling over as inflation surprise climbs. Feature U.S. equities prices rose last week as U.S.-China tariffs kicked in. The U.S. dollar and 10-year Treasury yields dipped, while oil and gold held steady to start the first quarter. Despite the relative calm, investors remain concerned about the impact of trade policy and rising labor and raw materials costs on corporate margins. BCA expects S&P 500 margins to peak later this year. In the next section of this report, we examine the performance of a broad range of asset classes after the economy reaches full employment. Higher labor and input costs, along with the impact of global trade disputes, will be key topics of discussion as the Q2 earnings seasons kicks off this week. We provide a preview later in this report. Market participants are also worried that the weakness in Chinese equities and the decline in the CNY are signaling a repeat of late 2015-early 2016. We explore those concerns in the second section below. Although the June jobs report (see below) was mixed relative to consensus expectations, the Citigroup Economic Surprise Index (CESI) is poised to turn negative. In the final section of this week's report, we discuss how investors should positions as CESI troughs and how to prepare for the inevitable bounce higher. The rise in the U.S. unemployment rate to 4% in June is not the start of a new trend. The labor market continues to tighten and the FOMC is noticing (Chart 1, panels 1 and 2). Chart 1Don't Be Fooled By The Uptick##BR##In The U.S. Unemployment Rate The June Establishment Survey revealed a 213k rise in payrolls, along with upward revisions to the previous two months. The three-month average, at 211k, remains well above the underlying trend in labor force growth. In contrast, the Household Survey showed a more modest 102k increase in jobs in the month. Moreover, the number of people entering the workforce surged by 601k, which caused the unemployment rate to rise from 3.8% to 4%. We doubt this signals a trend change in the unemployment rate. The Household Survey is quite volatile relative to the Establishment Survey, suggesting that employment gains in the former are likely to catch up next month. The surge in the labor force in June could reflect the possibility that the tight labor market is finally drawing people into the workforce who were not previously looking for work. The participation rate rose by 0.2 percentage points to 62.9% (panel 4). However, this rate bounces around from month-to-month and is still in its post-2015 range. Moreover, the typical wave of college and high school students entering the workforce at this time of the year may have distorted the labor force figures due to seasonal adjustment problems. The real story is that the underlying labor market continues to tighten. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. Average hourly earnings edged up by 0.2% m/m in June. The y/y rate held at 2.7% in the month, but the trend in wage growth remains up (panel 3). Moreover, the June non-manufacturing ISM report highlighted that economic momentum remains very strong, and the respondents' comments noted widespread building cost pressures related to labor shortages, rising commodity prices and a shortage of transportation capacity. China: It's Not 2015...Yet Investor concerns escalated last week over emerging markets and specifically China. Market participants are worried that the weakness in Chinese equities and the decline in the CNY are signaling a repeat of late 2015-early 2016. BCA's Foreign Exchange Strategy's view1 is that Beijing is letting the CNY depreciate at a faster pace against the U.S. dollar for two reasons. First, it is a means to reflate the economy because the proposed U.S. tariffs on Chinese goods would inflict a non-negligible blow to China that would need to be softened if it materializes. Secondly, letting the yuan depreciate sends a message to the U.S.: China can weaponize its currency if necessary. Meanwhile, our China Investment Strategy service remains cautious on Chinese equities, but notes that the recent selloff in domestic stocks may be overdone (we remain neutral on the investable market).2 Chart 2China's Borrowing Costs Have Climbed... A 2015-style deceleration in the Chinese economy cannot be ruled out if it suffers a serious shock to its external sector, which would be very problematic for financial markets given our view that China has a higher pain threshold for stimulus than in the past. But tight monetary policy was a key driver of China's 2015 slowdown, and while monetary conditions have tightened since late-2016, they remain easier than what prevailed four years ago (Chart 2). There are key differences between 2015 and today from a U.S./global perspective as well. In late 2015, the dollar had moved up by 27% from its mid-2014 low, business capital spending was in freefall, credit spreads widened and oil dropped by over 50% year-over year. None of those conditions are currently in place. The key difference between 2015 and today is that three years ago there was no threat of a trade war with China, or the widespread imposition of protectionist measures more generally. Late Cycle Asset Return Performance Some of our economic and policy analysis over the past year has focused on previous late-cycle periods, especially those that occurred at the end of long expansions such as the 1980s, 1990s and the 2000s.3 Specifically, we analyzed the growth, inflation and policy dynamics after the point when the economy reached full employment (i.e. when the unemployment rate fell below the CBO estimate of full employment - NAIRU). This week we look at asset class returns during late-cycle periods. We wanted to use as broad a range of asset classes as possible, although data limitations mean that we can only analyze the late-cycle periods at the end of the 1990s and the mid-2000s (Chart 3). To refine the analysis, we split the late-cycle periods into two parts: before and after S&P 500 profit margins peak. One could use other signposts to split the period, such as a peak in the ISM or a peak in the S&P 500 index itself. However, using the S&P operating profit margin proved to be a more useful break point across the cycles in terms of timing trend changes in risk assets. Table 1 (and Appendix) presents total returns for the following periods: (1) the full late-cycle period - i.e. from the point at which full employment is reached until the next recession; (2) from the point of full employment to the peak in the S&P margin; (3) from the peak in margins to the recession; and (4) during the subsequent recession. All returns are annualized for comparison purposes, and the data shown are the average of the late 1990s and mid-2000 late-cycle periods. Chart 3Profit Margins Peak Late##BR##In The Late Cycle Period Table 1Historical Returns; Average Of##BR##Late 1990s And Mid-2000s We must be careful in interpreting the results because no two cycles are exactly the same, and we only have two cycles in our sample of data. Nonetheless, we make the following observations: Treasury bond returns are positive across the board, which seems odd at first glance. However, in both cycles the selloff occurred before the late-cycle period began. Yields then fluctuated in a range, and then began to fall after margins peaked. Global factors also contributed to Greenspan's "conundrum" of stable bond yields in the years before the Great Recession. We do not expect a replay this time around given the low starting point for real yields and the fact that the Fed is encouraging an overshoot of the inflation target. Bonds are unlikely to provide positive returns on a 6-12 month horizon. Similar to Treasuries, investment-grade (IG) corporate bond returns were positive across the board for the same reason. However, IG underperformed Treasuries after margins peaked and into the recession. High-yield (HY) bonds followed a similar pattern, but suffered negative returns in absolute terms after margins peaked. U.S. stocks began to sniff out the next recession after margins peaked. Small caps outperformed large caps in the recessions, but after margins peaked relative performance was mixed. We are avoiding small caps at the moment based on poor fundamentals and valuations. Growth stocks had a mixed performance versus value before and after margins peaked, but tended to outperform in the recessions. Dividend aristocrat returns performed well relative to the overall equity market after margins peaked and into the recession on average, but the performance is not consistent across the two late cycles. EM stocks performed well before margins peak, and poorly during the recessions. However, the performance is mixed in the period between the margin peak and the recession. We recommend an underweight allocation because of poor macro fundamentals and tightening financial conditions. In theory, Hedge funds are supposed to be able to perform well in any environment, but returns have been a mixed bag after margins peaked. The return performance of Private Equity, Venture Capital and Distressed Debt were similar to the S&P 500, albeit with more volatility. Avoid them after margins peak. Structured product is one of the few categories that performed well across all periods and cycles. The index we used includes MBS, CMBS and ABS. Farmland and Timberland returns are attractive across all periods and cycles, except for Timberland during recessions where the return performance was mixed. Oil and non-oil commodities tended to perform poorly during recession, but returns were inconsistent in the other phases shown in the table. Gold was also a mixed bag. The return analysis underscores that investing late in an economic cycle is risky because risk assets can begin to underperform well before evidence accumulates that the economy has fallen into recession. Using the peak in the S&P 500 operating profit margin as a signal to lighten up appears promising. Based on this approach, investors should remain overweight risk assets generally, including stocks, corporate bonds, hedge funds, private equity and real estate, as long as margins are still rising. Investor should scale back in most of these areas as soon as margins peak, although they can hold onto Farmland, Timberland, structured products, real estate (including REITs) for a while after margins peak because it may not be as important to exit these areas before the next recession begins. For fixed income, investor should be looking to raise exposure but move up in quality after margins peak. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. S&P 500 margins are still rising at the moment which, on its own, suggests that investors should be fully-exposed to all risk assets. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market (e.g. trade war, economic China slowdown, and EM economic and financial vulnerabilities). We are not yet ready to go underweight on risk assets, but the risk/reward balance at the moment suggests that risk tolerance should be no more than benchmark. Still Going Strong The consensus predicts a 21% year-over-year increase in the S&P 500's EPS in Q2 2018 versus Q2 2017, and 22% in calendar year 2018. Expectations are high; at the start of 2018, analysts projected 11% growth in Q2 and 12% in 2018. Energy, materials, technology and financials will lead the way in Q2 earnings growth, while real estate and utilities will struggle. Excluding the energy sector, the consensus expects a robust 18% increase in profits. The stout profit environment for Q2 2018 and the year ahead reflects sharply higher oil prices compared with Q2 2017, and the impact of last year's Tax Cut and Jobs Act on share buybacks and management confidence. However, global growth, which was a tailwind for S&P 500 results in 2017 and early 2018, has stalled. Moreover, rising costs for raw materials and labor will erode margins, but not until later this year. S&P 500 revenues are forecast to rise by 8% in Q2 2018 versus Q2 2017, matching the Q1 2018 year-over-year increase. The consensus expects a year-over-year gain in Q2 sales in all 11 sectors. Trade policy will continue to be at the forefront as managements discuss Q2 outcomes and provide guidance for 2H 2018 and beyond. In addition, capacity constraints, labor shortages and rising input costs will be key topics. Elevated corporate debt levels4 and climbing interest rates also will be debated as CEOs and CFOs provide guidance to Wall Street for Q3 2018 and beyond. Their counsel is more vital than the actual Q2 results. The markets probably have already priced in a robust 2018 earnings profile linked to the Tax Cut and Jobs Act, and are looking ahead to 2019 and 2020 (Chart 4). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 22% increase expected this year. Chart 4High Bar For 2018... But Focus Will Quickly Turn To 2019 At 9%, the consensus estimate for S&P 500 EPS growth in 2020 is too high (Chart 4). BCA's view5 is that the next recession in the U.S. will commence in 2020. Since 1980, S&P 500 profits have dwindled by 28%, on average, in the first year of a recession. Chart 5 (panel 1) shows that elevated readings on the ISM manufacturing index still provide a very favorable backdrop for S&P 500 profit growth in 2018. However, the top panel also illustrates that the index rarely stays above 60 (it was 60.2 in June), especially late in the business cycle. The ISM is a good proxy for S&P 500 forward earnings (panel 2) and sales (panel 3). The implication is that while the near-term environment for S&P 500 earnings and sales is solid, there is not much more upside. Chart 5Domestic Backdrop For S&P Profits In ''18 Still Looks Solid... Global growth is peaking despite the rosy domestic economic environment. At close to 3%, the consensus view of U.S. GDP growth in 2018 is still accelerating thanks to pro-cyclical fiscal, monetary and legislative policies in the U.S.6 However, in early April, analysts estimates for 2019 GDP growth in the U.S. reached a zenith at 2.5% and have since rolled over (Chart 6). The FOMC projects real GDP growth at 2.8% in 2018 and 2.4% in 2019.7 Meanwhile, global GDP growth estimates for 2018 began flattening near 3.5% in early April 2018, about a month after President Trump announced the first round of tariffs. Estimates for 2019 economic growth peaked in mid-May, near 3.25% (Chart 6). Chart 6Consensus GDP Estimates For U.S., World Are Rolling Over BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. The trade-weighted dollar is up by 2.5% year-to-date, and by 7% from its recent (February 2018) trough. Nonetheless, the dollar is down by 2% year-over-year and should not have a major impact on Q2 results. Furthermore, based on the minimal references to a robust dollar (only eight in the past eight Beige Books), the dollar probably will not be an issue for corporate profits in Q2 2018 (Chart 7). The handful of recent references is in sharp contrast with a surge in comments during 2015 and early 2016. The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. The implication is that a robust dollar may get a few mentions during the earnings season, but those mentions will be drowned out by concerns over global trade. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically-focused corporations versus globally-oriented ones. Economic growth trends, discussed above, also play a role. Chart 8 shows that sales of domestically-oriented firms in the U.S. are still in a clear uptrend (panel 2). However, revenues of U.S. companies with a global focus stalled in recent quarters, even before the first round of tariffs were announced (panel 4). Margins at domestically-focused firms are still accelerating (panel 1), while margins at global businesses are topping out, albeit at a higher level than domestic ones. Moreover, since the start of 2017, the weaker dollar has allowed profit and sales gains of global corporations to rebound and outpace those companies with only domestic concerns. BCA expects that margins for S&P 500 companies will peak later this year. Investors are skeptical that S&P 500 margins can advance in Q2 2018 for the eighth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate and raw materials costs escalate. Bottom Line: BCA expects that the earnings backdrop will support equity prices in 2018 (Chart 9). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on the upcoming 2019 and 2020 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 9). In late June,8 we downgraded our 12-month recommendation on global equities and credit from overweight to neutral. Chart 7The Dollar Should Not Be##BR##A Big Concern In Q2 Earnings Season Chart 8Global Sales,##BR##Margins Stalled... Chart 9Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Look Out Below Citi's Economic Surprise Index (CESI) is poised to turn negative (Chart 10) after hitting a four-year high in late 2017. Since then, a harsh winter and early spring in the U.S., coupled with elevated expectations following the introduction of the tax bill, saw most economic data fall short of expectations. Moreover, a slowdown in global growth and uncertainty around U.S. and global trade policy negatively affected U.S. economic data in the spring and early summer months. Chart 10Citi Economic Surprise Poised To Turn Negative In our late March 2018 report,9 we noted that there have been six other episodes since 2011 when the CESI behaved similarly. These phases lasted an average of 96 days; the median number of days from peak to trough was 66 days. Moreover, in our March 2018 report we stated that a trough in CESI may be a month or two away, but there are no signs that has occurred. Table 2 illustrates the performance of key U.S. dollar-based investments, commodities and the dollar itself as the CESI moves from zero to its ultimate trough. We identified eight periods since 2010 when the CESI moved lower from zero. Table 2U.S. Stocks, Credit And Commodities As Economic Surprise Turns Negative On average, these episodes lasted 43 days, with the longest (81 days) in early 2015 and the shortest (13 days) in January-February 2013. During these phases, U.S. equities posted minimal gains and underperformed Treasuries (Chart 11). Moreover, investment-grade and high-yield credit tracked Treasuries, and there was little difference between the performance of small cap and large cap equities. Gold and oil struggled, while the dollar barely budged. Chart 11U.S. Financial Assets, Commodities And The Dollar As Economic Surprise Troughs While the CESI is rolling over, the Citigroup Inflation Surprise index is on the upswing (Chart 12). We identified seven stages when the CESI rolled over while the Citi Inflation Surprise Index: 2003-2004, 2007-2008, 2009, 2011, 2012-13, 2014 and this year. The late 2007 period is most similar to today; the other five episodes occurred either during early cycle (2003-2004, 2009 and 2011) or mid-cycle (2012-13 and 2014). In late 2007, the U.S. economy was in the late stages of an expansion, the unemployment rate was below full employment and the Fed was raising rates. The stock-to-bond ratio fell, credit underperformed Treasuries and gold and oil rose. Furthermore, small caps outperformed large caps, and the dollar fell (Chart 13). Chart 12Episodes Of Rising Inflation Surprise##BR##When Economic Surprise Is Falling Chart 13U.S. Financial Assets,##BR##Commodities And The Dollar As... Our work10 shows that these periods were associated with higher wage and compensation metrics, and higher realized core inflation. Moreover, these phases tended to occur when the economy was at full employment and the Fed funds rate was above neutral. The implication is that inflation indices are poised to move higher in the coming year, and prompt the Fed to continue to boost rates gradually at first, but then more aggressively starting in mid-2019. Bottom Line: The disappointing run of economic data is not over. Treasury bond yields will likely dip as the CESI troughs. However, the weakness in the economic data does not signal recession. We expect that the Inflation Surprise Index will continue to grind higher, while unemployment dips further into excess demand territory and oil prices rise. After the CESI forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb.11 Fed policymakers have signaled that they will not mind an overshoot of their 2% inflation target. However, because core PCE inflation is already at the Fed's target, the central bank will be slower to defend the stock market in the event of a swoon. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Appendix 1 Please see BCA Research's Foreign Exchange Strategy Weekly Report "What Is Good For China Doesn't Always Help The World", published June 29, 2018. Available at fes.bcaresearch.com. 2 Please see BCA Research's China Investment Strategy Weekly Report "Standing On One Leg", published July 5, 2018. Available at cis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Equity Strategy Weekly Report "Till Debt Do Us Part", published May 8, 2018. Available at uses.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report "Third Quarter 2018: The Beginning Of The End", published June 29, 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Policy Line Up," published March 12, 2018. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180613.pdf 8 Please see BCA Research's U.S. Investment Strategy Weekly Report "Sideways," published June 25, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report "Waiting", published March 26, 2018. Available at usis.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report "Wait A Minute", published May 28, 2018. Available at usis.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Solid Start," published January 8, 2018 and "The Revenge Of Animal Spirits," published October 30, 2017. Both available at usis.bcaresearch.com.
Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Mathieu Savary, Foreign Exchange Strategist Highlights On a short-term basis, the dollar is massively overextended and is likely to experience a correction over the coming weeks. EM assets and currencies are the anti-dollar, and will benefit from these dynamics. As a result, oversold commodity currencies like the AUD, CAD, and NZD should be the main beneficiaries of a dollar correction within the G-10 FX space. However, this bout of dollar weakness is unlikely to mark the end of the greenback's 2018 rally. Global liquidity conditions remain very dollar bullish as the U.S. economy is absorbing liquidity from the rest of the world. This creates a scarcity of greenbacks in international markets. It is also dollar bullish because it weighs on the outlook for global growth, flattering the countercyclical nature of the USD. Gold should be the key gauge to judge whether these dynamics will be playing out as we foresee. Feature The last quarter was dominated by the dollar's strength and weakness in EM bonds; weakness that has now spread to EM equities. After such violent moves, it is now time to reflect and to try to understand what the second half of the year may have in store for the dollar. In our view, the dollar move has become overextended. As a result, we anticipate the dollar to experience a correction over the course of the coming months - a move that should benefit risk assets, and EM plays in particular. However, while this correction is likely to be playable for tactical traders, this does not spell the end of the dollar rally and EM selloff. The global liquidity backdrop supports a continuation of the trends seen over the past few months. Short-Term Momentum Extremes The vigor of the dollar rally this year along with the violence of EM bond, currency and equity selling has been eye-catching. However, we are seeing many signs that these moves may have become overdone on a short-term basis. Let's begin with EM assets. EM assets are very important due to their high sensitivity to global liquidity, global growth and the dollar. The market breadth of EM stocks is near its most oversold levels since the financial crisis. This suggests that commodity currencies are likely to experience a relief rally in the coming weeks (Chart I-1). In fact, both the MACD and 14-day RSI oscillators of EM stocks are corroborating this message, having hit some of their lowest levels since 2016 (Chart I-2). Such a rebound could be especially beneficial for the AUD, NZD, and CAD, as speculators have accumulated large short positions in these currencies (Chart I-3). Chart I-1EM Are ##br##Oversold Chart I-2EM Oscillators Point##br## To A Rebound Chart I-3More Reasons For The AUD ##br##And His Friends To Rebound The key for this rally to unfold will be U.S. dollar weakness - a correction that we feel is likely to materialize. From a technical perspective, our dollar capitulation index is currently flagging massively overbought conditions, a picture that our intermediate-term indicator also highlights (Chart I-4). Looking at the euro - the largest constituent of the DXY dollar index - provides a mirror image. The EUR/USD's intermediate-term momentum measure is flagging deeply oversold levels, and the paucity of up days in this pair over the recent month is also congruent with a temporary bottom (Chart I-5). In fact, shorter-term indicators like the MACD and 14-day RSI oscillators have not only reached deeply oversold readings, but have also recently begun to form positive divergences with the price of EUR/USD itself (Chart I-6). Chart I-4The Dollar Should Correct Chart I-5Euro Is The Anti-Dollar Chart I-6Positive Divergences In The Euro What could be a catalyst for a dollar correction that would also help EM assets and thus provide a welcome boost to the euro, and even more so commodity currencies? China obviously plays a key role. One of the crucial ingredients behind the recent generalized USD strength and selloff in EM-related plays has been the rapid fall in the yuan against the dollar. As we argued last week, this remains a key risk for the remainder of the year. However, we also prophesized that Beijing is concerned by the speed of the recent decline, and could try to manage the pace of CNY's fall for now.1 Early this week, the People's Bank of China began "open-mouth" operations in an effort to support the RMB, which seems to be putting a temporary floor under the renminbi. As long as the dam resists, the DXY's rally will pause. Additionally, the speed of the divergence between U.S. growth and the rest of the world has probably reached a short-term peak that will temporarily get reversed. As Chart I-7 illustrates, European, Japanese and Australian economic surprises are attempting to form a bottom, while U.S. ones have just moved below the zero line. Finally, the dollar is likely to lose one of its key supports from last quarter: the U.S. Treasury. As Chart I-8 illustrates, when the Treasury rebuilds its cash balances, the dollar does well. Essentially, through 2017, the Treasury was draining its cash balance ahead of the debt-ceiling standoff. By spending its stash of cash, the U.S. federal government was injecting reserves - in effect liquidity - into the banking system. After the debt-ceiling extension last September, the Treasury proceeded to rebuild its pile of funds, draining reserves and liquidity out of the banking system. This process is now over, and therefore this support for the dollar will continue to fade. Chart I-7Economic Surprises And The Dollar: ##br##From Friends To Foes Chart I-8The U.S. Treasury Is Done Rebalancing##br## Its Cash Balance Altogether, these dynamics are likely to cause the dollar to soften in the near term, especially since, as Dhaval Joshi highlighted in BCA's European Investment Strategy, currency market players are displaying a high degree of groupthink - as measured by the trade-weighted dollar's fractal dimension - and could easily be panicked by a defusing of the growth divergence theme (Chart I-9). Chart I-9Group Think In The Dollar = Hightended Risk Of Countertrend Bottom Line: The dominant trends of the second quarter - a strong dollar, weak commodity currencies and EM plays - are now crowded trades. With the Chinese monetary authorities trying to limit the speed of the CNY's decline, with economic surprises outside the U.S. finding a floor, and with the U.S. Treasury backing away from reducing liquidity in the banking system, a countertrend move across the dollar, EM assets, and commodity currencies is a growing possibility. Why A Countertrend Move And Not A New Trend? Our view remains that global growth has further room to decelerate, that investors have fully anticipated an increase in global inflation, and that the renminbi has greater downside. All these support our expectation that if a period of weakness in the dollar were to materialize this summer, it would be temporary.2 However, another factor plays a big role: The evolution of liquidity flows in the global economy. Essentially, at the core of this argument lies the fact that we worry that the continued growth outperformance of the U.S. along with the revival of animal spirits in this enormous economy will suck in dollar liquidity from the rest of the world. Not only will this create a scarcity of dollars, thus bidding up the price of the greenback in the process, but it will also hurt highly indebted EM economies - nations that have high dollar debts and thus need dollar liquidity to stay afloat (Chart I-10). To begin with, U.S. banks have been slowly increasing their lending to the U.S. private sector. The upsurge in business confidence, with the NFIB small business survey and the Duke CFO survey near record highs, along with the increase in U.S. capex, confirms the durability of this rebound. Additionally, U.S. households also have the wherewithal to increase their borrowings. Not only is household debt as a percentage of disposable income near a 15-year low but, most importantly, debt servicing costs as a percentage of disposable income remain at levels last seen in the early 1980s (Chart I-11). Moreover, banks are still easing their lending standards on mortgages - which represent nearly 70% of household credit - and mortgage quality as measured by FICO scores are still well above levels that prevailed prior to the financial crisis. Chart I-10EM Dollar Debt Is High EM##br## Have A Lot Of Dollar Debt Chart I-11U.S. Households Have The ##br##Wherewithal To Take On Debt This is important, because when banks increase their loan books, they run down their liquidity (Chart I-12). To be more specific, rising loan issuance results in banks selling securities on their balance sheets and running down their cash balances. As Chart I-13 illustrates, when the cash and security inventories of U.S. commercial banks decrease, the U.S. dollar rallies. This relationship was very strong from 1980 to 2008 but loosened for two years during the financial crisis. Since 2010, it has re-established itself. The probability is therefore high that it will remain in place, and be a dollar-bullish factor over the medium term. Chart I-12Rapid Loan Growth Means Less Liquid Chart I-13The Dollar Abhors Liquid Bank Balance Sheets Moreover, by looking at the holdings of securities on banks' balance sheets, we can see that since 2012, they have even provided a leading signal on the dollar. This relationship currently points toward additional dollar strength (Chart I-14). The tighter relationship between securities holdings and the dollar than between total liquidity on banks' balance sheets and the dollar is due to the fact that securities can be re-hypothecated, and therefore can create a much greater supply of dollars in offshore markets than cash alone. The dollar-bullish liquidity backdrop is not limited to banks' balance sheets alone. Long-term portfolio flows into the U.S. have increased substantially in recent months, but still remain well below previous peaks (Chart I-15, top panel). Moreover, as the U.S.'s growing energy independence has prevented the trade deficit from expanding, the American basic balance of payments is now back in positive territory (Chart I-15, bottom panel). This too suggests that the U.S. is absorbing more dollars than it is supplying to the global economy. Chart I-14Declining Security Holdings Of Banks##br## Point To A Surge In The Dollar Chart I-15Money Is Flowing##br## Out Of The U.S. This reality is mirrored by the link between the bond issuance of U.S. firms and the dollar. When U.S. businesses increase their issuance of bonds, this tends to result in a strong dollar and weak majors (Chart I-16). The vigor of the U.S. economy and the deregulatory tendencies of the Trump administration suggest that U.S. companies could continue to issue more bonds, which will drag more liquidity out of the rest of the world and support the dollar in the process. The profit repatriation initiated by President Trump's tax reform is also supportive of the dollar. As Chart I-17 illustrates, when U.S. entities repatriate funds from abroad, the dollar tends to strengthen. Today, they are doing so with more gusto than ever. It is important to remember that this is not a reflection of American firms necessarily buying dollars directly. After all, a lot of their foreign earnings are already held in USD. Instead, it reflects the fact that when U.S. firms bring back their dollars into the U.S., the supply of high-quality collateral available in offshore markets declines, which means that acquiring dollars becomes more expensive.3 Chart I-16Rising Bond Issuance Helps The Dollar Chart I-17Trump's Tax Repatriation Is Dollar Bullish Finally, this decline in dollar liquidity is starting to be felt abroad, a phenomenon magnified by the slowdown in global trade. Global reserves are not increasing as fast as they were in 2017. As a result, a key component of global dollar-based liquidity, the Federal Reserve's accumulation of custodial holdings of securities, is also declining fast - a decrease exacerbated by the fact that the Fed is curtailing the size of its own balance sheet (Chart I-18). Historically, a decline in dollar-based liquidity is not only associated with lower global growth and a stronger greenback, but also with falling EM asset prices, EM currencies, and commodity currencies. Gold prices will provide insight on whether global liquidity remains favorable to the dollar and negative for EM assets. As Chart I-19 illustrates, gold has already broken down an intermediate upward sloping trend line, but is rebounding against the primary trend in place since the early days of 2016. If this rebound peters off and gold breaks below this primary trend line, it will be a clear indication that the decline in liquidity outside the U.S. is having a nefarious impact on global growth. This headwind to global economic activity will support additional dollar strength and asset price weakness. Chart I-18Declinning Dollar Bond Liquidity Chart I-19Litmus Test For Liquidity Bottom Line: The dollar faces near-term downside risk, but this move is likely to prove to be countertrend in nature as the global liquidity backdrop remains dollar bullish. The U.S. economy is currently sucking in global liquidity from the rest of the world, which is creating a scarcity of dollars in offshore markets. Not only is this scarcity inherently dollar bullish, but it also weighs on global growth, further flattering the dollar - a currency that performs well when global growth softens. As a result, while short-term investors should hedge some of their long-dollar exposure over the coming weeks, longer-term investors should use this correction to accumulate more dollars in order to benefit from another leg of the dollar's rally this fall. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 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 2 Please see Foreign Exchange Strategy Weekly Reports, titled "What Is Good For China Doesn't Always Help The World", dated June 19, 2018, "Inflation Is In The Price", dated June 15, 2018, and "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "It's Not My Cross To Bear", dated October 27, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: ISM manufacturing increased to 60.2 from 58.7; ISM prices paid declined to 76.8 from 79.5; Continuing and initial jobless claims both increased, disappointing expectations; Factory orders grew by 0.4% in monthly terms. After hitting deeply overbought levels, the dollar is losing momentum and risks correcting as economic surprises in the U.S. continue to decline while global ones are finding a floor, for now. Even if the dollar were to correct, budding inflationary pressures and higher growth in the U.S. are likely to prompt the Fed to hike at a faster rate than the rest of the developed world, providing the greenback with substantial upside. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 This Time Is NOT Different - May 25, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: Manufacturing PMI improved for Italy, declined for France and remained unchanged for Germany, while decreasing for the euro area as a whole; Euro area retail sales increased by 1.4%, less than the expected 1.5%; Speculations about the ECB's actions are causing substantial movements in markets. The French 5/30 yield curve flattened by about 30 bps at rumors of an "Operation Twist" by the ECB, following the end of the APP in December. However, the euro has remained stable for around a month now, suggesting that markets have already discounted a substantially easier monetary policy. Despite this, the current slowdown in global growth is likely to have a further detrimental effect on the euro. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Housing starts yearly growth surprised to the upside, coming in at 1.3%. However, the Markit Services PMI came in at 51.4, underperforming expectations. Moreover, consumer confidence surprised to the downside, coming in at 43.7. USD/JPY has rallied by roughly 0.5% this past week. Overall we continue to be positive on the yen tactically, given that trade tensions as well as tightening in China should continue to create a risk-off environment where the yen thrives. However, on a longer term basis we maintain our bearish stance, as the BoJ will keep its ultra-dovish monetary policy in order to kick start Japan's moribund inflation. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: Mortgage approvals outperformed expectations, coming in at 64.526 thousand. Moreover, Construction PMI surprised to the upside, coming in at 53.1. Finally, Markit Services PMI also outperformed expectations, coming in at 55.1. GBP/USD has risen by roughly 1% since last week. Overall, we expect that cable will continue to depreciate, as any pullback in the dollar will likely be temporary. Nevertheless, the pound should outperform the euro, given that Europe will likely suffer more from emerging market weakness than the U.K. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was disappointing: The AiG Performance of Manufacturing Index declined slightly from 57.5 to 57.4; RBA Commodity Index in SDR terms grew by 6.6% only, less than the expected 7.5%; Building permits contracted by 3.2% on a monthly basis; The trade balance came out less than expected at AUD 827 million. In its latest monetary policy statement, the RBA highlighted that Australian monetary conditions have tightened, noting lower housing credit growth and tighter lending standards. As 85% of home loans are variable-rate mortgages, the highly indebted Australian households are extremely susceptible to a direct tightening in interest rates. Furthermore, wage growth at 2.1% and inflation at 1.9% implies a paltry 0.2% real wage growth, adding additional risk to household financial conditions. Alongside a clouded global growth outlook, the RBA is therefore unlikely to hike in this environment anytime soon. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi has been relatively flat this week. Overall, even if a short-term bounce is likely over the coming weeks, we continue to be bearish on this cross, as commodity currencies like the NZD or the AUD should suffer in the current risk-off environment where liquidity is scarce. However, the New Zealand dollar will probably outperform the Australian dollar. After all, Australia is more exposed to the Chinese Industrial Cycle than New Zealand, being a large base metals exporter. Meanwhile, we remain bearish on the NZD on a longer term basis, as the new government will restrict immigration and implement a dual mandate for the RBNZ, both measures which will lower the neutral rate in New Zealand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Despite the rapid increase in oil prices, the Canadian dollar has not been able to keep up. NAFTA tensions are placing downward pressure on the loonie, despite the Canadian economy's rosy conditions. The most recent Business Outlook Survey by the BoC shows increasing economic activity with a robust sales outlook. In addition, capacity utilization is becoming ever tighter, with the amount of firms finding it difficult to meet unexpected demand at the highest level since the history of the data. Furthermore, the labor market continues to tighten, as hiring plans continue to trend upward. This is likely to keep the BoC somewhat hawkish, despite trade worries. The strength of the Canadian economy is therefore likely to lift the CAD above other G10 currencies this year, except against the greenback. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The KOF leading indicator outperformed expectations, coming in at 101.7. Moreover, the SVME PMI index also surprised to the upside, coming in at 61.6. However, retail sales yearly growth underperformed expectations, coming in at -0.1%. Finally, headline inflation came in line with expectations, coming in at 1.1%. EUR/CHF has risen by roughly 0.5% this week. Overall, we continue to be bullish on a tactical basis on the franc, given that trade tensions and the policy tightening in China should ultimately keep the current risk-off in place. That being said we are cyclically bearish on the CHF, as the SNB will continue to maintain an extraordinarily easy monetary policy stance in order to prevent an appreciating franc to prevent the Swiss central bank from reaching its inflation target. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales growth outperformed expectations, coming in at 1.8%. Moreover, registered unemployment continued to be very low at 2.2%, in line with expectations. USD/NOK has fallen by nearly 1% since last week, partly due to the rise in oil price, caused by a large draw in inventories. Overall we continue to be bullish on this cross, given that we maintain that the U.S. dollar will continue rising. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 A shift in stance at the Riksbank has been the major force behind the SEK's appreciation of around 2% against both USD and EUR in the past couple of days. The upward revision of CPIF inflation from 1.9% to 2.1% in both 2018 and 2019, and the downward revision of the unemployment rate were particularly important. In addition, three policymakers expressed hawkish views: Deputy Governors Flodén and Skingsley suggested a hike in October or December, while Ohlsson advocated for a higher repo rate of 25 bps now in response to stronger economic growth in both Sweden and abroad. Consistently, these members expressed similar opinions on the termination of foreign exchange interventions, as inflation is near its target. However, the underlying dovish intonations of Stegan Ingves still lurk within the Riksbank, presenting possible downside risk in the short-term. Nevertheless, these views support our longer-term bullish view of the SEK vis-à-vis the euro, based on diverging rate differentials. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Domino dynamics continue escalating within the EM universe confirming that a major bear market is underway. Several global cyclical market segments have recently experienced technical breakdowns. This confirms that global growth is slowing. It is not too late to short/sell EM risk assets. We reiterate the long Indian / short Chinese banks equity trade. Feature The selloff in global risk assets continues to exhibit a pattern of falling dominos. It began with the breakdown in the weakest spots of the EM world, Turkey and Argentina, and then spread to Brazil and Indonesia. Only weeks later it hit other vulnerable EM markets such as South Africa. During this period, north Asian stocks and currencies - Chinese, Korean and Taiwanese - displayed resilience. It was tempting to argue that the EM selloff was being driven by idiosyncratic risks and was limited to current account deficit countries vulnerable to U.S. Federal Reserve tightening. However, in recent weeks these north Asian markets have plunged - making the EM selloff largely broad-based and pervasive. In our June 14 report,1 we argued that major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. Since then, the domino effect has escalated confirming our bias that EMs are in a major bear market. Several important markets and cyclical market segments have recently broken down, and investors should heed messages from them: Copper prices fell below their 200-day moving average; they have also broken down the trading range that had persisted since last September (Chart I-1, top panel). The precious metals price index seems to be sliding through the floor of its trading range of the past 18 months (Chart I-1, bottom panel). Global cyclical equity sectors and sub-sectors such as mining, steel, chemicals and industrials have also broken their 200-day moving averages in absolute term (Chart I-2). They have also been underperforming the global equity index, which is consistent with the global trade slowdown that is beginning to escalate. Chart I-1Breakdown in Metals Prices Chart I-2Global Equities: Cyclicals Have Broken Down Although Chinese PMI data have not been particularly weak, anecdotal evidence from the ground suggests that the credit tightening of the past 18 months is taking its toll on China's financial system and economy. There are numerous reports about bankruptcies of Peer-to-peer lending platforms and struggles in other parts of the shadow banking system. The selloff in Chinese onshore A shares confirms this. Presently, this market has become less driven by retail investors as it was back in 2015. Hence, one can argue that portfolio managers on the mainland are selling their stocks because they believe economic conditions are worsening. Meanwhile, international investors have so far been more sanguine. Importantly, EM corporate and sovereign U.S. dollar bond yields are rising, heralding lower share prices (Chart I-3). Bond yields are shown inverted on this chart. The top panel is for EM overall and the bottom panel is for Asia only. Chart I-3EM Credit Markets Entail More Downside In EM Share Prices Chart I-4EM Versus U.S.: New Lows Lie Ahead Finally, the resilience of the U.S. equity index and corporate spreads has been due to robust domestic demand - the slowdown in global trade has not affected the U.S. However, odds are that the current global selloff continues to develop in a typical domino fashion. If so, the U.S. markets - equities and credit - will be the last dominos to fall but they will outperform their global peers. It is very unlikely that American stocks and credit markets will be able to sail through this EM storm unscathed. Notably, the resilience of the S&P 500 can be attributed to 10 large-cap stocks that are extremely overbought and likely expensive. This gives us more confidence to argue that this EM riot will meaningfully affect U.S. equity and credit markets. The link will be the U.S. dollar. The greenback will continue its unrelenting rally, which will trim U.S. multinationals' profits and weigh on the S&P 500. Bottom Line: EM risk assets are in a major bear market, and there is still a lot of downside. It is not too late to sell or underweight EM. This is despite EM's relative performance versus the S&P 500 is back to its early 2016 lows, as is the JP Morgan EM currency index (Chart I-4). News lows lie ahead. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018 available on page 17. Chart II-1More Upside In Long Indian/Short ##br##Chinese Bank Stocks Reiterating Long Indian / Short Chinese Banks Trade This week we revisit our long Indian / short Chinese banks trade that we initiated on January 17.1 The trade is up only 5.7% since inception (Chart II-1), and with more monetary policy easing occurring in China and the recent sharp rise in non-performing loans (NPL) in India, it is appropriate to reassess this recommendation. Having updated the stress tests on the largest public banks in both countries and performed a new stress test on five Indian private banks, we are reiterating our strategy of being long Indian / short Chinese banks. A Perspective On Credit Cycles In India And China Both India and China have gone through major credit binges over the past 10-15 years, albeit over different time periods (Chart II-2A and Chart II-2B). Chart II-2ACredit Boom Was Smaller In India...Than In China Chart II-2BCredit Boom Was Smaller In India...Than In China India's public banks have, in recent years, recognized bad loans and provisioned meaningfully for them. Non-performing loans (NPLs) for Indian public banks now stand at a whopping 15% of total outstanding loans, while provisioning levels have spiked to 7% of total loans (Chart II-3). Chart II-3NPLs And Their Provisions: India And China By comparison, Chinese public banks - the largest five banks, excluding policy banks, where the central government owns 70-80% of equity - are at the early stages of dealing with their troubled assets. Their NPLs and provisions stand at mere 1.8% and 3.3% of total outstanding loans, respectively (Chart II-3). Does such a wide disparity in NPL ratios between Chinese and Indian banks make sense? We do not think so. It is unlikely that Indian public banks are more poorly managed vis-a-vis Chinese public banks. All are run by government-appointed officials and are equally prone to politically driven and inefficient lending. Further, the magnitude of the Chinese credit boom since 2009 was considerably greater than India's during the 2003-2012 period. It is therefore highly unlikely that the resulting NPLs are substantially smaller in China than in India. In fact, several cases of Chinese banks hiding bad assets have recently been publicized.2 We strongly believe this phenomenon is widespread on the mainland, and that NPLs among Chinese public banks are being grossly underreported. It's All About Regulation The true vindication for this disparity lies in the drastically different stances that financial regulators in both countries have adopted to deal with the non-performing and stressed assets that their banks sit on. The Chinese authorities have been exhibiting greater forbearance with their commercial banks. For instance, in March, they lowered the provision coverage ratio for commercial banks. This is ameliorating Chinese commercial banks' short-term profitability and capitalization ratios. In brief, Chinese regulators have been very accommodative by allowing commercial banks to pursue "window dressing" of their financial statements and ratios. Indian regulators, by contrast, have been exerting relentless pressure on their banks to swiftly deal with their stressed assets at the cost of short-term profitability. For instance, the Reserve Bank of India (RBI) recently introduced an extremely stringent framework for the recognition and resolution of NPLs. Indian commercial banks now have to immediately recognize stressed assets and find a resolution within 180 days. Failure to resolve a stressed account forces banks to take the defaulter to court in order to initiate bankruptcy procedures. Bottom Line: India has taken painful measures to push its banks to clean up their balance sheets. By comparison, China has so far been kicking the can down the road with respect to its banking system. As a result, the banks' balance sheet cleansing cycle is much more advanced in India than in China. Public Banks Stress Tests Below we present our updated stress tests which we performed on India's top seven public banks and China's top five public commercial banks (excluding policy banks). We used the following assumptions in our analysis (Tables II-1 and II-2): Table II-1Stress Test Of Top 7 Indian Public Banks Table II-2Stress Test Of Top 5 Chinese Public Banks Indian non-performing risk-weighted assets (NPA) to rise to 16% (optimistic), 18% (baseline), and 19% (pessimistic), up from 15% currently. For China, we assume NPAs to rise to 10% (optimistic), 12% (baseline), and 13% (pessimistic), up from 1.6% currently. Provided the magnitude and duration of China's credit boom has considerably surpassed that of India, the assumption of this stress test that NPAs will rise to 12% in China but 18% in India implies that Chinese public banks allocated credit much better than their Indian peers. Hence, this exercise in no way favored Indian banks over Chinese ones. We used risk-weighted assets to calculate losses. Risk-weighting adjusts bank assets for their riskiness which in turn makes comparisons between the two banking systems more sensible. Finally, we assumed a 30% recovery ratio (RR) for both countries. The RR on Chinese banks' NPLs from 2001 to 2005 was 20%. This occurred amid much stronger nominal and real growth. Thus, a 30% RR rate today is not low. The outcome of the tests are as follows: Under the baseline scenario of 18% NPA in India and 12% NPA in China, losses post recovery and provisions amount to 1.8 trillion rupees in the former (1.3% of GDP) and RMB 3.3 trillion in the latter (3.9% of GDP) (Tables II-1 and II-2, column 6). These losses would impair 41% of equity capital in India and 44% in China (Tables II-1 and II-2, column 7). Adjusting the current price-to-book value (PBV) ratios for public banks in both countries to the equity impairment under the baseline scenario lifts their PBV ratios to 1.5 in India and 1.7 in China (Tables II-1 and II-2, column 8). Assuming a 1.3 fair PBV ratio3 for banks in both countries, Indian banks appear overvalued by 15% and Chinese banks by 29% (Tables II-1 and II-2, last column). In other words, after the recognition and provisioning of reasonable levels of NPA, Indian public banks appear less overvalued than their Chinese counterparts. These results make sense to us; Indian public banks have been provisioning aggressively for their troubled assets, and bad news is somewhat discounted in their share prices. Chart II-4Loan Write-Offs Have Been Much ##br##Greater In India Than In China Remarkably, Indian public banks have also been writing off more bad loans than their Chinese counterparts. Chart II-4 shows cumulated write-offs of these public banks in India and China since 2010. Bad asset write-offs have so far amounted to RMB 1.2 trillion in China and 3 trillion rupees in India. This is equivalent to 2% and 8% as a share of current risk-weighted assets, respectively. Another way to compare and analyze NPA cycles between two countries is to assess the progress that each country has made toward resolving the full amount of outstanding bad assets - i.e. a full NPA cycle. We define a full NPA cycle in the following way: Total NPA losses under our baseline scenario, plus cumulated past write-offs. In order to measure progress toward resolving the full NPA cycle, we take the ratio of the stock of provisions plus cumulated write-offs and divide that by the full NPA cycle losses (i.e. [provisions + write-offs] / full NPA cycle losses). In India, assuming that NPAs on its largest public banks reach 18% of risk weighted assets - then the full NPA cycle for India would amount to 9.4 trillion rupees, or 26% of current risk-weighted assets (i.e. 6.4 trillion rupees in NPA remaining plus 3 trillion in write-offs made). Meanwhile, India's public banks' progress amounts to 5.6 trillion rupees. This is equal to 60% of India's full NPA cycle. By contrast, Chinese public banks' full NPA cycle would amount to RMB 8 trillion (or 14% of risk-weighted assets) under our baseline scenario. Further, China's banks progress amounts to RMB 2.6 trillion. This is equivalent to only 33% of the full NPA cycle in China. Hence, Indian public banks are closer to their peak NPA cycle versus their Chinese counterparts. Note that this particular analysis assumes no recovery in bad loans in either country. Further, the above analysis does not attune for the fact that Chinese banks have more risky off-balance sheet assets than their Indian peers. Incorporating off-balance sheet assets and liabilities would make the stress tests much more favorable for Indian public banks relative to China. Stress Test For India's Private Banks Private banks are a part of our long Indian / short Chinese banks trade. Indian private banks are also not insulated from regulatory clean-up efforts. In recent years, these lenders significantly boosted their credit to the consumer and service sectors. Higher than normal defaults have not yet transpired but this is a scenario that cannot be ruled out given the frantic pace of lending (Chart II-5). We performed a stress test on five4 large Indian private banks as well (Table II-3): Chart II-5India: Consumer And Service ##br##Credit Is Booming Table II-3Stress Test Of 5 Large Indian Private Banks We assumed the following NPA scenarios: 6% (optimistic), 8% (baseline), and 9% (pessimistic), up from 5% currently. Similar to the above analysis, we used risk-weighted assets to calculate asset losses, though we used a recovery ratio of 50% for private banks instead of 30% for public banks. The basis is that private banks' lending has been concentrated on consumer loans and mortgages and the recovery ratio on these loans will likely be higher - especially taking into consideration the quality of collateral. Our results are as follows: Under the baseline scenario of an 8% NPA ratio, 7% of these private banks' equity would be impaired (Table II-3, column 7). The adjusted PBV would move to 3.9. This compares to a fair value of 3.3 for Indian private banks (Table II-3, column 8), which is the historical PBV mean of private banks in India. In other words, Indian private banks are overvalued by 18% - slightly more than their public peers (Table II-3, column 9). Bottom Line: Indian private banks are overvalued too but less so than Chinese public banks. Investment Conclusions We reiterate our long Indian / short Chinese banks equity trade, initiated on January 17. We track the performance of this recommendation using the BSE's Bankex index for India and the MSCI Investable bank index for China in common currency terms - currency unhedged. In addition, among Chinese-listed banks, we maintain our short small / long large banks (Chart II-6). Smaller banks are more leveraged as well as exposed to non-standard assets and regulatory tightening than large public banks. Finally, the Indian bourse's relative performance against the EM equity benchmark negatively correlates with oil prices - the oil price is shown inverted on this chart (Chart II-7). Chart II-6Stay Short Chinese Small / Long Large Banks Chart II-7India's Relative Equity Performance To EM And Oil Prices Given BCA's Emerging Markets Strategy service expects oil prices to drop meaningfully in the second half of this year,5 this should help Indian equities outperform their EM peers. Besides, Indian banks are more advanced than many of their EM peers in terms of bad assets recognition and provisioning and that should also help the Indian bourse outperform the EM overall equity index in common currency terms. We reiterate our overweight stance on Indian equities within a fully invested EM equity portfolio. In contrast, we are neutral on China's investable stock index's relative performance versus the EM stock index. The main reason why we have not underweighted the Chinese bourse - despite our negative view on China - is the exchange rate; the potential downside in the value of the RMB versus the U.S. dollar in the next six months is less than potential downside in many other EM exchange rates. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Long Indian / Short Chinese Banks" dated January 17, 2018 available at ems.bcaresearch.com. 2 Please see the following article: http://www.scmp.com/business/banking-finance/article/2139904/pressure-chinas-banks-report-bad-debt-good-news-foreign 3 It is the average PBV ratio for EM banks since 2011. 4 HDFC Bank, ICICI Bank, Axis Bank, Yes Bank, and IDFC Bank. 5 Please see Emerging Markets Strategy Special Report "China's Crude Oil Inventories: A Slippery Slope" dated June 21, 2018 available on page 17. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights A positive tailwind from exports has prevented China's old economy from decelerating over the past year as much as money & credit trends would have predicted. Barring a response from policymakers, a serious export shock, were it to materialize, would likely cause a material further slowdown in Chinese economic activity. Several observations point to the selloff in domestic Chinese stocks being advanced. Investors should avoid trying to catch a falling knife, but should be on the lookout for any signs of an improvement in the economic outlook as a catalyst for a turnaround in A-shares. We are opening the following "shadow" trade: long MSCI China A Onshore index / short MSCI China index, which we will consider implementing in response to a 5% rally in relative performance. Feature The month of June was an extraordinarily difficult time for Chinese stock prices. Chart 1 presents the magnitude of the peak-to-trough selloff in the MSCI China Index, the A-share market, and the S&P 500, all relative to their 1-year highs. The chart shows that the decline in Chinese stocks intensified significantly following President Trump's threat on June 18 that the U.S. would impose a 10% tariff on an additional $200 billion worth of imports from China. The selloff was also magnified by disappointing May economic data; Chart 2 highlights that the Citigroup economic surprise index fell sharply into negative territory in the middle of the month. Chart 1A Significant Selloff In Chinese Stocks Chart 2Recent Economic Data Has Disappointed The Market The selloff in Chinese equities occurred in response to risks that BCA's China Investment Strategy service has repeatedly outlined over the past several months. We have argued since last October that China's "old economy" was likely to slow and characterized the slowdown as benign and controlled in terms of its contribution to global growth. But we have warned over the past few months that the risks of an old economy slowdown were growing for China's equity market and recommended that investors place Chinese ex-tech stocks on downgrade watch over the course of Q2 in our March 28 Weekly Report.1 In last week's report we presented our thoughts on the potential for stimulus from Chinese policymakers,2 and opened a new trade that investors can use to profit from periods of Chinese equity market weakness. In this week's report we review the macro data series that we have been following closely over the past several months, and provide some insight on the outsized selloff in China's domestic market relative to investable stocks. Trade: China's Crutch Table 1 presents the dashboard of select macro series that we have showed in several reports over the past few months. It highlights the evolution of the key six components of our BCA Li Keqiang Leading Indicator, four housing market series that we have found to have strongly leading properties, as well as the NBS and Caixin manufacturing PMIs. Table 1Measures Of Money & Credit Are Telling A Consistently Bearish Story The table highlights that all six components of our leading indicator are in a downtrend and are deteriorating on a sequential basis, whereas our house price indicators remain strong. Housing sales volume, one of the most important leading indicators for the housing sector, ticked up in May but remains below its 200-day moving average. Finally, both manufacturing PMIs deteriorated in May, and are below their 12-month averages. The table highlights another important point, which is that the Li Keqiang index (LKI) itself has risen for two months in a row, which is in stark contrast to the trend in our leading indicator. What has driven this increase, and does it suggest that a renewed uptrend in Chinese economic activity is at hand? In our view, the answer to the first question suggests that the answer to the second is "no". Chart 3 shows that 60% of the May increase in Bloomberg's measure of the LKI occurred due to a significant increase in rail cargo volume, with the remaining 40% due to an increase in electricity production. Li Keqiang originally included rail cargo volume in his list of variables to watch because it is an indicator of trade flows, and we strongly suspect that recent trade activity in China has been influenced by actions on the part of exporters to front-load shipments prior to the imposition of tariffs by the U.S. This includes the possibility that import growth is currently stronger than it otherwise would be due to manufacturers stocking up on intermediate goods whose price could be affected by the previously announced tariffs on steel and aluminum (which were not China-specific). This suspicion is supported by Chart 4, which highlights that the rolling 2-year volatility of monthly changes in the LKI has increased significantly since the beginning of the year. Chart 3Both Electricity Production ##br##And Freight Turnover Picked Up In May Chart 4The Li Keqiang Index ##br##Has Been Relatively Volatile This Year We highlighted past reports that a positive export tailwind has been boosting Chinese economic activity beyond what measures of money and credit would have predicted, and Chart 5 highlights that the deviation of the LKI from what is suggested by our indicator has strongly correlated with export growth over the past year. This implies that China's old economy is standing on one leg (with export growth as the crutch), at a time when the risk of a serious export shock is high. This is concerning, given the strongly positive relationship between the export sector and real investment in China (Chart 6). Chart 5Export Strength Appears ##br##To Be Propping Up The LKI Chart 6China's Export Sector##br## Is Highly Investment-Intensive We acknowledge that the surge in electricity production is more of a challenge to our view, but here too we would resist the argument that it heralds a bullish turning point for the economy. Chart 7 shows a 3-month moving average of overall electricity consumption, alongside consumption excluding the residential sector and tertiary industry (i.e., services). The chart shows that while both series rebounded in May, electricity consumption in the old economy recently contracted for the first time in two years (and has been trending lower). As such, the recent tick higher in the old economy series likely just reflects a move away from extremely weak/contractionary growth rates, but still within the context of an ongoing downtrend. Chart 7Electricity Consumption Has Been Weaker##br## In Primary And Secondary Industries As a final point, Table 1 also highlighted that Chinese house prices are rising broadly, and that floor space sold ticked up again in May on a smoothed basis. Housing construction has also been strong over the past year, and it is likely that this has somewhat boosted Chinese import demand above what it otherwise would have been. However, we have highlighted in several reports the leading relationship between floor space sold and housing starts, which suggests that the recent strength in housing construction is unlikely to continue over the coming year unless sales pick up materially. Until evidence of a durable uptrend in sales presents itself, we are sticking with our view that the cyclical trajectory of China's economy will be determined by the trends in money & credit and the external sector. Bottom Line: A positive tailwind from exports has prevented China's old economy from decelerating as much as money & credit trends would suggest. Barring a response from policymakers, a serious export shock, were it to materialize, would likely cause a material further slowdown in Chinese economic activity. A-Shares: Is The Selloff Overdone? Chart 1 highlighted that Chinese domestic stocks have fallen 25% from their late-January peak, compared with approximately 15% for the MSCI China index. It is too soon to conclude that A-shares have fully priced a slowdown in China's economy given the considerable uncertainty surrounding the outlook for external demand, but several observations point to the selloff being advanced: A 25% peak-to-trough decline in A-shares represents roughly half of the total decline that occurred in 2015 and early-2016, when the global economy experienced a coordinated economic slowdown, Chinese monetary policy was considerably tighter than it is today, and valuation ratios had more than doubled in the year prior to the peak. Chart 8 highlights how much lower trailing multiples were for A-shares at the start of the year compared with their peak in 2015, implying that the deterioration in investment sentiment has already been severe. Chart 9 supports the idea of an outsized collapse in sentiment, by showing the rolling 3-month correlation between daily A-share returns and percent changes in CNY/USD. In our view, the recent spike in the correlation reflects fears among investors (perhaps among domestic retail investors) that the decline in CNY/USD is a harbinger of the global financial market panic that followed the PBOC's decision to devalue the RMB in August 2015. Chart 8Versus 2015, A-Shares Are Selling Off##br## From A Cheaper Starting Point Chart 9The Sharp Decline In CNY/USD Is Panicking ##br##Some Buyers Of Domestic Stocks The panic that occurred following China's 2015 devaluation occurred in the context of a much weaker global economy: Chart 10 highlights that while global import demand and manufacturing PMIs have deteriorated somewhat recently, this decline is from a much stronger level. In short, it remains far from clear that the tariff-related decline in global business sentiment represents a shock of the same magnitude as what occurred in late-2015/early-2016, which suggests that panic selling in the A-share market may be overdone. Chart 11 shows that the selloff in the domestic market has largely been indiscriminate, not isolated to export-sensitive sectors (which presumably would fare worse if the shock to China's economy is externally-driven). This has pushed our technical indicator for A-shares down to deeply oversold territory (panel 2). Two crucial market indicators that we recommended investors watch closely are not yet providing warning of a crisis. Chart 12 shows that China's relative sovereign CDS spread, while rising, is well below levels that prevailed in the lead-up to China's 2015 currency devaluation, and panel 2 shows that there has been no breakdown in large bank alpha versus global banks. Small banks in China have sold off aggressively over the past few weeks, but this also occurred in late-2016 and in the first half of 2017 without consequence. Chart 10The Global Economy Is Stronger Now##br## Than It Was In 2015 Chart 11An Indiscriminate Selloff Has Rendered##br## A-Shares Deeply Oversold Chart 12The Outlook Has Darkened, ##br##But A Crisis Appears Unlikely We have highlighted in previous research that while China's domestic stock market is relatively volatile, it is not a "casino" market that is untethered from fundamentals.3 This suggests that investors should be on the lookout for any signs of an improvement in the economic outlook as a catalyst for a turnaround in A-shares. To be clear, we are not recommending that investors try to catch a falling knife: the export outlook remains highly uncertain, and a more pronounced slowdown in the global economy may unfold if President Trump follows through with his threat to expand the imposition of tariffs on other G7 countries. However, considering the observations above, we are opening the following shadow trade: long MSCI China A Onshore index / short MSCI China index, which we will consider implementing in response to a 5% rally in relative performance. Bottom Line: Several observations point to the selloff in domestic Chinese stocks being advanced. Investors should avoid trying to catch a falling knife, but should be on the lookout for any signs of an improvement in the economic outlook as a catalyst for a turnaround in A-shares. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "Now What?", dated June 27, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Weekly Reports " A-Shares: Stay Neutral For Now", dated March 14, 2018 and "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights The not-so-veiled threat to Gulf Arab oil shipments through the critically important Strait of Hormuz by Iran's President Rouhani earlier this week was a response to the ramping up of maximum pressure by the Trump administration, which is demanding importers of Iranian crude reduce volumes to zero. This was a predictable first step toward what could become a chaotic oil pricing environment (Map 1).1 Map 1Iran Threatens Gulf Shipments Again Oil prices surged on reports of the Iranian threat Tuesday morning, sold off, and recovered later in the day. Pledges from the Kingdom of Saudi Arabia (KSA) to lift production to as much as 11mm b/d this month - a record high - were all but ignored by the market. The threat to safe passage through the Strait of Hormuz - where ~ 20% of global supply transits daily - raises the spectre of military confrontation between the U.S. and Iran, and their respective allies. The growing risks from tighter supply - markets could lose as much as 2mm b/d of Iranian and Venezuelan exports as things stand now - now must be augmented by the likelihood of a Gulf conflict. Energy: Overweight. We remain long call spreads along the Brent forward curve and the S&P GSCI, as we expect volatility, prices and backwardation to move higher. These recommendations are up 34.6% since they were recommended five months ago. Base Metals: Neutral. Treatment and refining charges are higher following smelter closings. Metal Bulletin's TC/RC index was ~ $80/MT at end-June, up ~ $3 vs end-May. Precious Metals: Neutral. Gold traded below $1,240/oz over the past week, but recovered above $1,250/oz as geopolitical tensions rise. Ags/Softs: Underweight. The USDA expects U.S. farm exports in 2018 will come in at $142.5 billion, the second-highest level on record, according to agriculture.com. Feature Oil pricing could become chaotic, as U.S. policy measures aimed at Iran are countered by responses that are not altogether unexpected. In addition to limited spare capacity, and increased unplanned production outages, markets now must discount the likelihood of renewed armed conflict (short of all-out war) in the Gulf between the U.S. and Iran, and their respective allies. To appreciate the significance of President Rouhani's not-so-veiled threat to deny safe passage through the Strait of Hormuz to oil tankers carrying Gulf Arab states' exports, one need only consider that some 20% of the world's oil supply flows through this narrow passage on any given day.2 The response of the president of Iran to U.S. policy - nominally directed at denying Iran the capacity to develop nuclear weapons, but arguably meant to force the existing regime from power - is a predictable next step in the brinkmanship now being played out between these long-standing rivals.3 Following the lifting of nuclear-related sanctions in 2015, Iran's production rose ~ 1mm b/d from 2.8mm b/d to 3.8mm b/d. We expect 500k b/d of Iran's exports will be lost to the market by the end of 1H19, as a result of sanctions being re-imposed November 4. Other estimates run as high as 1mm b/d being lost if the U.S. succeeds in getting importers to drastically reduce purchases. The ire of the U.S. also is directed at Venezuela, where the loss of that country's ~ 1mm b/d of exports would become all but certain, if, as U.S. Secretary of State Mike Pompeo pressed for last month, U.S. trade sanctions against the failing state are imposed.4 We estimate Venezuela's production is down close to 1mm b/d since end-2016, and will average ~ 1.07mm b/d in 2H18 (Table 1). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) BCA's Ensemble Forecast Includes Extreme Events In our updated balances modeling, our base case front-loaded the OPEC 2.0 production increase announced by the coalition at its end-June meeting in Vienna. Core OPEC 2.0's 1.1mm b/d increase (1H19 vs 1H18) is offset by losses in the rest of OPEC 2.0 amounting to ~ 530k b/d in 2H18, and ~ 640k b/d in 1H19. This leaves OPEC 2.0's net output up ~ 275k b/d in 2H18, and down ~ 430k b/d in 1H19 vs. 1H18 levels. We assume Iran's exports fall 200k b/d by the end of this year, and another 300k b/d by the end of 1H19, resulting in a total loss of 500k b/d by 2H19. Global supply rises ~ 2mm b/d this year and next, averaging 99.9mm b/d and 101.7mm b/d, respectively, in our estimates. The bulk of this growth is provided by U.S. shale-oil output, which we estimate will rise by 1.28mm b/d this year, and 1.33mm b/d next year. On the demand side, we expect global growth to remain strong, powered as always by stout EM consumption. That said, rising trade frictions, signs the synchronized global growth that powered EM oil demand could move out of synch, and divergent monetary policies at systematically important central banks could take some of the wind out of our consumption-forecast sails (Chart of the Week). That said, if a supply-side event results in a sharp upward price move, we would expect demand growth to adjust lower in fairly short order. This is because many EM states removed or reduced oil-price subsidies in the wake of the prices collapse following OPEC's declaration of a market-share war in late 2014, which leaves consumers in these state more directly exposed to higher prices than in previous cycles. Our base case is augmented with three scenarios. In our simulations, the Venezuela collapse is met by OPEC 2.0's core producers lifting production another 200k b/d, which takes its total output hike to 1.2mm b/d in 2019. OPEC 2.0 does not respond to the lower-than-expected U.S. shale growth contingency we're modeling, which is brought on by pipeline bottlenecks in the Permian Basin. Our scenarios are: A reduction in our forecasted U.S. shale production increase arising from pipeline bottlenecks (Scenario 2, Chart 2); Venezuela production collapses to 250k b/d from current levels of ~ 1.07mm b/d, which allows it to support domestic refined product demand and nothing more (Scenario 3, Chart 2); Both of these occurring simultaneously in the Oct/18 - Sep/19 interval (Scenario 4, Chart 2). Chart of the WeekTight Supply, Strong Demand##BR##Remain Supportive of Prices Chart 2BCA's Scenarios Include##BR##Production Losses In Venezuela, Iran The Stark Reality Of Low Spare Capacity Chart 3Global Spare Capacity Stretched Thin Our scenario analyses - particularly Scenarios 3 and 4 - illustrate the stark reality confronting oil markets: Spare capacity will not be sufficient to keep prices below $80/bbl in the event Venezuela collapses, or if Iranian export losses are greater than the 500k b/d we currently are modeling. The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year. This will fall to just over 1mm b/d next year (Chart 3).5 As things stand now, idle and spare capacity of KSA, Russia and core OPEC 2.0 states that actually can increase production would be taxed to the extreme to cover losses of Iranian exports, if some of the higher levels projected by analysts - i.e., up to 1mm b/d - are realized (Chart 4). KSA's maximum sustainable capacity is believed to be ~ 12mm b/d; officials have indicated production will be raised to close to 11mm b/d in July, then likely held there. This record level of production will test KSA's production infrastructure, and would leave the Kingdom with 1mm b/d of spare capacity. Russia is believed to have ~ 400k b/d of spare capacity; it likely will restore ~ 200k b/d of production to the market over the near future, leaving 200k b/d as spare capacity. If just the two high-loss events described above are realized - i.e., Iran export losses come in at 1mm b/d instead of the 500k b/d we expect, and Venezuela's 1mm b/d of exports are lost because the state collapses - global inventory draws will accelerate until enough demand is destroyed via higher prices to clear the market at whatever level of supply can be maintained (Chart 5). Approaching that point, we would expect OECD strategic petroleum reserves (SPRs) to be released.6 Chart 4OPEC 2.0's Core Producers Would Be##BR##Taxed to Replace Lost Exports Chart 5A Supply Shock Would Draw##BR##Crude Inventories Sharply Chart 6Falling Net Imports Implies##BR##Current SPR Could Be Too Large It is difficult to forecast the price at which markets would clear if we get to the state described above. However, it is worthwhile noting that OPEC spare capacity in 2008 stood at 1.4mm b/d, or 2.4% of global consumption. The 1.8mm b/d of OPEC spare capacity EIA estimates is now available to the market represents 1.8% of daily consumption globally. By next year, the EIA's estimated 1mm b/d of OPEC spare capacity will represent a little over 1% of global daily consumption. It was in this economic setting that WTI and Brent breached $150/bbl in mid-2008, just before the Global Financial Crisis tanked the world economy.7 Bottom Line: Into the mix of tightening global supply and limited spare capacity, oil markets now confront higher odds of armed conflict in the Gulf once again. Oil pricing will remain volatile, and could become chaotic as brinkmanship raises the level of uncertainty in markets. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Rouhani says U.S. pressure to stop Iranian oil may affect regional exports," published by uk.reuters.com July 3, 2018. We explore the Trump administration's maximum pressure in a Commodity & Energy Strategy Special Report published June 7, 2018, entitled "Iraq is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. We are using the term chaotic in the sense of "... sensitive dependence on initial conditions or 'the butterfly effect'" described in "Weak Emergence" by Mark A. Bedau (1997), which appears in Philosophical Perspectives: Mind, Causation, And World, Vol. 11, J. Tomberlin, ed., Blackwell, Malden MA. 2 The U.S. EIA calls the Strait of Hormuz "the world's most important oil chokepoint" in its "World Oil Transit Chokepoints," published by the U.S. EIA July 25, 2017. By the EIA's estimates, 80% of the crude oil transiting the strait is bound for Asian markets, with China, Japan, India, South Korea and Singapore being the largest markets. 3 Please see "Mattis's Last Stand Is Iran," published by Foreign Policy June 28, 2018, on foreignpolicy.com. The essay describes the state of play within the Trump administration vis-à-vis Iran. President Trump's third national security advisor, John Bolton, has stated the goal of the administration's policy is not regime change, but denial of the capacity to develop nuclear weapons. However, Bolton repeatedly called for regime change in Iran prior to being tapped as the national security advisor, and has advocated going to war with Iran to prevent it from developing a nuclear weapons capability, in a New York Times op-ed published March 26, 2015, entitled "To Stop Iran's Bomb, Bomb Iran." 4 Please see "Pompeo calls on OAS to oust Venezuela," published by CNN Politics June 4, 2018. 5 OPEC 2.0 is the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. On June 22, 2018, the coalition agreed to raise production 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman, and Qatar. The other core members of OPEC 2.0 are believed to have close to 300k b/d of spare capacity. Other estimates put the spare capacity as high as 3.4mm b/d. The ex-KSA estimates are pieced together by using the International Energy Agency's estimates for core OPEC and Citicorp's estimates for Russia. Please see "Russia's OPEC Deal Dilemma Worsens as Idled Crude Capacity Grows," published by bloomberg.com May 16, 2018. 6 In just-completed research, our colleague Matt Conlan writes the U.S. SPR, at ~ 660mm barrels, can cover more than 100 days of net U.S. crude imports (Chart 6). This coverage will rise to 140 days of net crude imports by the end of 2019. Please see "American Energy Independence And SPR Ramifications," published by BCA Research's Energy Sector Strategy July 4, 2018. 7 Please see the discussion of demand beginning on p. 228 of Hamilton, James D. (2009), "Causes And Consequences Of The Oil Shock Of 2007 - 08," published by the Brookings Institute. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
The GAA DM Equity Country Allocation model is updated as of June 29, 2018. The model has reduced weights in Italy, the U.S., the Netherlands and France to beef up weights in Spain, Australia, Canada, Switzerland and Germany. After these adjustments, Australia is now upgraded to overweight from neutral and Italy is downgraded to neutral from overweight, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 34 bps in June, largely driven by the Level 2 model which outperformed its benchmark by 87 bps. The Level 1 model performed in line with its benchmark in June. Since going live, Level 2 and Level 1 have outperformed their respective benchmarks by 171 bps and 5bps, resulting in overall model outperformance of 47 bps. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Mode (Chart 4) is updated as of June 30, 2018. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Following our Quarterly Update that was released yesterday, the model corroborates the defensive stance with an aggregate underweight of 5.8% in cyclical sectors. The switch to a defensive mode was driven by a weaker growth outlook. The upgraded sectors were consumer staples and health care. Additionally, the model has turned more negative on the two largest sectors - financials and technology. Resources-based sectors remain unattractive on the back of weaker growth outlook. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com.
Highlights Portfolio Strategy Five key drivers - late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar, firming operating metrics and investor and analyst capitulation- all suggest that it no longer pays to be bearish the S&P pharma and S&P biotech indexes. Lift to neutral. This also raises the S&P health care sector exposure to neutral, as these two heavyweight health care sub-indexes command a 49% weighting in the sector. Recent Changes Act on the upgrade alert and lift the S&P pharma and S&P biotech indexes to neutral today for a profit of 14.5% and 13.9%, respectively since inception (we are also removing the S&P pharma index from our high-conviction underweight list). Lock in gains in the S&P health care sector of 5.3% since inception and upgrade exposure to a benchmark allocation today. Table 1 Feature Stocks continued to wrestle with escalating geopolitical threats last week, but remained resilient. While the global trade soft patch could morph into a steep contraction if protectionism proliferates, our working assumption is that the executive branch's bark will be worse than its bite. The SPX is in the midst of a recalibration to a cooling in EPS momentum in calendar 2019 as we have been highlighting in recent research, and were the U.S. dollar to continue its ascent in the back half of the year, the sell-side's calendar 2019 almost 10% growth estimate will sink like a stone. This remains our number one downside risk that we are closely monitoring, though it should be reasonably contained by mounting signs of a healthier corporate sector and an easing in financial stress (Chart 1). This week we are updating our corporate pricing power proxy that has reaccelerated. Importantly, the breadth of the surge has gone parabolic, which bodes well for its staying power (second panel, Chart 2). This firming corporate inflation backdrop suggests that businesses have been successful in passing on skyrocketing input costs down the supply chain, and thus implies that final demand remains robust. Chart 1Reset Chart 2Pricing Power Flexing Its Muscles On the flip side, rising labor costs have stabilized. Compensation growth remains contained, and according to our diffusion index, just over half of the 44 industries we track have to contend with rising wages. In addition, the Atlanta Fed Wage Growth Tracker switcher/stayer index provides a reliable leading indication for the trend in overall labor expenses and it recently ticked down. In other words, pricing power is rising on a broad basis while wage inflation is moving laterally. Consequently, there are decent odds that upbeat forward operating margin expectations are attainable, further prolonging the near two year margin expansion phase (bottom panel, Chart 2). Delving deeper into our corporate pricing power update is revealing. Table 2 summarizes the results. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power 80% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. This is on a par with our late-April report. Chart 3Cyclicals Come Out On Top Outright deflating sectors increased by two to 12 since our last update. Encouragingly, only 7 industries are still experiencing a downtrend in selling price inflation, in line with our most recent report. Impressively, deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 3). Despite the ongoing global export jitters, escalating trade war fears and year-to-date gains in the greenback, the commodity complex's ability to increase prices is extraordinary. In contrast, airlines, soft drinks, telecom, autos and tech populate the bottom ranks of Table 2. In sum, accelerating business sector selling prices will continue to underpin top line growth in the back half of the year. Recent evidence of a slight letdown in wage inflation is welcome news for corporate sector profit margins and earnings. In fact, it will be critical for labor costs to remain tame or at least continue to trail pricing power gains, otherwise profit margins will be at risk of a squeeze. This week we are locking in gains and lifting a defensive sector to a benchmark allocation by acting on our recent upgrade alert on two of its key subcomponents. Upgrade Pharma & Biotech To Neutral... We are pulling the trigger on our recent upgrade alerts and are upgrading the S&P pharma and biotech groups to neutral from underweight, locking in relative gains of 14.5% and 13.9%, respectively since inception, and we are also removing the S&P pharma index from our high-conviction underweight list. As a reminder, we set the heavyweight S&P pharmaceuticals and S&P biotech indexes on upgrade alert, and thus the overall S&P health care sector, on May 22nd following the insight from our Special Report titled 'Portfolio Positioning For A Late Cycle Surge'. In more detail, health care stocks excel in both phases we examined - ISM peak-to-SPX peak and SPX peak-to-recession commencement (Tables 3, 4 & 5). This is largely due to the high-beta biotech sub-sector outperforming early with the more defensive pharma sub-group sustaining the outperformance following the SPX peak. Table 3Health Care Outperforms In The Late Cycle Table 4High Beta Stocks Outperform Early... Table 5...Defensive Stocks Beat Late Moreover, recent pricing power developments point to a softer than previously expected blow to drug pricing practices revealed in the President's recent speech. This is music to the ears of Big Pharma executives and can serve as a catalyst to unlock latent buying power in this traditionally considered defensive sector. While no bill has been drafted yet and we are awaiting more details, at the margin, this is a net positive for pharma and biotech top line growth at least from a cyclical perspective (Chart 4). The thesis we postulated last July was that the easy pricing power gains were behind the pharma and biotech industries and likely a secular decline in the ability of these groups to raise prices at a faster pace than overall inflation was in order (Chart 5). While this thesis remains intact from a structural perspective, in the next 9-12 months there is scope for some relief. Chart 4Overdone Cyclically... Chart 5...But Structural Issues Remain Beyond these two drivers, the trade-weighted U.S. dollar's year-to-date gains also signal that it no longer pays to be bearish this safe haven group. Chart 6 shows that relative pharma profits are positively correlated with the greenback as Big Pharma's domestically-derived earnings dwarf foreign sourced EPS. Keep in mind that the industry still dictates terms to the U.S. government, a key end-market. The opposite is true with regard to other governments around the world, especially in the key European markets, where the industry is a price taker. This partially explains the positive correlation with the currency. On the operating front, there are also signs of a bottom. Not only are pharmaceutical factories humming, but also our pharma productivity proxy (industrial production / employment) is gaining steam, underscoring that profits can surprise to the upside (second panel, Chart 7). Chart 6Appreciating Dollar Helps Chart 7Bullish Operating Metrics With regard to demand, pharma retail sales are expanding nicely and overall industry shipments are also rising at a healthy clip, at a time when inventories are whittled down (third and bottom panels, Chart 7). This represents a positive pharma pricing power backdrop in the coming quarters. In terms of investor and analyst sentiment, a near full capitulation has taken root. Relative share price momentum is steeply contracting close to 15%/annum, a rate that has previously coincided with cyclical troughs (second panel, Chart 4). Sell-side pessimism reigns supreme as pharma profits are slated to trail the broad market by a wide margin both for the next year and on a 3-5 year time frame. In fact, the latter just sunk to all-time lows (Chart 8). Analyst gloom is pervasive as relative top line growth expectations also call for a contraction in the coming twelve months. Valuations are as good as they get with the relative forward price-to-earnings ratio trading way below par and the historical mean (bottom panel, Chart 8). Finally, the S&P pharma and S&P biotech indexes are more alike than different, as biotech stocks have long had blockbuster billion dollar selling drugs and therefore have substantial earnings (unlike 78% of the NASDAQ biotech index that do not even have forward earnings) and are really disguised pharma outfits hiding under the biotech label. The biotech index also offers a near 2% dividend yield, on par with the SPX, but still trailing the S&P pharma index roughly by 70bps (Chart 9). As such, there is an inverse correlation of both indexes with interest rates. Not only are higher interest rates punitive to growth stocks, but also fierce competitors to fixed income proxies. The implication is that if the broad equity market reset continues for a while longer and the 10-year Treasury yield continues to fall, relative share prices will likely come out of their recent funk (Chart 10). Chart 8Full Capitulation Chart 9Close Siblings... Chart 10...That Despise Higher Rates Adding it up, five key drivers - late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar, firming operating metrics and investor and analyst capitulation- all suggest that it no longer pays to be bearish the S&P pharma and S&P biotech indexes. Bottom Line: Lock in profits of 14.5% and 13.9% in the S&P pharma and S&P biotech indexes respectively since inception and lift to a benchmark allocation. Also remove the S&P pharma group from the high-conviction underweight list. The ticker symbols for the stocks in the S&P biotech and S&P pharma indexes are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY and BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, NKTR, respectively. ...Which Lifts Health Care To A Benchmark Allocation The S&P pharma and biotech indexes command roughly a 50% weighting in the S&P health care sector. As a result, their profit fortunes are closely tied and relative share prices tend to move in lockstep (Chart 11). Today's upgrade to a benchmark allocation in both of these sub-groups also lifts the health care sector to a neutral portfolio weighting. Relative share prices have been in correction mode for the better part of the past year and may now have found support near their upward sloping long-term trend line (top panel, Chart 12). Importantly, our S&P health care EPS growth model is making an effort to trough (bottom panel, Chart 12), and if the Trump Administration does not clamp down on pharma pricing power as initially feared and recently hinted at, then overall health care sector profits will likely overwhelm. Keep in mind that the bar for upward surprises is extremely low as analysts have thrown in the towel on the sector. Similar to the S&P pharma index, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive (third panel, Chart 13). Chart 11Joined At The Hip Chart 12EPS Model Says Trough Is Near Chart 13Underappreciated And Unloved We would not hesitate to lift exposure further to overweight were the Trump Administration to put forth a bill with minimal damage inflicted upon drug prices, were the green back to keep on appreciating and were a steep 'risk off' phase to grip the broad equity market. Bottom Line: We are acting on our May 22nd upgrade alert and lifting the S&P health care sector to neutral, crystalizing relative profits of 5.3% since the July 31st, 2017 inception. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Global Growth: The divergence between strong U.S. and weak non-U.S. growth will increase in the coming months and culminate in wider credit spreads. The Fed's reaction to wider credit spreads will determine how Treasuries perform. High-Yield: High-Yield bonds will deliver excess returns in line with the historical average as long as default losses occur at close to historically low levels. This points to an unfavorable risk/reward balance in junk. Credit Curve: Investors should maintain a below-benchmark duration bias in their overall bond portfolios, but should lengthen maturities within their corporate bond allocations as much as possible while also maintaining a balanced or slightly up-in-quality allocation across credit tiers. Feature Chart 1Growth Divergence Redux Two factors influenced our recent decision to reduce the recommended exposure to credit risk in our U.S. bond portfolio.1 First, our indicators show that we are in the late stages of the credit cycle, meaning that small positive excess returns are the best case scenario for corporate bonds. Second, a large divergence in growth has emerged between the United States and the rest of the world, much like in 2014/15 (Chart 1). As was the case in 2014/15, such a divergence will put upward pressure on the U.S. dollar and eventually lead to a period of turmoil in U.S. risk assets - i.e. wider credit spreads and lower equity prices. Whether this turmoil translates into a playable rally in U.S. Treasuries will depend on how the Fed responds. First Spreads, Then (Maybe) Yields Chart 2The 2015 Template Using the 2015 episode as a template, we see that credit spreads widened sharply beginning in mid-2015. But despite the risk-off sentiment in credit markets, Treasury yields stayed roughly flat (Chart 2). This should not be too surprising. Since the weakness in global growth was concentrated outside the United States and a significant proportion of corporate profits are driven by foreign demand, a non-U.S. growth shock will have a more immediate impact on the U.S. corporate sector than it will on overall U.S. aggregate demand. Most of the latter is driven by the U.S. consumer who actually stands to benefit from a stronger dollar. Treasury yields and the Federal Reserve take their cues from overall GDP growth, not corporate profits. In fact, we contend that the 2015 widening in credit spreads was exacerbated by the fact that the Fed maintained its focus on overall U.S. growth and continued to signal a relatively steady pace of rate hikes. Spreads widened even further as the notion that the Fed would not bail out corporate bond investors took hold. Eventually, credit spreads widened enough by early 2016 that the Fed was forced to conclude that tighter financial conditions weighed significantly on the growth outlook. It then signaled a slower pace for rate hikes (Chart 2, panel 2), and only then did Treasury yields fall (Chart 2, bottom panel). The Fed's retreat also marked the peak in corporate bond spreads. We envision a similar pattern playing out this time around. Weaker foreign growth will first impact corporate credit, and eventually financial conditions may tighten so much that the Fed is forced to back away from its "gradual" 25 bps per quarter rate hike pace. However, with inflation much closer to target than in 2015, the Fed will be more reluctant to respond. A Less Responsive Fed Our Fed Monitor shows why this is the case (Chart 3). The Monitor is composed of indicators related to economic growth, inflation and financial conditions. It is designed so that a reading above zero signals that the Fed should be hiking rates and a reading below zero signals that it should be cutting. If we consider the three components of the Fed Monitor individually, it is clear that we have recently seen a fairly substantial tightening of financial conditions (Chart 3, bottom panel), but this has barely made a dent in the overall Monitor. The reason is that the components related to economic growth and inflation are on solid footing, and they are offsetting the message from the financial conditions component. In other words, with the output gap much narrower and inflation much closer to target than in 2015, the Fed will need to see more market pain before putting rate hikes on hold. Even if financial conditions tighten so much that a pause in rate hikes is justified, it is highly unlikely that such a delay will last for more than a quarter or two. The end result could be that Treasury yields see only limited downside, even as credit spreads widen. Chart 3Fed Can Tolerate More Market Pain China To The Rescue? Another possibility is that we never even reach the point of significant market turmoil and much tighter financial conditions. Non-U.S. growth might recover in the months ahead, ushering in a renewed synchronized global recovery that prevents corporate bond spreads from widening. The most likely driver of such a revival would be significant policy easing from China that puts a floor under global growth before U.S. financial markets feel much pain. Chart 4 shows that China did ease monetary conditions dramatically in 2015 as U.S. credit spreads widened. That easing was achieved through a combination of lower real interest rates, stronger credit growth and a weaker exchange rate. The evidence also suggests that Chinese authorities have started to devalue the renminbi in recent weeks, but so far the weakness is limited and overall monetary conditions have not eased at all. If China is attempting to spur a rebound in global growth, a lot more easing will be required in the coming months and it is not at all obvious that policymakers are willing to go down that path.2 If China does engage in a significant currency devaluation, it will obviously increase the foreign demand for U.S. Treasuries. However, in general, we think that foreign demand will exert less downward pressure on U.S. Treasury yields than it did during the 2014/15 period. This has less to do with Chinese official demand than with the simple fact that U.S. government bonds are now a much less attractive investment vehicle for conventional non-U.S. fixed income investors. After we account for the cost of currency hedging on a 3-month horizon, a typical European investor who wants to gain exposure to the U.S. bond market without taking currency risk is faced with a lower realized yield from a 10-year U.S. Treasury note than from a 10-year German bund (Chart 5). This was not the case at all in 2014/15 when hedged U.S. yields offered a huge advantage over bunds. Japanese investors are faced with a similar quandary. The 10-year U.S. Treasury yield hedged into yen still looks attractive relative to a 10-year JGB, but the yield advantage is nowhere near the levels seen in 2014/15 (Chart 5, panel 3). Chart 4Policy Easing In China? Chart 5Less Foreign Demand For USTs U.S. bonds are much less enticing for foreign investors on a currency hedged basis because the Fed has raised rates seven times since 2015, while European and Japanese interest rates are still at the floor. This large rate divergence means that investors must pay a lot more to swap foreign currency for dollars. Essentially, foreign investors are faced with an unpalatable choice. They can gain access to elevated un-hedged U.S. Treasury yields only if they are willing to take on the substantial currency risk. If not, then they are better off keeping their money at home. The end result should be less foreign demand for U.S. bonds. Bottom Line: The divergence between strong U.S. and weak non-U.S. growth will increase in the coming months and culminate in wider credit spreads. The Fed's reaction to wider credit spreads will determine how Treasuries perform. High-Yield: The Good News Is Priced In Our measure of the excess spread available in the High-Yield index after accounting for default losses has recently widened to 260 bps, slightly above its long-run historical average (Chart 6). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 260 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. While the default-adjusted spread suggests that junk bonds are fairly valued relative to history, it's important to also consider the balance of risks surrounding our default loss assumptions. To calculate the default-adjusted spread we start with the Moody's baseline default rate projection for the next 12 months. It is currently 1.99% (Chart 6, panel 2). Then, we project the recovery rate based on its historical relationship with the default rate. This gives us a forecasted recovery rate of 48% (Chart 6, panel 3). Combined, the forecasted default rate and recovery rate give us expected high-yield default losses of 1.03% for the next 12 months (Chart 6, bottom panel). The only historical period to show significantly lower default losses was 2007, a time when non-financial corporate balance sheets were in much better shape than they are today. This is not to suggest that our default forecasts are unrealistically low. The economic and corporate landscape is consistent with a relatively low default rate. But that outlook can change quickly, and the historical record shows that the risk that we are underestimating future default losses is far greater than the risk that we are overestimating them. Gross non-financial corporate leverage is highly correlated with the default rate over time (Chart 7, top panel). It has flattened off during the past few quarters, but is likely to rise modestly in the second half of the year. As we have discussed in prior reports, corporate revenue growth is elevated but close to peaking, and labor costs are just now starting to ramp up. Even a small moderation in profit growth will be enough for leverage to start moving higher.3 Chart 6High-Yield Expected Returns Chart 7Macro Drivers Of The Default Rate Interest coverage is also still consistent with a low default rate (Chart 7, panel 2). But the combination of peaking profit growth and rising interest rates clearly biases it lower going forward. Other indicators that correlate strongly with corporate defaults, such as layoff announcements and C&I lending standards, also remain supportive for the time being (Chart 7, bottom 2 panels). Bottom Line: High-Yield bonds will deliver excess returns in line with the historical average as long as default losses occur at close to historically low levels. This points to an unfavorable risk/reward balance in junk. Considering The Credit Curve Two weeks ago we examined the risk/reward proposition of moving down in quality within an allocation to investment grade corporate bonds.4 We concluded that a move down the rating scale has a greater positive impact on risk-adjusted portfolio performance when excess return volatility and index duration-times-spread (DTS) are low. With index DTS currently elevated, now is not the best time to move down-in-quality. This week we perform a similar analysis using the maturity buckets of the investment grade corporate bond index. Charts 8-11 show four excess return Bond Maps. The horizontal axes of these maps show the number of months of average spread widening required for each maturity bucket to underperform duration-matched Treasuries by the return threshold indicated in the chart's title. Buckets plotting further to the left require more months of spread widening, and are thus less risky. Chart 8Investment Grade Corporate Excess Return ##br##Bond Map: +/- 50 BPs Threshold Chart 9Investment Grade Corporate Excess Return ##br##Bond Map: +/- 100 BPs Threshold Chart 10Investment Grade Corporate Excess Return##br## Bond Map: +/- 200 BPs Threshold Chart 11Investment Grade Corporate Excess Return ##br##Bond Map: +/- 300 BPs Threshold The vertical axes of the maps show the number of months of average spread tightening required for each maturity bucket to outperform duration-matched Treasuries by the return threshold indicated in the chart's title. Buckets plotting closer to the top require fewer months of spread tightening, and thus provide greater potential reward. Much like what we found with the different credit tiers, the maturity buckets tend to cluster together when we set a low return threshold. The risk/reward trade-off becomes more linear as the return threshold increases. We can therefore conclude that shorter maturities offer similar return potential to longer maturities when return volatility is low, along with less risk. The risk-adjusted advantage in low maturity buckets disappears as we transition into higher volatility environments. At the moment, average index DTS is elevated compared to other non-recession periods. There is no obvious advantage to maintaining a bias toward the short maturity buckets. Fundamental Drivers In addition to the risk/reward trade-offs shown in our Bond Maps, we also identify two fundamental drivers of relative performance across the corporate maturity spectrum. First, we notice that while long maturities offer a substantial spread advantage over short maturities, the advantage is entirely driven by differences in duration (Chart 12). Logically, if the duration difference between the short and long ends of the curve were to decline, then the option-adjusted spread term structure would flatten. In fact, this is exactly what should transpire as Treasury yields rise (Chart 12, bottom panel). The second factor that can influence the credit spread curve is the outlook for default losses. Short-maturity spreads widen more than long-maturity spreads when default losses increase. This is because only the highest quality firms are able to issue long maturity debt. Chart 13 shows that, after controlling for differences in duration, the credit spread curve is inversely correlated with default losses. Higher default losses coincide with a flatter spread curve, and vice-versa. A model of the credit spread curve (duration-adjusted) versus expected default losses shows that the curve is currently fairly valued relative to our optimistic default loss assumptions (Chart 13, bottom panel). In other words, if default losses were to surprise to the upside, then the credit spread curve would appear too steep. Chart 12IG Term Structure Is Steep Chart 13Rising Defaults Flatten The Spread Curve All in all, our outlook for higher Treasury yields and the negative balance of risks surrounding our default loss forecast both suggest that investors should favor the long-end of the maturity spectrum within an allocation to investment grade corporate bonds. Bottom Line: Investors should maintain a below-benchmark duration bias in their overall bond portfolios, but should lengthen maturities within their corporate bond allocations as much as possible while also maintaining a balanced or slightly up-in-quality allocation across credit tiers. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Now What?", dated June 27, 2018, available at cis.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification