Financials
Foreign flows had put a solid bid under U.S. bonds and artificially suppressed yields and this is at the margin reversing. In addition, the market was hoping for a 50bps rate cut from the Fed in the September meeting further weighing on the UST yield, but now…
Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market. While the broad financials index is levered to interest rate movements, banks are hyper-sensitive to changes in the risk-free asset. Thus, the recent jack-up in interest rates…
Highlights Portfolio Strategy Small cracks are forming in the labor market according to the ISM manufacturing, ISM services and NFIB surveys, and if the Fed goes ahead and cuts interest rates in half in the coming year as the bond market currently forecasts, then a recession would be a foregone conclusion. Stay cautious on the prospects of the broad equity market. The budding recovery in the 10-year UST yield, a rising Citi Economic Surprise Index (CESI) into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Healthy credit growth, still pristine credit quality and early signs of a recovery in the price of credit all signal that an overweight stance is warranted in the S&P banks index. Recent Changes Last Wednesday we removed the S&P software index from the high-conviction overweight list for a 10% gain. Last Wednesday we removed the large cap size bias from the high-conviction list for a 9% gain. Table 1 Feature The SPX built on recent gains last week, but failed to surpass the July highs. Beneath the surface, some big sector shifts are taking place, but it is still early to declare a definitive change in trend. Dormant value stocks have awaken and are riding a high at the expense of growth and momentum names, on the back of a selloff in the bond market (Chart 1). Similarly, small cap stocks have a pulse, and started to outshine large caps. Even in a red SPX day, small cap indexes managed to close in the black (Chart 1). As a reminder with regard to our portfolio, last Wednesday we obeyed our S&P software stop and removed it from the high-conviction call list for a 10% gain, and simultaneously booked gains in the tactical large cap bias and removed it from the high-conviction call list (Chart 1). In both cases our shorter-term confidence was taken down a notch, and we intend to obey our cyclical trailing stops in both positions in order to protect gains for our portfolio (for additional details please refer to the Daily Sector Insights available here and here). Following up from last week’s ISM-related analysis, we turn our attention to the labor market that is beginning to reveal some minor cracks. While the ISM debate has centered around the steep divergences between services and manufacturing on the headline number and the new orders subcomponents, the labor components have gone nearly unnoticed. Chart 1Healthy Rotation Worrisomely on the employment front, the surveys are in agreement (second panel, Chart 2), warning that the labor market will have trouble standing on its own two feet. This is a bearish backdrop for the broad equity market (third panel, Chart 2). Tack on the latest NFIB survey, and the news gets grimmer. Chart 3 shows that an equally-weighted index of small business job openings and hiring plans is quickly losing momentum. Given that roughly 2/3 of job creation originates in small and medium businesses, non-farm payroll growth will likely continue to lose steam in the coming months (Chart 3). Chart 2Labor Market… Chart 3…Yellow Flags This week, we update an early cyclical sector and one of its key subcomponents. Finally, the still sinking stock-to-bond ratio corroborates the ISM and NFIB surveys’ messages. Crudely put, the longer that bonds outperform stocks, the higher the chances that employment will suffer a severe setback (Chart 4). Chart 4Last Man Standing Granted, the labor market is a lagging indicator and typically one of the last, if not the last, shoes to drop on the eve of recession. With regard to recession, a simple thought experiment is in order. If we assume the bond market’s forecast for another 100bps of fed funds rate (FFR) cuts in the coming year as accurate, then the FFR will fall to 1.25%. This Fed policy easing will represent a 44% fall in the FFR on a year-over-year basis. Since the late 1960s recession there have not been any mid-cycle slowdowns that the Fed has engineered by clipping the FFR in half (Chart 5). Put differently, when the Fed is compelled to cut interest rates so deeply in every iteration we examined a recession followed suit. Chart 5When The Fed Funds Rate Gets Halved, Recession Is The Reason In sum, small cracks are forming in the labor market according to the ISM manufacturing, ISM services and NFIB surveys and if the Fed goes ahead and cuts interest rates in half in the coming year, as the bond market currently forecasts, then a recession would be a foregone conclusion. Stay cautious on the prospects of the broad equity market. This week, we update an early cyclical sector and one of its key subcomponents. Stick With Financials… The 45bps rise in the 10-year U.S. Treasury (UST) yield over the past two weeks has breathed life back into the S&P financials sector, and for the time being we are sticking with an overweight recommendation. While it remains to be seen how sustainable the rise in yields will be, BCA's long-held view remains that the 10-year UST yield will sell off on a cyclical 9-12 time month horizon. If this is the case then financials stocks will lead the nascent sector rotation that commenced in late-August and outperform the SPX in the coming months (top panel, Chart 6). Foreign flows had put a solid bid under U.S. bonds and artificially suppressed yields and this is at the margin reversing. In addition, the market was hoping for a 50bps rate cut from the Fed in the September meeting further weighing on the UST yield, but now the odds of that happening are nil. Finally, the Citi Economic Surprise Index (CESI) has also come out of hibernation and spiked in positive territory, evidence that economic data estimates had hit rock bottom. This slingshot recovery in the CESI is tonic for financials stocks (bottom panel, Chart 6). On the earnings front, our profit growth model has kissed off the zero line. While financials sector EPS cannot grow indefinitely at a 30%/annum clip, the turn in our three-factor macro model is a positive development (second panel, Chart 7). Chart 6Moving In Lockstep With Rates Chart 7Unwarranted Extreme Bearishness Importantly, it stands in marked contrast to the sell side community. Analysts have been feverishly cutting EPS estimates for the sector, and now net earnings revisions have sunk to a level last hit during the great recession (middle panel, Chart 7). Similarly, relative 12-month and five-year forward profit growth forecasts are overly pessimistic. The upshot is that this lowered profit bar will be easy to surpass. With regard to shareholder friendly activities, while the overall share buyback frenzy has taken a breather, financials sector equity retirement is alive and kicking and on track to register the largest annual buyback since the short history of the data (second panel, Chart 8). If there is any sector with pent up buyback demand it is the financials sector that has been a net equity issuer until very recently still wrestling with equity dilution in the aftermath of the GFC. Adding it all up, the budding recovery in the 10-year UST yield, a rising CESI into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Dividend growth has been steady and in expansionary territory and the dividend payout ratio is far from waving any yellow flags. Moreover, financials yield 2.07% or 25bps higher than the 10-year UST yield and 17bps higher than the SPX, which is attractive for yield seeking investors (Chart 8). Moving on to relative valuations beyond the enticing relative dividend yield, relative price-to-book, relative forward P/E and our bombed out composite relative valuation indicator that collapsed to all-time lows suggest that financials are a screaming buy. Technicals remain oversold and also suggest that an overweight stance is warranted (Chart 9). Chart 8Pent-Up Demand For Shareholder Friendly Activities Chart 9Undervalued And Unloved Adding it all up, the budding recovery in the 10-year UST yield, a rising CESI into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Bottom Line: Stay overweight the S&P financials sector, that is compellingly valued, under-owned, and with promising profit prospects. … And Banks For A While Longer Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market, and we continue to recommend an above benchmark allocation in the S&P banks index. This is a global phenomenon as even the ultimate global value group, Eurozone bank equities, bottomed out on August 15 alongside their U.S. peers. While the broad financials index is levered to interest rate movements, banks – that comprise roughly 42% of the S&P financials sector – are hyper-sensitive to changes in the risk-free asset. Thus, the recent jack up in interest rates represents a profit-augmenting opportunity for this early cyclical subgroup (Chart 10) Beyond the rising price of credit, credit growth is another key industry profit driver. Our bank loan models have crested, but are still expanding at a healthy clip (second and bottom panels, Chart 11). As long as they manage to remain above the zero line, they will prove a boon to bank earnings. Specifically on the consumer front, sky high consumer confidence coupled with rising wage inflation signal that consumer credit growth prospects remain upbeat (Chart 11). Chart 10Rising Rates=Buy Banks Importantly, the latest Fed Senior Loan Officer Survey painted a bright picture on both the demand and supply of credit. In more detail, bankers reported that a rising number of credit categories reversed course and demand for loans slingshot higher, likely as a delayed consequence of the dramatic fall in interest rates since last November (bottom panel, Chart 12). Chart 11Loan Growth… Chart 12…Prospects Are Firming Encouragingly, bank officers also reported that they were willing extenders of credit. Our in-house calculated overall gauge of loan tightening standards fell compared with last quarter, signaling that at the margin it is easier to get a loan (middle panel, Chart 12). Netting it all out, early signs of a recovery in the price of credit, healthy credit growth and still pristine credit quality signal that an overweight stance is warranted in the S&P banks index. Finally, credit quality, the third key bank profit driver, is also emitting a positive signal. While a few loan categories have deteriorated recently in absolute terms, as percentage of loans outstanding, credit quality remains pristine (Chart 13). The upshot is that this credit quality backdrop combined with a jump in bank return-on-equity to low double digits, should serve as catalysts to unlock excellent value (third & bottom panel, Chart 13). Nevertheless, there are two risks worth close monitoring. First, parts of the yield curve inverted last December and more recently the 10/2 yield curve slope inverted warning that the path of least resistance is lower for bank net interest margins (NIMs, middle panel, Chart 14). Chart 13Pristine Credit Quality Is A Catalyst To Unlock Excellent Value Chart 14Two Risks To monitor Second, the ISM manufacturing survey fell below the boom/bust line in August for the first time since the late-2015/early-2016 manufacturing recession (bottom panel, Chart 14). Given that C&I loans are the largest loan category on the asset side of bank balance sheets, the current manufacturing recession may hurt bank profitability in two distinct ways. Not only C&I credit quality will worsen as the risk of defaults rises, but also C&I loan growth may take the back seat and weigh on bank profit growth prospects. Netting it all out, early signs of a recovery in the price of credit, healthy credit growth and still pristine credit quality signal that an overweight stance is warranted in the S&P banks index. Bottom Line: Continue to overweight the S&P banks index, but keep it on the downgrade watch list, acknowledging the yield curve-related potential decline in NIMs and manufacturing recession-related C&I loan growth risks. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
Highlights The lingering global manufacturing recession and the substantial drop in U.S. bond yields have been behind the decoupling between both EM stocks and the S&P 500, and cyclical and defensive equities. Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to indicate either further bifurcation in global markets or a risk-off period. We review some of our long-standing themes and associated recommendations. Feature Global financial markets have become bifurcated. On one hand, numerous segments of global financial markets leveraged to global growth, including EM stocks, have already sold off (Chart I-1). On the other hand, share prices of growth companies, defensive stocks and global credit markets have remained resilient. Chart I-2 shows that a similar divergence has taken place within EM asset classes: EM share prices have plummeted while EM corporate credit excess returns have not dropped much. Chart I-1Bifurcated Equity Markets Chart I-2Bifurcated Markets In EM How to explain this market bifurcation? Financial markets sensitive to global trade and manufacturing cycles have been mirroring worsening conditions in global trade and manufacturing. Some of the affected segments include: Global cyclical equity sectors. Emerging Asia manufacturing-related currencies (KRW, TWD and SGD) versus the U.S. dollar (Chart I-3). EM and DM commodity currencies (Chart I-4). Chart I-3Total Return (Including Carry): KRW, TWD And SGD Vs. USD Chart I-4EM And DM Commodity Currencies Industrial and energy commodities prices. U.S. high-beta stocks as well as U.S. small caps (Chart I-5). Chart I-5U.S. High-Beta Stocks DM bond yields. Crucially, the current global trade and manufacturing downturns have taken place despite robust U.S. consumer spending. In fact, our theme for the past several years has been that a global business cycle downturn would occur despite ongoing strength in American household spending. The rationale has been that China and the rest of EM combined are large enough on their own to bring down global trade and manufacturing, irrespective of strength in U.S. consumer spending. At the current juncture, one wonders whether such a market bifurcation is justified. It is not irrational. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Corporate bonds have also done well, given the background of a falling risk-free rate. Will the current market bifurcation continue? Or will these segments in global financial markets recouple and in which direction? What To Watch China rather than the U.S. has been the epicenter of this slowdown, as we have argued repeatedly in the past. Hence, a major rally in global cyclical equities and EM risk assets all hinge on a recovery in the Chinese business cycle. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Even though Caixin’s PMI for China was slightly up in August, many other economic indicators remain downbeat: The latest hard economic data out of Asia suggest that global trade/manufacturing continues to contract. Korea’s total exports in August contracted by 12.5% from a year ago, and its shipments to China plunged by 20% (Chart I-6). The import sub-component of China’s manufacturing PMI is not showing signs of amelioration (Chart I-7). The mainland’s import recovery is very critical to a revival in global trade and manufacturing. Chart I-6Korean Exports: No Recovery Chart I-7Chinese Imports To Remain Weak Chart I-8German Manufacturing Confidence German manufacturing IFO business expectations and current conditions both suggest that it is still early to bet on a global trade recovery (Chart I-8). Newly released August data points reveal that U.S., Taiwanese, and Swedish manufacturing new export orders continue to tumble. To gauge whether bifurcated markets will recouple and whether it will occur to the downside or the upside, investors should watch the relative performance of China-exposed markets, global cyclicals and high-beta plays – the ones that have already sold off substantially. The notion is as follows: These markets’ relative performance will likely bottom before their absolute performance recovers. If so, their relative performance will likely foretell the outlook for their absolute performance. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. In other words, they could sell off even if a global recession is avoided. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. To assess the outlook for global cyclicals and China-related plays, we are monitoring the following financial market indicators: The Risk-On/Safe-Haven currency ratio is the average of high-beta commodity currencies such as the CAD, AUD, NZD, BRL, CLP and ZAR total return (including carry) indices relative to the average of JPY and CHF total returns (including carry). This ratio is dollar-agnostic. This ratio is making a new cyclical low (Chart I-9). Hence, it presently warrants a negative view on global growth, China’s industrial sector and commodities. Global cyclical equity sectors seem to be on the edge of breaking down versus defensives (Chart I-10). This ratio does not signal ameliorating global growth conditions. Chart I-9The Risk-On/Safe-Haven Currency Ratio Chart I-10Global Cyclicals Versus Defensives Chart I-11U.S. High-Beta Stocks Versus S&P 500 Finally, U.S. high-beta stocks continue to underperform the S&P 500 (Chart I-11). This is consistent with overall U.S. growth deceleration. Bottom Line: Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to foreshadow either further bifurcation in global markets or a risk-off period. Continue trading EM stocks and currencies on the short side, and underweighting EM risk assets versus DM. Our Investment Themes And Positions Some of our open positions often run for years because they reflect our long-standing themes. Our core theme has for some time been that a global trade/manufacturing recession will be generated by a growth relapse in China. To capitalize on this theme, we have been recommending a short EM stocks / long 30-year U.S. Treasurys strategy since April 2017. This recommendation has produced a 25% gain since its initiation (Chart I-12). Continue betting on lower local interest rates in emerging economies where the central bank can cut rates despite currency depreciation. To implement this theme, we have been recommending receiving swap rates in Korea and Chile for the past several years. Our reluctance to recommend an outright buy on local bonds stems from our bearish view on both currencies – the Korean won and Chilean peso. In fact, we have been shorting both the KRW and the CLP against the U.S. dollar. Chart I-13 shows that swap rates in Korea and Chile have dropped substantially since our recommendations to receive rates in these countries. More rate cuts are forthcoming in these economies, and we are maintaining these positions. Chart I-12EM Stocks Have Massively Underperformed U.S. Bonds Chart I-13Continue Receiving Rates In Korea And Chile We have been bearish on EM banks in general and Chinese banks in particular. We have expressed these themes in a number of ways: Short EM and Chinese / long U.S. bank stocks. Short EM banks / long EM consumer staples (Chart I-14). Within Chinese banks, we have been short Chinese medium and small banks / long large ones. All these strategies remain valid. In credit markets, we have been favoring U.S. corporate credit versus EM sovereign and corporate credit. Ability to service debt is better among U.S. debtors than EM/Chinese borrowers. We have been playing this theme in the following ways: Underweight EM sovereign and corporate credit / overweight U.S. investment-grade corporates (Chart I-15). Chart I-14Short EM Banks / Long EM Consumer Staples Chart I-15Underweight EM Credit / Overweight U.S. Investment-Grade Corporates Underweight Asian high-yield corporate credit / overweight emerging Asian investment-grade corporates. As a bet on a deteriorating political and business climate in Hong Kong, in our Special Report on Hong Kong SAR from June 27, we reiterated the following positions: Short Hong Kong property stocks / long Singapore equities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Mexico: Crying Out For Policy Easing The Mexican economy is heading into a full-blown recession. Most segments of the economy are in contraction, and leading indicators point to further downside. Both manufacturing and non-manufacturing PMIs are well below 50 (Chart II-1). Monetary policy remains too restrictive: Nominal and real interest rates are both very high and plunging narrow money (M1) growth is signaling further downside in economic activity (Chart II-2). Chart II-1The Economy Is Deteriorating Chart II-2Narrow Money Points To Negative Growth An inverted yield curve signifies that the central bank is behind the curve and foreshadows growth contraction (Chart II-3). Fiscal policy has tightened as the government has remained committed to achieving a primary fiscal surplus of 1% of GDP in 2019 (Chart II-4, top panel). Consequently, nominal government expenditures have been curbed (Chart II-4, bottom panel). The government’s fiscal stimulus has not been large and has been implemented too late. Chart II-3A Message From The Inverted Yield Curve Chart II-4Fiscal Policy Has Tightened A Lot Finally, business confidence is extremely low due to uncertainty over President Andrés Manuel López Obrador’s (AMLO) policies towards the private sector. The president is attempting to revive business confidence, but it will take time. Chart II-5Mexico Versus EM: Domestic Bonds And Sovereign Credit Our major theme for Mexico has been that both monetary and fiscal policies are very tight. Consequently, we have been recommending overweight positions in Mexican domestic bonds and sovereign credit relative to their respective EM benchmarks. (Chart II-5). Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Meanwhile, we have been favoring the Mexican peso relative to other EM currencies due to the fact that AMLO is not as negative for the country as was initially perceived by markets. With inflation falling and the Federal Reserve cutting rates, Banxico will ease further. Yet, it will likely cut rates slower than warranted by the economy. The longer the central bank takes to ease, the lower domestic bond yields will drop. Concerning sovereign credit, investors should remain overweight Mexico within an EM credit portfolio. Mexico’s fiscal position is healthier, and macroeconomic policies will be more prudent relative to what the market is currently pricing. We continue to believe concerns about Pemex’s financing and its impact on government debt are overblown, as we discussed in detail in our previous Special Report. In July, the government released an action plan for Pemex financing. We view this plan as marginally positive. To supplement this plan, the government can use the $14.5 billion federal budget stabilization fund to fill in financing shortfalls in the coming years. Importantly, the starting point of Mexican public debt is quite low, which will allow the government to finance Pemex in the years to come by borrowing more from markets. Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Lastly, our overweight recommendation in Mexican stocks has not played out. However, we are maintaining it for the following reasons: Chart II-6 illustrates that when Mexican domestic bond yields decline relative to EM ones (shown inverted on Chart II-6), Mexican share prices usually outperform their EM counterparts in common currency terms. Consistent with our view that Mexican local currency bonds will outperform their EM peers, we expect Mexican stocks to outpace the EM equity benchmark. The Mexican bourse’s relative performance against EM often swings with the relative performance of EM consumer staples versus the EM equity benchmark. This is due to the large share of consumer staples stocks in Mexico (34.5%) compared to that in the EM benchmark (7%). Consumer staples stocks are beginning to outpace the EM equity index, raising the odds of Mexican equity outperformance versus its EM peers (Chart II-7). Chart II-6Local Bond Yields And Relative Stocks: Mexico Versus EM Chart II-7Consumer Staples Have A Large Weight In Mexican Bourse We do not expect a major rally in this nation’s stock market given the negative growth outlook. Our bet is that Mexican share prices - having already deflated considerably - will drop less in dollar terms than the overall EM equity index. Bottom Line: We continue to recommend an overweight stance on Mexican sovereign credit, domestic bonds and equities relative to their respective EM benchmarks. The main risk to the Mexican peso stems from persisting selloff in EM currencies. Traders’ net long positions in the MXN are elevated posing non-trivial risk (Chart II-8). We have been long MXN versus ZAR but are taking profit today. This trade has generated a 9.7% gain since March 29, 2018. A plunging oil-gold ratio warrants a caution on this cross rate in the near term (Chart II-9). Chart II-8Investors Are Long MXN Chart II-9Take Profits On Long MXN / Short ZAR Trade Juan Egaña, Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Underweight While insurers have enjoyed a knee jerk rally recently, relative share prices remain in a downtrend, and we recommend fading this run-up. House and auto sales have been in contraction for nearly a year, which bodes ill for insurance profits that have already been struggling to keep pace with the broad market (second panel). This is largely reflected in insurance pricing power, which has barely climbed out from outright deflation (third panel). Bottom Line: Decelerating house and auto sales will continue to weigh on insurers’ pricing power prospects. Stay underweight the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU – CB, MMC, MET, PGR, AON, PRU, AIG, AFL, TRV, ALL, WLTW, HIG, AJG, PFG, CINF, L, LNC, RE, AIZ, GL, UNM.
Highlights Analysis on Brazil is available below. If banks in China are forced by regulators to properly recognize and provision for non-performing assets, large banks would become substantially undercapitalized while many small- and medium-sized banks (SMBs) would have little equity capital left. That would hammer their ability to finance the economy. Provided on aggregate SMBs have actually outgrown larger ones in terms of balance sheet size, the precarious state of the former’s financial health has become a matter of macro significance. The principal danger to shareholders of mainland banks is equity dilution. We reiterate our long U.S. banks/short Chinese bank shares trade, and within the latter our long large/short SMB stocks position. Feature Chinese Banks: A Value Trap Chart I-1Chinese Bank Share Prices Are On Edge Banks are crucial to financing the private sector as well as all levels of government in China. Not only do banks originate a substantial share of credit, but also they account for 82% of purchases of government bonds. That is why today we revisit the fundamentals of the Chinese banking sector. Besides, their equity valuations appear very cheap, and many investors are tempted to buy their shares. Chinese banks’ financial ratios look healthy and valuations appear extremely cheap because they have not recognized and provisioned for non-performing assets. By expanding their balance sheets enormously and not provisioning for bad assets, their profits have mushroomed. Banks have retained a share of these profits, boosting their capital. Yet, their share prices have been flat over the past 10 years. Recently, investable bank stocks have been lingering around their December lows. Another gap down could be lurking around the corner (Chart I-1). We highlight their poor financial health in the section below, where we perform stress tests for both large as well as small and medium sized banks (SMB). The principal danger to shareholders is equity dilution that will continue occurring among mainland banks (Chart I-2). Our bearish view on Chinese bank stocks has not been contingent on a systematic financial crisis but on inevitable and substantial equity dilution. Investment conclusions: Absolute return investors should stay clear of Chinese bank stocks – they are the ultimate value trap. For relative value traders, we reiterate our long U.S. banks/short Chinese bank shares trade, and within the latter our long large/short SMB stocks position (Chart I-3). Chart I-2Beware Of Equity Dilution Chart I-3Our Trades On Chinese Banks Large Versus Small And Medium Banks China’s banking system consists of five large banks (Industrial and Commercial Bank of China, China Construction Bank, Bank of China, Agricultural Bank of China, and Bank of Communications) and about 3150 small- and medium-sized banks (SMBs). All five large banks are publically listed but the central government still holds about 70-80% of their equity. About 36 of the SMBs are also listed but the central authorities in Beijing have a stake in some of the medium-sized banks. Notably, the central government has no equity in any of the small banks. In recent years, SMBs have been playing a greater role in sustaining the credit boom: First, on aggregate SMBs have actually outgrown the five large banks in terms of balance sheet size. The former’s risk-weighted assets1 (RWAs) of RMB 73 trillion exceeds the RMB 65 trillion of large banks (Chart I-4). Recently, investable bank stocks have been lingering around their December lows. Another gap down could be lurking around the corner. The value of RWAs emphasizes banks’ claims on enterprises, non-bank financial institutions and households over holdings of government bonds. Hence, RWAs of banks are a more pertinent measure of non-government financing than total assets. Second, over the past 12 months large banks and SMBs have accounted for 40% and 60% of the rise in the aggregate banking system’s RWAs, respectively (Chart I-5). Therefore, further credit acceleration will be difficult to engineer if – as we discuss below – SMBs begin retrenching under regulatory pressures and amid tighter market financing in the wake of the Baoshang bank failure. Chart I-4SMBs Have Outgrown Large Ones Chart I-5SMBs Have Contributed Enormously To The Credit Boom Finally, there has so far been no deleveraging among SMBs. Large banks’ RWAs-to-nominal GDP ratio has been in decline since 2014, but the same ratio for SMBs has not dropped at all (Chart I-6). This chart corroborates that the credit boom between 2015 and 2017 was driven by SMBs, rather than by large banks. In fact, SMBs along with shadow banking are what primarily drove the credit boom that occurred over the past decade. This confirms the thesis that the unprecedented credit bubble has spiraled beyond the central authorities’ control. While China’s entire banking system is in poor health, SMBs are in considerably worse shape than large ones. In particular: SMBs have much more assets classified as equity and other investments than large banks (Chart I-7). Equity and other investments stands for non-standard credit assets that are typically much riskier than loans and corporate bonds. This is the principal reason why in our stress test we use higher ratios of non-performing assets for SMBs than for large banks. Chart I-6No Deleveraging Among SMBs Chart I-7SMBs Exposure To Non-StandarD Credit Assets Is Huge Chart I-8Large Banks Versus SMBs Big banks are better capitalized than SMBs. The capital adequacy ratio among big banks is higher compared with the other banks (Chart I-8, top panel). Similarly, the ratio of non-performing loans (NPL) to total loans is considerably lower for large banks than for SMBs (Chart I-8, bottom panel). On the liquidity side, SMBs are more dependent on the wholesale funding market than their larger peers. Interbank transactions account for 10% of SMBs own liabilities. On the other hand, big banks are the main lenders in the interbank market. Bottom Line: SMBs have become more important than large ones in providing financing to companies and households. Yet these SMBs are much more vulnerable. A Stress Test We conducted separate stress tests on large banks and SMBs. Our findings are not optimistic. Some 71% of equity of SMBs will be wiped out if 14% of their RWAs turn sour (Table I-1). 43% of large banks’ equity will be impaired if 12% of their RWAs become non-performing (Table I-2). The reason we use RWAs rather than loans is because banks have been accumulating claims on enterprises, non-bank financial institutions and households beyond their loan books. Hence, RWAs better captures all credit assets. We use a higher impairment rate for SMBs than for large banks because the former have substantially more non-standard credit assets. Typically, the quality of non-standard credit assets is inferior to those of corporate bonds or loans. We used the following assumptions in our stress tests: For large banks, we assumed non-performing assets (NPAs) ratios of 10% in the optimistic scenario, 12% (baseline), and 14% (pessimistic) (Table I-2). For SMBs, we employed NPAs ratios of 12% (optimistic), 14% (baseline), and 16% (pessimistic) (Table I-1). The magnitude and duration of China’s current credit boom has considerably surpassed that of the 1990s, when Chinese banks held over 25% of non-performing loans (Chart I-9). Therefore, our stress test assumption that the NPAs ratio will rise above 10% is reasonable. Chart I-9China's Credit Booms In Perspective We applied a 30% recovery rate on NPAs. The recovery rate on Chinese banks’ NPLs from 2001 to 2005 was 20%. This occurred amid much stronger economic growth. Thus, an assumption of a 30% recovery rate today is realistic. Finally, we calculated overvaluations assuming the fair price-to-book value ratio for all banks is 1. How has it been possible for banks in China to continue expanding their balance sheets aggressively despite such moribund financial health? Banks can operate and expand their balance sheets with zero or even negative de facto equity capital, so long as they obtain liquidity from other banks or the central bank. This is how many Chinese SMBs have been operating in recent years. Barring institutional and regulatory constraints, banks theoretically can expand their balance sheets indefinitely by creating loans and deposits “out of thin air.” We have deliberated extensively in past reports that banks do not intermediate savings or deposits into loans and credit. Rather, they create deposits when they make a loan to or buy an asset from a non-bank entity. Loans and deposits are nothing other than accounting entries on banks’ books. It is regulators’ and shareholders’ forbearance – or lack of it – that allows banks to, or prevents banks from, expanding their balance sheets. Although Chinese authorities have been easing both monetary and fiscal policies, they have not completely abandoned their regulatory tightening efforts on banks and shadow banking, or their plans to curb leverage and speculation in the real estate market. For example, in April bank regulators released draft rules on how banks should classify all types of assets and provision for them. Over the past several years, many banks have transformed their bad loans into non-loan assets to disguise the true level of their non-performing loans (NPLs). The new regulation, if and when it is adopted and properly executed, will force banks to recognize NPAs and increase their provisions. Although Chinese authorities have been easing both monetary and fiscal policies, they have not completely abandoned their regulatory tightening efforts on banks and shadow banking, or their plans to curb leverage and speculation in the real estate market. Ultimately, this will substantially impair banks’ capital and dampen their ability to originate new credit – both in the form of making loans and buying securities. Consequently, the credit impulse will relapse and the business cycle recovery will be delayed. Bottom Line: If banks in China are forced by regulators to properly recognize and provision for NPAs, large banks would become substantially undercapitalized while many SMBs would have little equity capital left. That would hammer their ability to finance the economy. Investment Ramifications Given the increased importance of SMBs in China, the precarious state of their financial health has become a matter of macro significance. Even if regulators partially reinforce recognition of provisions for NPAs, aggregate credit growth will decelerate. A simple simulation to illustrate this point: If SMBs RWAs growth were to decelerate from 11% currently to 8%, large banks’ RWA annual growth would need to surge from 8% now to 16% for all banks’ RWA growth to accelerate from the current 9.5% to 12%. The latter is probably what is required to promote an economic recovery. Such a ramp-up in large banks’ RWAs is unlikely, given they would also be facing stricter regulatory requirements. The key point is that the positive effects of monetary and fiscal easing continue to be hampered by regulatory tightening on the credit system. The latter will delay a business cycle recovery in China. For now, although the credit plus fiscal spending impulse has picked up, economic growth has not yet revived (Chart I-10, top two panels). The reason has been a declining marginal propensity to spend among households and companies (Chart I-10, bottom two panels). We have discussed this issue at great length in past reports. Consistently, nominal industrial output, car sales and smartphone sales as well as total imports are either very weak or are in outright contraction (Chart I-11). All series in Chart I-11 and I-12 include June data. Chart I-10Stimulus Versus Marginal Propensity To Spend Chart I-11Chinese Economy: No Recovery So Far Chart I-12Chinese Corporate EPS: The Outlook Is Downbeat Importantly, Chinese corporate per-share earnings in RMB are contracting for the MSCI investable universe and will soon be contracting for A-share companies as well (Chart I-12). We maintain our negative outlook for EM risk assets and China-plays globally due to our downbeat view on China’s credit cycle. This differs from BCA’s House View, which is positive on global/Chinese growth. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com Brazil: Buy The Rumor, Sell The News? Having surged on the back of Congress’s initial approval of the social security reform, Brazilian financial markets are attempting to break above important technical resistance levels both in absolute and relative terms (Chart II-1 and Chart II-2). If the Bovespa decisively breaks above these technical resistance lines, it would mean it is in a structural bull market. A failure to break out will lead to a sizable setback. Chart II-1Are Brazilian Equities Poised For A Breakout In Absolute Terms… Chart II-2…And Relative Terms? We upgraded Brazilian equity and fixed-income markets right after the first round of presidential elections on October 7, but then downgraded them in early April. In retrospect, the downgrade was a miscalculation. Presently, investor confidence in Brazil is very high, sentiment is very bullish and markets are overbought. Faced with the choice of chasing the market higher or waiting, we are opting for the latter. Pension Reform: Necessary But Not Sufficient Chart II-3Public Debt-To-GDP Ratio Will Rise Further The nation’s pension bill is a very positive and much-needed step in the structural reform process. However, in its current form, it is insufficient to make public debt dynamics sustainable – i.e., halt the rise in the government debt-to-GDP ratio (Chart II-3). Table II-1 illustrates the savings from the social security reform adopted in the lower house. As estimated by the Independent Fiscal Institute, an advisory think-tank of the Senate, the reform would bring only BRL 744 billion of savings over the next decade. Is this sufficient to stabilize the public debt-to-GDP ratio? One way these reforms could contain the rise in the public debt-to-GDP ratio is if the savings generated significantly exceed the primary fiscal deficits over the next several years – i.e., the government runs continuous robust primary fiscal surpluses. Yet, the pension bill falls short of achieving this goal. The estimated savings in the first four years will likely be around BRL 130 billion. This amounts to annual savings of BRL 33 billion. Chart II-4 demonstrates that savings from the reform are too small to flip the government’s (often optimistic) projected primary fiscal deficit into a surplus in the forecast period. One way these reforms could contain the rise in the public debt-to-GDP ratio is if the savings generated significantly exceed the primary fiscal deficits over the next several years. Another scenario for stabilizing the public debt-to-GDP ratio is for interest rates to drop meaningfully below nominal GDP growth. Having plummeted amid very benign global and domestic backdrops, local currency bond yields still remain about 100 basis points above current nominal GDP growth (Chart II-5). It remains to be seen whether local currency borrowing costs will drop and stay below nominal GDP in the years to come. Chart II-4Primary Fiscal Balance Will Remain Negative Despite Pension Reform Chart II-5Borrowing Costs Remain Above Nominal GDP Growth Overall, the pension reform in current form does not guarantee public debt sustainability in Brazil: It is simply insufficient to get the government to run recurring primary fiscal surpluses. Another prerequisite – nominal GDP growth exceeding local bond yields over next several years – is contingent on further reforms as well as on a substantial improvement in confidence among investors, companies and households. It Is All About Confidence The sustainability of public debt, economic growth and financial markets are interlinked, with the common thread being confidence. In a virtuous cycle, financial markets typically rally while the currency stays firm. Subdued inflation will allow the central bank to rapidly reduce interest rates. This will help boost confidence among businesses and consumers, buoying the economy. In turn, lower policy rates could sustain the stampede into domestic bonds, pushing government borrowing costs below rising nominal GDP growth. At that point, the country’s public debt dynamics will become sustainable, the risk premium will continue to fall, and the nation’s financial markets will be in a secular bull market. On the contrary, a vicious cycle is possible if there is a negative external or internal shock that prompts the Brazilian real to depreciate by more than 10%. On the contrary, a vicious cycle is possible if there is a negative external or internal shock that prompts the Brazilian real to depreciate by more than 10%. In this case, the central bank cannot slash interest rates. On the contrary, government bond yields – which are presently at record lows – could or will likely rise (Chart II-6 and Chart II-7). These events will hurt confidence and suppress nominal GDP growth below borrowing costs. This could aggravate investors’ anxiety over Brazil’s public debt, leading them to demand a higher risk premium. As a result, a vicious cycle could unfold. Chart II-6Government Bond Yields Are At Historical Lows Chart II-7Credit Spreads Are Very Tight Chart II-8Commodity Prices And The BRL: Positive Correlation To be clear, we are not presently forecasting the onset of a vicious cycle. Nevertheless, given our negative view on EM risk assets and currencies, we expect a pullback in the Brazilian real and risk assets in the near term. The U.S. dollar is about to rally, as we discussed in detail in last week’s report. Commodities prices will tumble as China’s growth downshift persists. Given that the Brazilian real is a high-beta currency and is often positively correlated with commodities prices (Chart II-8), it could depreciate quite a bit. Patience is especially warranted in the case of Brazilian equities because share prices have decoupled from corporate profits and the business cycle. Stock prices have surged despite plummeting net EPS revisions and contracting profits of non-financial and non-resource companies (Chart II-9) and relapsing economic growth (Chart II-10). Clearly, the rally has been driven by expanding equity multiples due to progress on the social security reform. Chart II-9Stock Prices Are Diverging From Corporate Profits Chart II-10Domestic Demand Has Stalled Bottom Line: A lot of good news has been priced into Brazilian financial markets. For now, the risk-reward profile is not attractive: investors should wait for a better entry point. This is true for both absolute return investors and dedicated EM equity and fixed-income managers. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 Risk-weighted asset is a bank's assets or off-balance sheet exposures, weighted according to risk. It is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution. Usually, different classes of assets have different risk weights associated with them. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The onset of a down-oscillation in growth strongly suggests a rotation out of the growth-sensitive Industrials and Materials into the relatively defensive Healthcare sector. But if the sharpest move in bond yields has already happened, it also suggests that Banks might hold up versus other cyclical sectors. New recommendation 1: Overweight Banks versus Industrials. New recommendation 2: Overweight Eurostoxx50 versus Nikkei225. Remain overweight Eurostoxx50 versus Shanghai Composite and neutral versus the S&P500. Feature Chart of the WeekEuro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Several decades ago, English football’s top division was a showcase for the top English and British footballers. But not anymore. This year, the top six footballers in the English Premier League hail from Argentina, the Netherlands, Belgium, Senegal, Portugal, plus a token Englishman. Nowadays, if you want to see English or British footballers you have to go to the lower divisions.1 The English Premier League provides a powerful analogy for the FTSE100. Many of the top companies in this blue-chip index have their origins and main businesses outside the U.K. The names say it all: Royal Dutch, Hong Kong and Shanghai Banking Corporation, British American Tobacco, and so on. Just like in football, if you want stock market exposure to the U.K, you now have to go to the lower divisions: the FTSE250 or the FTSE Small Cap. A view on an economy does not necessarily translate into the same view on its mainstream stock market. The leading companies in the FTSE100 are multinationals, whose sales and profits have a minimal exposure to the economic fortunes of the U.K. This leads to a result which causes investors a great deal of cognitive dissonance: a view on an economy does not necessarily translate into the same view on its mainstream stock market. Picking Stock Markets The Right Way Royal Dutch is neither a Dutch company nor a U.K. company, it is a global company. And the same is true for the vast majority of companies in the FTSE100 and all other major indexes such as the Eurostoxx50, Nikkei225, and S&P500. However, Royal Dutch is most definitely an oil and gas company which moves in lockstep with the global energy sector. Hence, by far the most important performance differentiator for any mainstream equity index is the sector fingerprint that distinguishes the equity index from its peers. Each major stock market has a distinguishing ‘long’ sector in which it contains up to a quarter of its total market capitalisation, as well as a distinguishing ‘short’ sector in which it has a significant under-representation. The combination of this long sector and short sector gives each equity index its distinguishing fingerprint (Table 1): FTSE100 = long energy, short technology. Eurostoxx50 = long banks, short technology. Nikkei225 = long industrials, short banks and energy. S&P500 = long technology, short materials. MSCI Emerging Markets = long technology, short healthcare. Another important factor is the currency. Royal Dutch receives its revenues and incurs its costs in multiple major currencies, such as euros and dollars. In other words, Royal Dutch’s global business is currency neutral. But the Royal Dutch stock price is quoted in London in pounds. Hence, if the pound strengthens, the company’s multi-currency profits will decline in pound terms, weighing on the stock price. Conversely, if the pound weakens, it will lift the Royal Dutch stock price. This means that the domestic economy can impact its stock market through the currency channel. Albeit it is a counterintuitive relationship: a strong economy via a strong currency hinders the stock market; a weak economy via a weak currency helps the stock market. Be Careful With Valuation Comparisons Chart of the Week to Chart I-7 should prove beyond doubt that the sector plus currency effect is all that you need to get right to allocate between these four major regions. The charts show all the permutations of relative performances taken from the S&P500, Eurostoxx50, Nikkei225 and FTSE100 over the last decade. Chart I-2FTSE 100 Vs. S&P 500 = Global Energy In Pounds Vs. Global Technology In Dollars Chart I-3FTSE 100 Vs. Nikkei 225 = Global Energy In Pounds Vs. Global Industrials In Yen Chart I-4FTSE 100 Vs. Euro Stoxx 50 = Global Energy In Pounds Vs. Global Banks In Euros Chart I-5Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Chart I-6Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Chart I-7S&P500 Vs. Nikkei225 = Global Tech In Dollars Vs. Global Industrials ##br##In Yen One important implication of sectors and currencies driving stock market allocation is that the head-to-head comparison of stock market valuations is meaningless. Two sectors with vastly different structural growth prospects – say, energy and technology – must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Likewise, if investors anticipate the pound to ultimately strengthen – because they see that the pound is structurally cheap today – they might downgrade Royal Dutch’s multi-currency profit growth expectations in pound terms and trade the stock at an apparent discount. But allowing for the anticipated decline in other currencies versus the pound there is no discount. It follows that any multinational listed in Europe will give a false impression of cheapness if investors see European currencies as structurally undervalued. Another implication is that simple ‘value’ indexes may not actually offer value. In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. The sector plus currency effect is all that you need to allocate between equity markets. Some people suggest comparing a valuation with its own history, and assessing how many ‘standard deviations’ it is above or below its norm. Unfortunately, the concept of a standard deviation is meaningful only if the underlying series is ‘stationary’ – meaning, it has no step changes through time. But sector valuations are ‘non-stationary’: they do undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange! The Current Message Last week, we pointed out that current activity indicators are losing momentum, or outright rolling over. The reason being that “both the interest rate impulse and short-term credit impulses are now on the cusp of down-oscillations, which will bear on economies and financial markets in the second half of the year.” This week’s profit warning from BASF supports this analysis. To be clear, this is not a binary issue about recession or no recession. This is just a common or garden down-oscillation in European (and global) growth which tends to happen every 18 months or so with remarkable regularity. Nevertheless, the down-oscillation has a major bearing on sector allocation (Chart I-8) and, therefore, a major bearing on regional equity allocation. Chart I-8Switch Out Of Growth-Sensitives Into Healthcare Based on the major equity index ‘sector fingerprints’ we need to rank the attractiveness of six major global sectors: Materials, Energy, Industrials, Banks, Healthcare, and Technology. In the first half of the year, Industrials outperformed while Banks underperformed. Why? Because Industrials were following the up-oscillation in growth whereas Banks were tracking the bond yield down, as the flattening (or inverting) yield curve ate into their margins. Now, the onset of a down-oscillation in growth strongly suggests a rotation out of the growth-sensitive Industrials and Materials into the relatively defensive Healthcare sector (Chart I-8). But if the sharpest move in bond yields has already happened, it also suggests that Banks might hold up versus other cyclical sectors (Chart I-9 and Chart I-10). Meanwhile, for Energy and Technology we do not hold a high-conviction view. Hence, our ranking of the sectors is as follows: Chart I-9Banks Have Tracked The Bond Yield ##br##Down... Chart I-10...But If The Sharpest Move In Yields Is Over, Banks Can Outperform Other Cyclicals Healthcare Banks Energy and Technology Industrials and Materials On the basis of this ranking, and the major equity index sector fingerprints we are making two new recommendations. Overweight Banks versus Industrials. Overweight Eurostoxx50 versus Nikkei225. For completeness, remain overweight Eurostoxx50 versus Shanghai Composite and neutral versus the S&P500. A New Look To Our Recommendations Finally, from this week onwards we are changing the way we show our investment recommendations. Trades will refer to an investment horizon of 3 months or less, and these will mostly fall within the Fractal Trading System. Cyclical Recommendations will refer to an investment horizon usually between 3 months and a year, and will be sub-divided into asset allocation, equities, and bonds, rates and currencies. Structural Recommendations will refer to an investment horizon longer than a year, and will also be sub-divided into asset allocation, equities, and bonds, rates and currencies. We are changing the way we show our investment recommendations. We have also taken the opportunity to close long-standing stale positions. We hope you find the new look more user-friendly. Next week we will be publishing a jointly written round table discussion in which we debate and explore the interesting view differences within BCA. Absent a major development in the markets, this will replace the normal weekly report. Fractal Trading System* This week we note that the strong rally in the Australian stock market has reached a 65-day fractal dimension which has signalled previous countertrend reversals especially in relative terms. Accordingly, this week’s recommended trade is short ASX 200 vs. FTSE100. The profit target is 2% with a symmetrical stop-loss. In other trades, we are pleased to report that short euro area industrials vs. market achieved its profit target and is now closed. This leaves five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The top six players are based on the six nominations for the 2019 PFA Footballer of the Year: Sergio Aguero (Argentina), Virgil Van Dijk (Netherlands), Eden Hazard (Belgium), Sadio Mane (Senegal), Bernardo Silva (Portugal), and Raheem Sterling (England). Virgil Van Dijk was the winner. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights The Chinese economy slowed in May following two months of improvement, but the June PMI data suggests that the pace of decline is moderating. Still, the economy remains highly vulnerable in a full-tariff scenario. This weekend’s agreement to continue trade talks was a weaker result compared with what emerged from the G20 meeting in Argentina, and did not represent any real progress toward a final trade agreement that includes a substantial tariff rollback. Our 6-12 month investment outlook remains unchanged: Chinese stocks face potentially acute near-term risks, but are likely to outperform global stocks over the coming year as mounting economic weakness forces policymakers to overcome their reluctance to act and to ultimately stimulate as needed. Feature The Caixin PMI decline in June appears to have been preceded by the official PMI in May. No change in the latter in June is thus somewhat encouraging. Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, May’s activity data shows that the economy slowed following two months of improvement, which underscores that the budding, credit-driven recovery in China’s investment relevant economic activity remains in its infancy and is vulnerable to a further deterioration in external demand. The Caixin manufacturing PMI fell back below the 50 mark in June, but this appears to have simply confirmed the prior decline in the official PMI. June’s official PMI was flat on the month, which in combination with only a modest further decline in new export orders, implies that the May slowdown in activity noted above did not repeat itself in June (at least not in terms of magnitude) Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, Chinese stocks actively outperformed the global benchmark over the past month as the latter rallied. The rally was in response to assurances from the PBoC about the capacity to ease further if needed, and the steadily rising odds over the course of the month that a new tariff ceasefire would be reached at the G20 meeting in Osaka. While this expectation was indeed validated, our view is that the agreement to continue talks was a weaker result compared with what emerged from the G20 meeting in Argentina, and did not represent any real progress toward a final trade agreement that includes a substantial tariff rollback. As such, our 6-12 month investment outlook remains unchanged: Chinese stocks face potentially acute near-term risks, but are likely to outperform global stocks over the coming year as mounting economic weakness forces policymakers to overcome their reluctance to act and to ultimately stimulate as needed. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1A Sharp Decline In Electricity Production China’s economy slowed in May according to the Bloomberg Li Keqiang index, after having picked up for two months in a row. While both electricity production and rail cargo volume fell in May, the former fell sharply, almost into negative territory (Chart 1). This underscores that the budding, credit-driven recovery in China’s investment relevant economic activity remains in its infancy, and that economic activity is set to deteriorate meaningfully in a full-tariff scenario. Our LKI leading indicator rose modestly in May, with all six components showing an improvement. Still, the uptrend in the indicator is slight, and is being held back by the money supply components, particularly the growth in M2. Much stronger money & credit growth will be required if Chinese economic activity relapses and no deal to end U.S. import tariffs has occurred, but policymakers are likely to be reactive rather than proactive in this regard. The picture painted by China’s housing data continues to be a story of weak housing demand arrayed against seemingly strong housing construction and stable growth in house prices. However, we noted in a May 9 joint Special Report with our Emerging Market Strategy service that the strength observed in floor space started over the past year reflected a funding strategy by cash-strapped real estate developers.1 Launching new projects aggressively last year – i.e., more property starts – allowed real estate developers to pre-sell property units in order to raise cash in a tight credit environment. On the demand side, the annual change in the PBOC’s pledged supplementary lending injection has strongly predicted floor space sold over the past four years; it remains deeply in negative territory and our measure declined in May for the 8th month in a row. Given that housing construction cannot sustainably decouple from housing demand, we expect floor space started to slow meaningfully over the coming several months absent a major pickup in housing sales. Chart 2The Flat Official PMI In June Is Somewhat Encouraging The Caixin manufacturing PMI fell back below the 50 mark in June, but this appears to have simply confirmed the prior decline in the official PMI (Chart 2). The official PMI was flat in June with only a modest further decline in new export orders, which implies that the May slowdown in activity noted above did not repeat itself in June, at least not in terms of magnitude. Chinese stocks have rallied 8-9% over the past month in U.S. dollar terms, outpacing the EM and global equity benchmarks. The rally initially followed comments from Governor Yi Gang that the PBoC had “tremendous” room to ease monetary policy if needed, and was sustained by expectations later in the month of a second tariff truce emerging from the G20 meeting in Osaka. For China-exposed investors, the issue is not whether Chinese policymakers have the capacity to support China’s economy, but rather the willingness to ease materially. From our perspective, the renewal of trade talks with the U.S. does not represent material progress towards the ultimate removal of tariffs. But the existence of talks is likely to give Chinese authorities a reason (for now) to avoid aggressively stimulating the economy, meaning that our 6-12 month investment outlook remains unchanged. Chart 3The BAT Stocks Will Outperform China If Chinese Stocks Outperform Global The significant outperformance of the investable consumer discretionary has been the most meaningful equity sector development over the past month. We have noted in past reports that changes last December to the global industry classification standard (GICS) mean that trends in investable consumer discretionary are now largely driven by Alibaba’s stock price, and Chart 3 highlights that the BAT stocks (Baidu, Alibaba, and Tencent) have indeed risen relative to the overall investable index. We noted in last month’s macro & market review that investors appeared to be wrongly conflating the risks facing Huawei (U.S. supply chain reliance) with those facing the BATs (the outlook for Chinese consumer spending), and the outperformance of the latter over the past month, as expectations mounted of another tariff truce emerging from the G20, would appear to validate this view. This implies that the outlook for the relative performance of the BATs versus the Chinese equity benchmark is likely to be the same as that of Chinese stocks versus the global benchmark: near-term risk, but likely to outperform over a 6-12 month time horizon. Chinese interbank rates fell over the past month, in response to an injection of liquidity by the PBoC following the collapse and takeover of Baoshang bank. The event marked the first takeover of a commercial bank in China since 1998, and has been described by authorities as an isolated event that was caused, in part, by the illegal use of bank funds. Market participants have clearly been concerned that Baoshang is not an isolated event; China’s 3-month interbank repo rate rose nearly 60bps from early-April to mid-June, and the PBoC’s response was intended to help prevent a significant tightening in credit conditions for China’s smaller lenders. While bad debt concerns have clearly impacted the interbank market over the past several weeks, there has been little impact on China’s onshore corporate bond market (Chart 4). Spreads on bonds rated AA+ did rise meaningfully in June, but have since nearly returned to late-May levels. We continue to recommend an overweight stance towards Chinese onshore corporate bonds, on the basis that market participants are pricing in a much higher default rate than we expect over the coming 6-12 months. The risk to Hong Kong is not the stability of the peg, but the impact of higher interest rates on an extremely leveraged economy. Chart 4The Onshore Corporate Bond Market Is Not Concerned By The Baoshang Takeover Chart 5HKD Strength Reflects More Than Just Falling U.S. Rate Expectations The Hong Kong dollar has strengthened significantly over the past month, with USD-HKD having retreated to the midpoint of its band. This has occurred in part because of declining U.S. interest rate expectations, but also because of a sharp rise in 3-month HIBOR versus the base rate (Chart 5). The strengthening in HIBOR seems linked to the anti-extradition bill protests, implying that HKD has strengthened due to anti-capital flight measures by the HKMA. We see no major risk to the currency peg at the moment, but discussed the negative implications of higher interest rates in Hong Kong on the region’s property market and share prices in last week’s joint report with our Emerging Market Strategy service.2 Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy and China Investment Strategy Special Report, “China’s Property Market: Making Sense Of Divergences”, dated May 9, 2019, available at cis.bcaresearch.com. 2 Please see Emerging Markets Strategy and China Investment Strategy Special Report, “Hong Kong’s Currency Peg: Truths And Misconceptions”, dated June 27, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
In the context of de-risking our portfolio, this past Monday we added the S&P banks index on our downgrade watch list. The Fed’s signal of a cut in the upcoming July meeting has steepened the yield curve. While the yield curve has put in higher lows in the past eight months, relative bank performance has been facing stiff resistance and has failed to follow the yield curve’s lead (top panel). With regard to credit demand, the latest Fed Senior Loan Officer survey remained subdued confirming the anemic reading from our Economic Impulse Indicator (a second derivative gauge of six parts of the U.S. economy, bottom panel). Worrisomely, not only is the overall U.S. credit impulse contracting, but also U.S. Equity Strategy’s bank credit diffusion index is collapsing (middle panel). Such broad breadth of loan growth deterioration warns that bank earnings are at risk of underwhelming still optimistic sell-side analysts’ expectations (not shown). Bottom Line: We remain overweight the S&P banks index, but have put it on downgrade alert and are looking for an opportunity to downgrade to neutral. For additional details please refer to this Monday’s Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BaAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC.