Fixed Income
Please note that we will be presenting a webcast on Thursday March 11 at 10:00 AM EST for the Americas and EMEA regions and on March 12 at 9:00 HKT/12:00 AEDT for APAC clients. We will be discussing macro themes and investment strategies. Highlights EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were in 2013. Yet better does not mean they will be unscathed. The combination of rising US bond yields and a firming US currency will suffocate EM risk assets in the near-term. A neutral allocation is warranted in EM stocks and credit markets within global equity and credit portfolios, respectively. Feature Ever since the US elections concluded in January with a Blue Sweep, we have been warning that rising US bond yields could trigger a setback in global markets in general, and in EM markets in particular. EM equities, currencies and fixed-income markets have recently experienced a correction (Chart 1). The question now is: Is the market rout over? Or is there more to come? We are inclined to believe that the correction is not over. Rising US Treasury yields have been the culprit of the shakeout in global growth stocks, EM equities, as well as EM currencies. Therefore, taking a stance on US bond yields and on the US dollar is critical for assessing the outlook for EM financial markets. Odds are that the selloff in US long-term bonds and the rebound in the US dollar are not yet over because: Positioning and sentiment on US long-dated Treasuries is neutral, as illustrated in Chart 2. Chart 1Rising US Real Yields Have Caused A Shakeout In EM Chart 2Investor Sentiment And Positioning In US Treasurys Are Neutral Typically, US bond yields do not reverse their ascent until investor sentiment becomes downbeat and bond portfolios are of materially short duration. These conditions for a top in bond yields are not yet present. US government bond yields would have been much higher if it were not for the Federal Reserve and US commercial banks’ massive bond-buying spree. The Fed has bought $2.8 trillion and US commercial banks have purchased about $300 billion of Treasurys in the past 12 months (Chart 3). One of the main motives for commercial banks to buy US Treasurys has been the SLR relief initiative which commenced on April 1, 2020.1 This SLR relief is due to terminate on March 31, 2021. Unless it is extended, commercial banks will drastically curtail their net government bond purchases. This will exert upward pressure on Treasury yields. Regarding the greenback, investor sentiment remains quite bearish (Chart 4). From a contrarian perspective, this heralds further strength in the US dollar. Chart 3Surging Purchases Of US Treasurys By The Fed And Commercial Banks Chart 4Investors Are Still Bearish On The US Dollar From a cyclical perspective, US growth will be stronger relative to its potential, and vis-à-vis other DMs, EMs and China. Growth differentials moving in favor of the US foreshadows near-term strengthening of the dollar. Structurally, the bearish case for the US currency hinges on both the Federal Reserve falling behind the inflation curve and ballooning US twin deficits. In our view, this will ultimately be the case. Hence, the long-term outlook for the US dollar remains troublesome. That said, twin deficits alone are insufficient to produce a continuous currency depreciation. The twin deficits must also be accompanied with low/falling real interest rates – in order to generate sufficient conditions for currency depreciation. As long as US real rates continue rising, the dollar’s rebound will be extended. The USD/EUR exchange rate has been correlated with the 10-year real yield differential and this relationship will persist (Chart 5). Bottom Line: US government bonds will continue selling off. Rising bond yields (including rising real yields) will support the dollar in the near-term. The combination of rising US bond yields and a firming US currency will cause global macro volatility to rise (Chart 6). This will suffocate EM risk assets and EM currencies. Chart 5US Real Yields (TIPS) Will Continue Driving The US Dollar Chart 6Aggregate Financial Market Volatility: Higher Lows Impact On EM: 2013 Versus Now Are we entering another Taper Tantrum episode as in the spring of 2013 when many EMs were devastated? There are both similarities and differences between the current period of rising US bond yields and the 2013 episode. Similarities: Today, as in early 2013, investor sentiment on EM is very bullish and investors are long EM (Chart 7). Chart 7Investor Sentiment On EM Stocks Was At A Record High In January In early 2013, as is the case today, EM local currency bond yields were very low and EM credit spreads were too tight. When US Treasury yields spiked in the spring of 2013, EM assets tanked. Many commentators blamed it on the Fed. We disagree with that interpretation. Remarkably, the rise in US TIPS yields in 2013 had little impact on equity indices such as the S&P 500 and Nasdaq, or on US corporate spreads (Chart 8). The correction in the US equity market lasted about a week. Yet, EM equities, fixed income markets and currencies experienced a prolonged slump, and in many cases, a bear market. There is no basis to believe that the Fed’s policy and US bond yields are more important to EM than they are to US credit and equity markets. The core rationale for the EM bear market in 2013 was poor domestic fundamentals. The Fed’s tapering was the trigger, not the cause. Differences: The key difference between the current episode and the 2013 Taper Tantrum is EM macro fundamentals. Specifically: EM economies (ex-China, Korea and Taiwan) entered 2013 with booming bank loans and strong domestic demand as well as high inflation (Chart 9). Chart 8US Markets Were Not Hit By The Taper Tantrum In 2013 Chart 9EM (ex-China, Korea And Taiwan): 2013 Vs Now Chart 10EM (ex-China, Korea And Taiwan): 2013 Vs Now Presently, EM bank credit is subdued, domestic demand is dismal, and inflation is tame. Besides, EMs (ex-China, Korea and Taiwan) had a very large trade deficits in 2013 and were financing them via foreign borrowing, which was roaring prior to 2013 (Chart 10). Presently, their trade balances are in surplus and foreign indebtedness has not increased in recent years. Bottom Line: In 2013, EM economies (ex-China, Korea and Taiwan) were overheating and were addicted to foreign funding. These were the reasons why EM currencies and fixed income markets teetered when US bond yields spiked in 2013. Presently, the majority of EM economies (ex-China, Korea and Taiwan) have different types of malaises: domestic bank loan origination is too timid, consumer spending and capital expenditures are moribund, inflation is low and fiscal policy is tight. Consequently, EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were back in 2013. Yet better does not mean they will be unscathed. Investment Strategy Equities: The key variable to watch to assess the vulnerability of both US and EM equity markets is their respective corporate bond yields. Historically, rising corporate bond yields (shown inverted in both panels of Chart 11) heralds lower share prices. Chart 11Rising Corporate Bond Yields Are Bad For Share Prices Given that both EM and US corporate credit spreads are too tight, they are unlikely to narrow further to offset rising US Treasury yields. Instead, EM and US corporate bond yields are likely to rise with US Treasury yields. This will trigger more weakness in share prices. Besides, rising EM local currency government bond yields also point towards more downside in EM equities (yields are shown inverted on the chart) (Chart 12). Chart 12Rising EM Local Currency Bond Yields Heralds Weaker Equity Prices Concerning equity style, global growth stocks have peaked versus global value stocks. In the EM equity space, we have less conviction on growth versus value. As to regional allocation in a global equity portfolio, we continue recommending a neutral allocation to EM, underweighting US and overweighting Europe and Japan. Commodities: Investors’ net long positions in commodities are very elevated (Chart 13). As US bond yields rise and the US dollar continues rebounding, there will be a de-risking in the commodities space resulting in a pullback in commodities prices. Currencies: We continue shorting a basket of EM currencies – including BRL, CLP, ZAR, TRY and KRW versus the euro, CHF and JPY. Several EM currencies have failed to break above their technical resistance levels, suggesting that a pullback could be non-trivial (Chart 14). Chart 13Investors Are Record Long Commodities Chart 14Asian Currencies Hit Technical Resistances In central Europe, we are closing the long CZK/short USD trade with a 3.8% gain. Continue holding the long CZK/short PLN and HUF position. Local fixed income markets: EM local bond yields have risen in response to rising US treasury real yields and the setback in EM currencies. This might persist in the near-term, but we continue to recommend receiving 10-year swap rates in selected countries where inflation risks are low and monetary and fiscal policies are tight. These countries include Mexico, Colombia, Russia, China, India and Malaysia. A further rise in their swap rates would represent an overshoot and hence, should not be chased. EM currencies are more vulnerable to a selloff than local rates are. We continue to wait for a better entry point in currencies to recommend buying cash domestic bonds instead of receiving swap rates. EM Credit: A neutral allocation to EM sovereign and corporate bonds is warranted in a global credit portfolio. Our sovereign credit overweights are Mexico, Russia, Malaysia, Peru, Colombia, the Philippines and Indonesia, while our sovereign credit underweights are Brazil, South Africa and Turkey. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 The Supplementary Leverage Ratio (SLR) is equivalent to Basel III Tier-1 leverage ratio and varies from 3-5% for US banks. Under the relief program last April, the Fed allowed US banks to exclude holdings of US Treasury Bonds and cash kept in reserves at the Fed from their assets when calculating this ratio. The SLR relief is planned to end March 31, 2021. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights China’s economic recovery is in a later stage than the US. A rebound in US Treasury yields is unlikely to trigger upward pressure on government bond yields in China. Imported inflation through mounting commodity and oil prices should be transitory and does not pose enough risk for Chinese authorities to further tighten policies. Historically, Chinese stocks have little correlation with changes in US Treasury yields; Chinese equity prices are primarily driven by the country’s domestic credit growth and economic conditions. We maintain our tactical (0 to 3 months) neutral position on Chinese stocks, in both absolute and relative terms. However, the near-term pullbacks are taking some air out of Chinese equities' frothy valuations, providing room for a cyclical upswing. Chinese offshore stocks, which are highly concentrated in the tech sector, are facing multiple challenges. We are closing our long investable consumer discretionary/short investable consumer staples trade and we recommend long A-shares/short MSCI China Index. Feature Chinese stocks extended their February losses into the first week of March. Market participants fear that escalating real government bond yields in the US and elsewhere will have a sustained negative impact on Chinese risk assets, reinforced by ongoing policy normalization in China. Global equity prices have been buffeted by crosscurrents. An acceleration in the deployment of vaccines and increased economic reopenings provide a positive backdrop to the recovery of corporate profits. At the same time, optimism about global growth and broadening fiscal stimulus in the US has prompted investors to expect higher policy rates sooner. The US 10-year Treasury yield is up by 68bps so far this year, depressing US equity valuations and sending ripple effects across global bourses. In this report, we examine how rising US and global bond yields would affect China’s domestic monetary policy and risk-asset prices. Will Climbing US Treasury Yields Push Up Chinese Rates? Chart 1Chinese Gov Bond Yields Have Led The US Counterpart Since 2015 Increasing bond yields in the US will not necessarily lead to higher bond yields in China. Chart 1 shows that the direction of China’s 10-year government bond yield has a tight correlation with its US counterpart. It is not surprising because business cycles in these giant economies have become more synchronized. Interestingly, China’s 10-year Treasury bond yield has led the US one since 2015. This may be due to China’s growing importance in the world economy. China’s credit and domestic demand growth leads the prices of many industrial metals and in turn, business cycles in many economies. China’s rising long-duration government bond yields reflect expectations of an improving domestic economy, and these expectations often spill over to the rest of the world, including the US. Although the recent sharp rebound in the US Treasury yield is mainly driven by domestic factors, the rebound is unlikely to spill over to their Chinese peers, because the countries are in different stages of their business and policy cycles. America is still at its early stage of economic recovery and fresh stimulus measures are still being rolled out, whereas China has already normalized its policy rates back to pre-pandemic levels and its credit growth peaked in Q4 last year. Chinese fixed-income markets will soon start pricing in moderating growth momentum in the second half of this year, suppressing the long-end of China’s Treasury yield curve (Chart 2). Importantly, none of the optimism that has lifted US Treasury yields - a vaccine-led global growth recovery and a massive US fiscal stimulus – would warrant a better outlook for China. Reopening worldwide economies will likely unleash pent-up demand for services, such as travel and catering, rather than merchandise trade. Chart 3 shows that since the pandemic US spending on goods, which benefited Chinese exports, has soared relative to spending on services. The trend will probably reverse when the US and world economy fully opens, limiting the upside for China’s exports and its contribution to growth this year. Chart 2China And The US Are In Different Stages Of Their Economic Recoveries Chart 3US Consumers Have Been Spending Much More On Goods Than Services During The Pandemic Bottom Line: China’s waning growth momentum will insulate Chinese bond yields from higher US Treasury yields. Do Rising Inflation Expectations In The US Pose Risks Of Policy Tightening In China? Chart 4Imported Inflation Shouldnt Constrain The PBoC While China’s monetary policymaking is not entirely insulated from exogenous shocks, it is primarily driven by domestic economic conditions and inflation dynamics. We are not complacent about the risk of a meaningful uptick in global inflation, but we do not consider imported inflation a major policy constraint for the PBoC this year (Chart 4). Furthermore, at last week’s National People’s Congress (NPC), China set the inflation target in 2021 at 3%, which is a high bar to breach. Mounting commodity prices, particularly crude oil prices, may put upward pressures on China’s producer prices, but their impact on China’s overall inflation will be limited for the following reasons: China accounts for a large portion of the world’s commodity demand. Given that the country’s credit impulse has already peaked, domestic demand in capital-intensive sectors (such as construction and infrastructure spending) will slow this year. Reinforced policy restrictions on the property sector will also restrain the upside price potential in industrial raw materials such as steel and cement (Chart 5). For producers, the main and sustained risk for imported inflation will be concentrated in crude oil. The PPI may spike in Q2 and Q3 this year due to advancing oil prices and the extremely low base factor from the same period last year. The PBoC will likely view a spike in the PPI as transitory. Moreover, the recent improvement in producer pricing power appears to be narrow. The output price for consumer goods, which accounts for 25% of the PPI price basket, remains subdued (Chart 6). Chart 5Chinas Demand For Raw Materials Will Slow Chart 6Output Price For Consumer Goods Remains In Contraction Importantly, when oil prices plummeted in the first half of 2020, China’s crude oil inventories showed the fastest upturn on record (Chart 7). It suggests that China’s inventory restocking from last year may help to partially offset the impact from elevated oil prices this year. For consumers, oil prices account for a much smaller percentage of China’s CPI basket than in the US (Chart 8). Food prices, particularly pork, drive China’s headline CPI and can be idiosyncratic. We expect food price increases to be well contained this year due to improved supplies and the high base effect from last year. Chart 7Massive Buildup in Chinas Crude Oil Inventory In 2020 Chart 8Oil Prices Account For A Small Portion In China's Consumer Spending Importantly, China’s inflation expectations have not recovered to their pre-pandemic levels and consumer confidence on future income growth also remains below its end-2019 figure (Chart 9). If this trend holds, then it will be difficult for producers to pass through escalating input costs to end users. Although China’s economy has strengthened, it is far from overheating (Chart 10). Without a sustained above-trend growth rebound, it is difficult to expect genuine inflationary pressures. The pandemic has distorted the balance of global supply and demand, propping up demand and price tags attached to it. In China’s case, however, production capacity and capital expenditures rebounded faster than demand and consumer spending, constraining the upsides in inflation (Chart 11). Chart 9Consumer Inflation Expectations Have Not Fully Recovered Chart 10Chinese Economy Is Not Yet Overheating China’s CPI is at its lowest point since 2009, making China’s real yields much greater than in the US. Rising real US government bond yields could be mildly positive for China because they help to narrow the Sino-US interest rate differential and temper the pace of the RMB’s appreciation (Chart 12). A breather in the RMB’s gains would be a welcome reflationary force for Chinese exporters and we doubt that Chinese policymakers will spoil it with a rush to hike domestic rates. Chart 11And Production Has Recovered Faster Than Demand Chart 12Narrowing Real Rate Differentials Helps To Tamper The RMB Appreciation Bottom Line: It is premature to worry about an inflation overshoot in China. The current environment is characterized as easing deflation rather than rising inflation. Our base case remains that inflationary pressures will stay at bay this year. Are Higher US Treasury Yields Headwinds For Chinese Stocks? Historically, Chinese stocks have exhibited a loose cyclical correlation with US government bond yields, particularly in the onshore market (Chart 13). Equity prices in China are more closely correlated with domestic long-duration government bond yields, but the relationship is inconsistent (Chart 14). Chart 13Chinese Stocks Have Little Correlation With US Treasury Yields Chart 14Correlations Between Chinese Stocks And Domestic Gov Bond Yields Are Inconsistent Chinese stocks are much more sensitive to changes in the quantity of domestic money supply than the price of money. A sharp rebound in China’s 10-year government bond yield in the second half of last year did not stop Chinese stocks from rallying. The insensitivity of Chinese stocks to changes in the price of money is particularly prevalent during the early stage of an economic recovery. As we pointed out in a previous report, since 2015 the PBoC has shifted its policy to target interest rates instead of the quantity of money supply. Thus, credit growth, which propels China’s business cycle and corporate profits, can still trend higher even as bond yields pick up. This explains why domestic credit growth, rather than China’s real government bond yields, has been the primary driver of the forward P/E of Chinese stocks (Chart 15A and 15B). This contrasts with the S&P, in which the forward P/E ratio moves in lockstep with the inverted real yield in US Treasuries (Chart 16). Chart 15ACredit Growth Has Been Driving Up Chinese Stock Valuations Chart 15BCredit Growth Has Been Driving Up Chinese Stock Valuations Credit growth in China peaked in Q4 last year and the intensity of the economic recovery has started to moderate. Hence, regardless of the changes in bond yields, Chinese stocks will need to rely on profit growth in order to sustain an upward trend (Chart 17). Chart 16Falling Real Rates Were Propping Up US Equity Valuations Chart 17Earnings Growth Needs To Accelerate To Support Chinese Stock Performance The good news is that recent gyrations in the US equity market, coupled with concerns about further tightening in China’s domestic economic policy have triggered shakeouts in China’s equity markets. The pullback in stock prices has helped to shed some excesses in frothy Chinese valuations and has opened a door for more upsides in Chinese stock on a cyclical basis. Bottom Line: Rising Treasury yields in the US or China will not have a direct negative impact on Chinese equities. Last year’s massive credit expansion has lifted both earnings and multiples in Chinese stocks and an acceleration in earnings growth is now needed to support stock performance. Investment Implications The key message from last week’s NPC meetings suggests that policy tightening will be gradual this year. While the 6% growth target was lower than expected, it represents a floor rather than a suggested range and it will likely be exceeded. Bond yields and policy rates are already at their pre-pandemic levels, indicating that there is not much room for further monetary policy tightening this year. The announced objectives for the fiscal deficit and local government bond quotas are only modestly smaller than last year. The economic and policy-support targets support our view that policymakers will be cautious and not overdo tightening. We will elaborate on our takeaways from this year’s NPC in next week’s report. Chart 18Chinese Cyclicals Can Still Benefit From An Improving Global Economic Backdrop Meanwhile, there is still some room for Chinese cyclical stocks to run higher relative to defensives, given the current Goldilocks backdrop of global economic recovery and accommodative monetary policy (Chart 18). We maintain a tactical (0 to 3 months) neutral position on Chinese stocks, in both absolute and relative terms. The market correction has not fully run its course. However, the near-term pullbacks are taking some air out of Chinese equities' frothy valuations, providing room for a cyclical upswing. We are closing our long investable consumer discretionary/short investable consumer staples trade. Instead, we recommend the following trade: long A-share stocks/short MSCI China Index. Investable consumer discretionary sector stocks, which are concentrated in China’s technology giants, face a confluence of challenges ranging from the ripple effects of falling stock prices in the US tech sector and tightened antitrust regulations in China (Chart 19). In contrast, the A-share index is heavily weighted in value stocks while the MSCI China investable index has a large proportion of expensive new economy stocks (Chart 20). The trade is in line with our view that the investment backdrop has shifted in favor of global value versus growth stocks due to a strong US expansion, rising US bond yields and a weaker US dollar. Chart 19Chinese Investable Tech Sector Is Facing Strong Headwinds Chart 20Overweight A Shares Versus Chinese Investable Stocks Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
According to BCA Research’s US Bond Strategy service, only two of the five milestones on their Checklist For Increasing Portfolio Duration have been reached. Thus, a below-benchmark portfolio duration remains appropriate. The first item on the Checklist is…
Highlights Duration: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. The Fed & Financial Conditions: The recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. The Fed & The Labor Market: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Feature Chart 1Bearish Trend Intact The bond bear market rages on. The Bloomberg Barclays Treasury Index returned -1.8% in February, its worst monthly performance since 2016. The sell-off then continued through the first week of March, culminating with the 10-year Treasury yield touching 1.56% as of Friday’s close (Chart 1). The 5-year/5-year forward Treasury yield ended the week at 2.41%, near the top-end of primary dealer estimates of the long-run neutral fed funds rate (Chart 1, bottom panel). We don’t want to catch a falling knife, but eventually, yields will look attractive enough for us to increase our recommended portfolio duration. To help us make that decision, we unveiled a Checklist For Increasing Portfolio Duration in our February Webcast (Table 1).1 Table 1Checklist For Increasing Portfolio Duration This week, we check-in with our Checklist, concluding that it is still too early to increase portfolio duration. Checking-In With Our Duration Checklist Chart 2Cyclical & Valuation Indicators The first item on our Checklist is the 5-year/5-year forward Treasury yield reaching levels consistent with survey estimates of the long-run neutral fed funds rate. As noted above, this condition has been met. Second, we would like to see survey-derived measures of the 10-year term premium reach extended levels. Specifically, we’d like to see them approach their 2018 peaks (Chart 2). Currently, our two measures are sending diverging signals. The term premium derived from the New York Fed’s Survey of Market Participants is 60 bps, only 15 bps off its 2018 peak. However, the term premium derived from the New York Fed’s Survey of Primary Dealers is only 22 bps, 53 bps off its 2018 peak. For now, our assessment is that this condition has not been met. It’s important to note that the surveys used to construct our two term premium measures and to obtain our fair value range for the 5-year/5-year forward Treasury yield have not been updated since January, and that they will be revised ahead of this month’s FOMC meeting. If primary dealers and market participants revise up their fed funds rate expectations, then our valuation measures will give the 10-year yield more room to rise. Third, we continue to track high-frequency cyclical economic indicators like the CRB/Gold ratio (Chart 2, panel 3) and the relative performance of cyclical versus defensive equity sectors (see section titled “The Fed’s Approach To Financial Conditions” below). These measures have yet to show any signs of deterioration, consistent with an environment where bond yields should be rising. Fourth, if current trends continue, we are concerned that US yields may rise too far compared to yields in the rest of the world. This could entice foreign inflows into the US bond market, sending yields back down. Historically, bullish sentiment toward the US dollar is a good indicator of when US yields have risen too far. At present, dollar sentiment remains extremely bearish (Chart 2, bottom panel). This suggests that we are not yet close to the point when foreign purchases will push US yields lower. Finally, we consider the market’s fed funds rate expectations relative to the Fed’s most recent forecast, as inferred from its quarterly “dot plot”. Currently, the market is priced for Fed liftoff to occur in January 2023, with a second rate hike delivered in May 2023 and a third in October 2023 (Chart 3). This is considerably more hawkish than the Fed’s median forecast from December, which called for no rate hikes until at least 2024! Chart 3Market Expects Liftoff In January 2023 We think it’s conceivable that economic conditions could warrant Fed liftoff in late-2022 (see section titled “Tracking Payrolls And The Countdown To Fed Liftoff” below), but the Fed will probably be more cautious about how quickly it brings its expected liftoff date forward. FOMC participants will have an opportunity to push back against the market when they update their funds rate forecasts at this month’s meeting. The Fed will likely bring forward its anticipated liftoff date, but probably not all the way to January 2023. This could halt the uptrend in bond yields, at least for a while. Bottom Line: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. Other surveys used in the construction of our term premium estimates and 5-year/5-year yield targets will also be updated around this time. The Fed’s Approach To Financial Conditions Chart 4Financial Conditions Are Easy Remarks from Fed Chair Jay Powell were a catalyst for higher bond yields last week. Apparently, there had been some expectation in the market that Powell would use his platform to express concern about the recent increase in long-maturity bond yields. In fact, many expected him to foreshadow changes to the Fed’s balance sheet policy, either extending the maturity of its ongoing asset purchases or initiating an Operation Twist, where the Fed sells short-dated securities and buys long-dated ones.2 Powell didn’t announce any of these things. In fact, he didn’t even express concern about the recent rise in long-dated yields despite being given several opportunities to do so. To understand why, we need to understand how the Fed thinks about financial conditions. The Fed only cares about conditions in financial markets to the extent that they are expected to influence the real economy. This means that the Fed takes a broad view of financial conditions, including bond yields, credit spreads and equity prices. From this perspective, financial markets do not currently pose a risk to the economy (Chart 4). Yes, long-dated bond yields have risen, but short-dated yields remain low. Credit spreads also remain very tight and equity prices have only dipped modestly from high levels. The Chicago Fed’s broad index of financial conditions shows that they are extremely accommodative (Chart 4), and thus support continued economic recovery. This financial market back-drop is not one that will cause the Fed to take additional actions to ease policy. Even the recent drop in the stock market appears to be more a reflection of economic optimism than a cause for concern. Looking at the performance of different equity sectors, we find that the sectors that stand to benefit from the end of the pandemic and economic re-opening are surging. Meanwhile, the sectors that are performing poorly are simply giving back some of the huge gains that were realized when the pandemic was raging last year. For example, cyclical sectors (Industrials, Energy and Materials) are soaring while defensive sectors (Healthcare, Communications, Consumer Staples and Utilities) have hooked down (Chart 5A). The ratio between the two remains tightly correlated with the 10-year Treasury yield. Similarly, Bank stocks have exploded higher since bond yields troughed last fall while the Technology sector has had difficulty making further gains (Chart 5B). Last year, the Tech sector benefited from low bond yields and surging demand. This year, Banks stand to profit from higher yields and an improving labor market. Finally, our US Equity Strategy team put together a basket of “COVID-19 Winners” designed to profit from the pandemic and a basket of “Back To Work” stocks designed to benefit from economic re-opening. Not surprisingly, the former is dragging the S&P 500 lower while the latter is on a tear (Chart 5C). Chart 5ASector Rotation: Cyclicals Vs. Defensives Chart 5BSector Rotation: Banks Vs. Tech Chart 5CSector Rotation: COVID Winners Vs. Re-Open Winners The bottom line is that the recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. Other Reasons For The Fed To Change Its Balance Sheet Policy In addition to concerns about a drop in the stock market, several other reasons have been given for why the Fed might consider either increasing its asset purchases or shifting them toward the long end of the curve. 1) Treasury Market Liquidity Chart 6Treasury Market Liquidity First, there is an ongoing tension in the Treasury market between imposing stricter capital regulations on dealer banks and ensuring that they have enough balance sheet capacity to maintain Treasury market liquidity during periods of stress.3 This delicate equilibrium broke down last March when Treasury market liquidity evaporated at a time when both equities and bonds were crashing. The Fed was forced to step into the Treasury market to sustain market functioning. Last week’s Treasury sell-off had a whiff of illiquidity about it as well. One liquidity index that measures the average curve fitting error across all government bond yields increased slightly, but not nearly as much as it did last March (Chart 6). Treasury bid/ask spreads also widened a touch, but unlike last March, Treasury ETFs continued to trade close to their net asset values. A significant deterioration in Treasury liquidity would prompt a quick response from the Fed. That is, the Fed would quickly ramp up purchases to restore market functioning. However, last week’s blip was not nearly severe enough to raise alarm bells. Other periods of Treasury market stress that have prompted the Fed to step in have occurred during periods of extreme economic deterioration and market panic, such as in March 2020 and 2008. With economic growth accelerating rapidly, we place low odds on a major Treasury market liquidity event occurring this year. 2) Expiry Of The SLR Exemption Chart 7Reserve Supply Is Massive A second possible reason for the Fed to change its balance sheet policy is the upcoming expiry of the exemption to the Supplementary Leverage Ratio (SLR). The SLR is a regulation that requires large banks to hold common equity capital totaling at least 5% of assets. Assets are not risk-weighted for the purposes of the SLR. A problem arose with the SLR last March when the Fed bought massive amounts of bonds, flooding the banking system with reserves (Chart 7). The problem is that banks are forced to hold those reserves, and this makes it more difficult for them to meet their SLR requirement. To alleviate the problem, the Fed announced that reserves and Treasury securities would be exempted from the SLR calculation. Today, the issue is that this exemption is scheduled to expire at the end of March and the Fed has yet to announce whether it will be extended or allowed to lapse. Table 2US Bank Supplementary Leverage Ratios If the exemption lapses, then banks may try to unload Treasury securities to remain compliant with the SLR. In theory, this could lead to upward pressure on Treasury yields that the Fed could mitigate by ramping up its asset purchases. However, it’s unclear how much of an impact a lapsing of the SLR exemption would actually have on the Treasury market. Even adjusting for a lapsing of the exemption, all major US banks remain compliant with the 5% SLR (Table 2). Also, banks could always decide to increase their SLRs by reducing share buybacks rather than by shedding Treasuries. In any event, an increase in Fed asset purchases to lean against rising Treasury yields driven by bank selling would be counterproductive. It would only flood the banking system with more reserves, making the SLR even more difficult to meet. Our view is that a fair compromise would be for the Fed to continue the SLR exemption for bank reserves, but to allow the Treasury security exemption to lapse. But even if the SLR exemption is allowed to lapse completely, we doubt that it will lead to enough market turmoil to prompt a change in the Fed’s balance sheet strategy. 3) Supply/Demand Imbalance In Money Markets Finally, some have noted that the large and growing supply of bank reserves could lead to problems in money markets. Specifically, with the Treasury Department now in the process of paying down its cash account (Chart 7, bottom panel), there is a lot of cash flooding into money markets and coming up against limited T-bill supply. In theory, the Fed could try to mitigate this problem by engaging in an Operation Twist – selling some T-bills and buying some coupon bonds. But we doubt this will occur. The Fed already has tools in place to maintain control over short rates in such circumstances. For example, the same situation arose in 2013 when an over-supply of bank reserves pushed short rates down toward the bottom of the Fed’s target range (Chart 8A). The Fed’s response was to create the Overnight Reverse Repo Facility (ON RRP). This facility allows counterparties to park excess cash at the Fed in exchange for a security off the Fed’s balance sheet. This proved to be an effective floor on repo rates and the fed funds rate, and we expect it will be again (Chart 8B). Chart 8AFed Created ON RRP In 2013... Chart 8B... It Remains A Firm Floor On Rates T-bill yields remained below the ON RRP rate for some time in 2014 and 2015, and the same thing could happen again this year. But this will not be a major concern for the Fed as long as it maintains control over the fed funds rate and the overnight repo rate. Eventually, the Treasury Department can deal with the lack of bill supply by increasing the amount of T-bill issuance. Bottom Line: Treasury market liquidity remains an ongoing concern for the Fed, and the possible expiry of the SLR exemption and lack of T-bill supply present additional near-term technical challenges. We think it’s unlikely that any of these things will prompt the Fed to deviate from its current pace and composition of asset purchases in 2021. Tracking Payrolls And The Countdown To Fed Liftoff Chart 9The Fed's Maximum Employment Targets Employment growth surprised to the upside in February as 379 thousand jobs were added to nonfarm payrolls. This sent bond yields higher, but we caution that even stronger employment growth will be required to keep bond yields rising going forward. The Fed needs to see a return to “maximum employment” before it will lift rates off the zero bound. This means not only that the unemployment rate will have to fall to a range of 3.5% to 4.5%, but also that the labor force participation rate must make a full recovery to pre-pandemic levels (Chart 9). We calculate that average monthly employment growth of 419 thousand will be required to achieve this goal by the end of 2022 (Table 3). In other words, to justify the market’s January 2023 expected liftoff date, we will need to see average monthly payroll growth of at least 419 thousand going forward. Table 3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date This number seems high, but it may be attainable. With vaccine distribution kicking into high gear, many service sectors of the economy will soon be able to re-open. This already started to happen last month when the Leisure & Hospitality sector added 355 thousand jobs. Even after last month’s gains, Leisure & Hospitality still accounts for 36% of the net job loss since last February (Table 4). This means that there is scope for extremely large employment gains this year if the coronavirus can be contained. Table 4Employment By Industry Bottom Line: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 https://www.bloomberg.com/news/articles/2021-03-01/treasury-curve-dysfunction-ignites-talk-of-federal-reserve-twist?sref=Ij5V3tFi 3 For more details please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup, Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
The US 10-year Treasury yield had climbed 16 basis points so far this month, alarming equity investors. March’s selloff to date follows a 35 basis point rise in February – the deepest monthly bond rout since November 2016. Although investors are…
Highlights The recent backup in bond yields could cause stocks to fall further in the near term. However, history suggests that as long as yields remain low in absolute terms, as they are now, equities will recover. Market angst that the Fed is about to turn more hawkish is unwarranted. Central banks around the world have both the tools and the inclination to keep bond yields from rising excessively. Despite the jump in bond yields, the forward earnings yield is 540 basis points above the real bond yield in the US. Outside the US, the forward earnings yield is 615 basis points above the real bond yield. In 2000, the earnings yield was below the real bond yield. Just as value stocks began to outperform growth stocks in mid-2000, the end of the pandemic will herald a similar period of value-oriented outperformance. Commodity producers and banks will lead the way. Some Parallels Between Today And 2000… Stock prices have buckled in recent weeks, raising concerns that global bourses are at risk of a major crash, just like they were in early 2000. There are certainly some notable similarities between 2000 and the present: In both cases, the preceding rise in stock prices was fueled by the Federal Reserve’s desire to prevent an exogenous shock from causing a major recession (Chart 1). Last year, the shock was the pandemic. In 1998, it was the collapse of Long-Term Capital Management (LTCM). The Connecticut-based hedge fund imploded shortly after Russia defaulted on its debt, leading to a gut-wrenching 22% decline in the S&P 500. The brewing crisis prompted the Fed to cut rates by a total of 75 basis points. Spurred on by fears of Y2K, the Fed also injected vast amounts of liquidity into the financial system. Tech stocks led the market higher both in the late 1990s and last year. The NASDAQ Composite rose 68% between its intra-day low in October 1998 and March 2000. In 2020, the NASDAQ outperformed the S&P 500 by 24% and returned 44% overall. Chart 1The NASDAQ's 1999 Surge Followed The 1998 “Insurance Cuts” And Coincided With The Fed’s Balance-Sheet Expansion Chart 2Low-Priced Stocks Have Been The Winners In The First Quarter The speculative mania in the 1990s spread from large-cap tech stocks to small-cap companies. We saw the same pattern earlier this year, with prices and trading volumes exploding among smaller, low-priced stocks (Chart 2). As was the case in the late 1990s, retail investors – this time armed with “stimmy” checks and access to zero-commission trading accounts – plowed into the market. Chart 3Some Pockets Of Bullish Equity Sentiment Chart 4Some Pockets Of Bullish Equity Sentiment Bullish equity investor sentiment was rampant at the peak of the stock market in 2000. Although not quite to the same extent as back then, most measures of investor sentiment turned bullish prior to the recent selloff (Chart 3). Like most investors, analysts were wildly optimistic on stocks in the late 1990s (Chart 4). Long-term earnings growth projections are very optimistic today, a potentially ominous signal given that (unlike in the late 1990s), productivity growth is now more anemic. Rising stock prices in the late 1990s allowed corporate insiders to cash in their options, while enabling new companies to go public. Recently, we have seen a flurry of companies list their shares, in some cases through dubious SPAC vehicles (Chart 5). Valuations reached nosebleed levels in 2000. While the forward P/E ratio on the S&P 500 is somewhat below its 2000 peak, other valuation measures such as price-to-sales, Tobin’s Q, and enterprise value-to-EBITDA are above where they were in 2000 (Chart 6). Chart 5Renewed Interest In Listing Stocks Chart 6Stretched Valuations, Then And Now … But One Important Difference Despite the parallels between today and 2000, there is an important difference: The Federal Reserve. Having cut rates in 1998, the Fed reversed course in mid-1999, eventually taking the fed funds rate up to 6.5% in May 2000. The yield curve inverted in February of that year, shortly after the 10-year yield reached a high of 6.79%. Chart 7What Happens To Equities When Treasury Yields Rise? Bond yields have risen briskly over the past six months. However, they remain very low in absolute terms. While rising yields can produce a temporary stock market correction, they need to move into restrictive territory in order to trigger a recession and an accompanying bear market in equities. Chart 7 highlights some research that Garry Evans and BCA’s Global Asset Allocation team recently produced. It shows eight episodes since 1990 of a sharp rise in the 10-year Treasury yield. On every occasion (except in 1993-94, when the Fed unexpectedly raised rates in February 1994), equities performed strongly while rates were rising (Table 1). Today, the forward earnings yield on the S&P 500 is 540 basis points above the real yield. In 2000, the real bond yield was higher than the earnings yield (Chart 8). The gap between earnings yields and real bond yields is even greater outside the US, where valuations are generally more attractive. By the same token, the S&P 500 dividend yield was well below the bond yield in 2000. Today, they are roughly the same. Even if one were to pessimistically assume that US companies are unable to raise nominal dividend payments at all for the next decade, the S&P 500 would need to fall by 21% in real terms for equities to underperform bonds. Many other stock markets would have to decline by more than that (Chart 9). Table 1As Long As Bond Yields Don't Rise Into Restrictive Territory, Stocks Will Recover Chart 8Relative To Bonds, Stocks Are More Favorably Valued Now Than in 2000 Chart 9Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Central Banks Will Lean Against Rising Bond Yields Stocks sold off earlier today on the perception that Jay Powell had failed to push back forcefully against the recent increase in bond yields. We think this angst is unwarranted. As Powell noted, most of the rise in bond yields reflected economic optimism. If yields were to continue rising in the absence of further economic improvements, the Fed would dial up the rhetoric, stressing its ability to buy bonds in unlimited quantities in order to support the economy. Despite all the fiscal stimulus, the unemployment rate remains elevated – perhaps as high as 10% according to some Fed measures. The prime-age employment-to-population ratio is four percentage points below where it was before the pandemic (Chart 10). Moreover, many stimulus measures will expire towards the end of the year. With the prospect of a “fiscal cliff” in 2022, we expect the Fed to want to tread carefully in withdrawing monetary support. What would really rattle investors is if long-term inflation expectations were to rise above the Fed’s comfort zone. However, considering the 5-year/5-year forward inflation breakevens are still below where they were in 2012-13, this is not an imminent risk (Chart 11). Chart 10The Fed Will Remain Accommodative To Aid The Labor Market Recovery Chart 11Inflation Expectations Have Recovered But Are Still Low Like the Fed, the ECB wants to keep financial conditions highly accommodative. On Tuesday, ECB Executive Board member Fabio Panetta, echoing comments made by other senior ECB officials, said that higher yields were “unwelcome and must be resisted.” He noted that “We are already seeing undesirable contagion from rising US yields into the euro area yield curve,” adding that the ECB “should not hesitate” to increase the pace of bond purchases. The ECB’s threat is credible. Already, its purchases have deviated significantly from its capital key, revealing Frankfurt’s willingness to act where and when it is needed. In the same spirit, the Reserve Bank of Australia boosted its government bond purchases earlier this week after the 10-year yield backed up from 0.7% last October to over 1.9% late last week. The RBA also reaffirmed its intent to maintain the current 3-year Yield Curve Control target at 0.1%, stating that “The Board will not increase the cash rate until actual inflation is sustainably within the 2-to-3 percent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The Board does not expect these conditions to be met until 2024 at the earliest.” The RBA’s determination to keep bond yields down is noteworthy given that the neutral rate of interest is higher in Australia than in most other developed economies.1 If the RBA does not intend to raise rates for the next three years, it may take even longer for other central banks to take away the punch bowl. Will Value Stocks Begin To Outperform As They Did Starting In Mid-2000? There is another potential parallel with 2000 that is worth mentioning. This was the year that the outperformance of growth stocks came to a halt and value stocks began to shine. In fact, outside of the tech sector, the S&P 500 did not peak until May 2001 (Chart 12). Value continued to outperform right through to 2007. Since February 12th of this year, the price of the highly liquid Vanguard Growth ETF (VUG, market cap of $143 billion) has fallen by 8.9% while the price of the Vanguard Value ETF (VTV, market cap of $97 billion) has risen 0.5%. Despite the nascent outperformance of value names, they still remain relatively cheap. According to a simple valuation measure that combines price-to-earnings, price-to-book, and dividend yields, value stocks are more than three standard deviations cheap relative to growth stocks – a bigger valuation gap than seen at the height of the dotcom bubble (Chart 13). Chart 12The Non-Tech Portion Of The Stock Market Peaked More Than A Year After The Tech Bubble Burst Chart 13The Tech Bust Of 2000 Also Marked The Start Of A Multi-Year Outperformance By Value The Outlook For Commodity Stocks And Bank Shares Commodity producers are overrepresented in value indices. Strong global growth against a backdrop of tight supply should heat up the commodity complex over the next 12-to-18 months. Chart 14 shows that capital investment in the oil and gas sector has fallen by more than 50% since 2014. BCA’s Commodity & Energy Strategy service, led by Robert Ryan, expects crude oil demand to outstrip supply over the remainder of this year (Chart 15). Chart 14Oil + Gas Capex Collapses In COVID-19’s Wake Chart 15Crude Oil Demand To Outstrip Supply Over The Remainder Of This Year A physical deficit in the metals markets – particularly for copper and aluminum – should also persist this year (Charts 16A & 16B). While the boom in electric vehicle (EV) production represents a long-term threat to oil, it is manna from heaven for many metals. A battery-powered EV can contain more than 180 pounds of copper compared with 50 pounds for conventional autos. By 2030, the demand from EVs alone should amount to close to 4mm tonnes of copper per year, a big slug of demand in a market that consumes about 26mm tonnes per year. Chart 16ACopper Will Be In Physical Deficit... Chart 16B...As Will Aluminum Ongoing strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then. The incremental increase in China’s metal consumption, as measured by the volume of commodities consumed, is also double what it was 20 years ago (Chart 17). As we discussed in our report To Deleverage Its Economy, China Needs MORE Debt, the Chinese government has no choice but to continue to recycle persistently elevated household savings into commodity-intensive capital investment. This will ensure ample commodity demand from China for years to come. Chart 17China Keeps Buying More And More Commodities Chart 18Credit Growth Has Been Recovering Along with commodity producers, financials helped propel value indices during the 2000s. While credit growth is unlikely to revert to its pre-GFC days, it has been trending higher in both the US and Europe (Chart 18). Analysts are starting to take note of improving bank earnings prospects. EPS estimates for banks are rising more quickly than for tech companies on both sides of the Atlantic (Chart 19). Not only is the “E” in the P/E ratio for banks likely to rise, the ratio itself will increase. Currently, US and European banks are trading at 14 and 10-times forward earnings, respectively, a huge discount to the broad market in general, and tech stocks in particular (Chart 20). Chart 19EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (I) Chart 19EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (II) Chart 20Banks Are Cheap Bottom Line: Despite near-term uncertainty, investors should overweight stocks on a 12-month horizon, while pivoting away from last year’s winners (growth stocks) towards last year’s losers (value stocks). Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 According to RBA’s estimates, the neutral rate of interest in Australia is at the high end of developed market estimates. Specifically, Australia’s R-star is higher than the average of the US and euro area R-stars and is slightly lower than the average of the Canadian and UK neutral rates. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Dear client, In addition to this week’s abbreviated report, we are also sending you a Special Report on currency hedging, authored by my colleague Xiaoli Tang. Xiaoli’s previous work mapped out a dynamic hedging strategy for developed market equity investors in various home currencies. In this report, she extends the work to emerging market exposure. I hope you will find the report insightful. Next week, in lieu of our weekly report on Friday, we will be sending you a joint Special Report on the UK on Tuesday, together with our Global Fixed Income colleagues. Kind regards, Chester Highlights The DXY index is up for the year, but further gains will be capped at 2-3% from current levels. Long yen positions are offside amid the dollar rally. This should wash out stale longs, and underpin the bull case. Lower the limit-sell on the gold/silver ratio to 68. We were stopped out of our short AUD/MXN position amidst a broad-based selloff in EM currencies. We are reinitiating the trade this week. Feature Chart I-1The Dollar Has Been Strong In 2021 The DXY index has once again kissed off the 90 level and is gaining momentum in March. Year-to-date, the DXY index is up 1.1%. This performance has been particularly pronounced against other safe haven currencies, such as the Swiss franc and the Japanese yen. GBP and AUD have fared rather well in this environment (Chart I-1). As the “anti-dollar,” the euro has also suffered. Our technical indicators continue to warn that the dollar still has upside. Net speculative positions are at very depressed levels, consistent with many sentiment indicators that are bearish USD. However, this time around, any dollar rally could be capped at 2-3%, in sharp contrast to the bounce we witnessed in March 2020. The Message From Dollar Technical Indicators Our dollar capitulation index has bounced from very oversold levels, and is now sitting above neutral territory (Chart I-2). The index comprises a standardized measure of sentiment, net speculative positioning and momentum. It is very rare that a drop in this index below the -1.5 level does not trigger a rebound in the dollar. This time around, the bounce has been rather muted. Chart I-2BCA Dollar Capitulation Index Suggests Some Upside Part of the reason has been concentration around dollar short positions. Investors throughout most of the pandemic executed their bearish dollar bets through the euro, yen and the Swiss franc (countries that already had negative interest rates). Positioning on risk on currencies such as the Australian dollar and the Mexican peso were neutral. This also explains the underperformance of the yen, as the dollar rises. From a sizing standpoint, ever since the dollar peaked in March 2020, counter-trend moves have been in the order of 2-3%. We expect this time to be no different. What To Do About The Yen The yen has been one of our core holdings on three fundamental pillars: it is cheap, it tends to rise during dollar bear markets and the economy in Japan is more hostage to deflation than the US. This bodes well for real rates in Japan, relative to the US. Over the last month, our long yen position has been put offside. First, demand for safe havens has ebbed as US interest rates have gapped higher (Chart I-3, panel 1). King dollar has once again become the safe haven of choice. As Chart I-1 illustrates, low beta currencies such as the Swiss franc and yen, that tend to do relatively well when the dollar is rallying, have underperformed. Yield curve control (YCC) in Japan is also negative for the yen as interest rates rise (panel 2). Economic momentum in Japan is also rolling over (panel 3). Prime Minister Yoshihide Suga’s mulling to extend the state of emergency in the Tokyo region could further cripple any Japanese economic recovery. Chart I-3A Healthy Reset In The Yen Chart I-4USD/JPY Support Should Hold For short-term investors, USD/JPY is very overbought and is approaching strong resistance (Chart I-4). In our view, a washing out of stale shorts would provide a healthy reset for the bear market to resume. Meanwhile, USD/JPY and the DXY change correlations during risk-off periods, where the yen appreciates versus the dollar. Therefore, a market reset is also positive for the yen. Housekeeping Chart I-5Remain Short AUD/MXN We were stopped out of our short AUD/MXN trade last week for a loss of 6.1%. We are reinitiating the trade this week. The case for the trade, made a month ago, remains intact. A short-term recovery in the US economy, relative to the rest of the world, argues for an AUD/MXN short. In fact, a divergence has occurred between the BRL/MXN and the AUD/MXN exchange rate (Chart I-5). Domestic factors have certainly tempered the Brazilian real, but the underperformance of metal prices relative to oil in recent months is also a factor. We expect some convergence to occur, with MXN appreciating much faster than the AUD. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have stepped up: Personal income rose by 10% in January, while personal spending rose by 2.4% month-on-month. The ISM report was stellar. The manufacturing PMI improved from 58.7 to 60.8 in February. Prices paid rose to 86. Factory orders were slightly above expectations at 2.6% month-on-month in January. The DXY index rose by 165 bps this week. The narrative of a counter-trend reversal in the DXY index isn playing out. As the story unfolds, it will be important to establish targets. Our bias is that the DXY stalls before 93-94 is reached. Report Links: Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 Sizing A Potential Dollar Bounce - January 15, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area remain weak: Core CPI in the Eurozone came in at 1.1%, in line with expectations. The unemployment rate declined from 8.3% to 8.1% in January. January retail sales were weak at -6.4% year-on-year. The euro fell by 1.7%% against the US dollar this week. It will be almost impossible for the euro to rise in an environment where the dollar is in a broad-based decline. Given elevated sentiment on the euro, a healthy reset is necessary for the bull market to resume. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been marginally positive: The employment report was positive, with the unemployment rate dipping to 2.9% and an improvement in the jobs-to-applicants ratio in January. Consumer confidence in February is rebounding from very low levels. The Japanese yen fell by 1.5% against the US dollar this week. The recovery in the Japanese economy is fragile, and tentative signs of a renewed lockdown will knock down confidence. In this transition phase, yen long positions could be hostage to losses. Longer-term, the yen is cheap and will benefit from a broad-based dollar decline. Report Links: On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been in line: Mortgage approvals rose 99K in January, in line with expectations. The construction PMI rose from 49.2 to 53.3 in February. Nationwide house prices are soaring, rising 6.9% in February on a year-on-year basis. The pound fell by 0.8% against the dollar this week. It is however the best performing currency this year. Our short EUR/GBP trade has benefited from faster vaccination in the UK (that could give way to a faster reopening of the economy) and a nice valuation starting point. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia was robust: Home lending remained in an uptrend. Owner-occupied loans increased by 11% in January, while investor loans increased by 9.4%. Terms of trade are soaring, rising 24% year-on-year in February. The current account surplus came in near a record A$14.5 billion in Q4. GDP grew by 3.1% QoQ in Q4. The Aussie fell by 1.8% his week. Terms of trade will continue being a tailwind for the AUD/USD. We also like the AUD/NZD cross, as a valuation and terms-of-trade bet. However, we expect that any positive surprises in the US will hurt AUD relative to the Americas. One way to play this is by shorting AUD/MXN. Report Links: Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 An Update On The Australian Dollar - September 18, 2020 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: Terms of trade rose by 1.3% in Q4. CoreLogic home prices rose 14.5% in February. The New Zealand dollar fell by 2.4% against the US dollar this week. The kiwi ranks as the most unattractive currency in our FX framework. For one, it has catapulted itself to the most expensive currency in our PPP models. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada was positive: The Nanos confidence index rose from 58.2 to 59.4 in February. Annualized 4Q GDP came in at 9.6%, above expectations. Building permits rose 8.2% month-on-month in January. The Canadian dollar fell 0.4% against the US dollar this week. Oil prices remain very much in an uptrend, which is underpinning the loonie. Better US economic performance in the near term should also help the CAD. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland have been improving: Swiss GDP rose by 0.3% quarter-on-quarter in 4Q. The KOF leading indicator rose from 96.5 to 102.7 in February. The February manufacturing PMI rose from 59.4 to 61.3. Switzerland remains in deflation, with the core CPI that came in at -0.3% year-on-year in February. The Swiss franc fell by 2.6% against the US dollar this week. Safe -haven currencies continue to be laggards, as rates rise and gold falls to the wayside. This is bullish on procyclical currencies, and negative the Swiss franc. We are long EUR/CHF on this basis, but short USD/JPY purely as portfolio insurance. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The data out of Norway has been robust: The unemployment rate fell from 4.4% to 4.3% The manufacturing PMI increased from 51.8 to 56.1 in February. The current account balance was robust in Q4. It should increase significantly in Q1 this year given the large trade balance in January. Being long the Norwegian krone is one of our high-conviction bets in the FX portfolio. The Norwegian krone fell by 1% against the US dollar this week, but outperformed the euro, amongst other currencies. The NOK ticks all the boxes of an attractive currency – cheap valuations, a liquidity discount, and primed to benefit from a global growth rebound. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Most Swedish data releases were in line with expectations: GDP came in at -0.2% quarter-on-quarter, below expectations. Retail sales rose 3.1% year-on-year, above expectations. The trade balance came in at a surplus of SEK 5.2 billion in January. The manufacturing PMI remained elevated at 61.6 in February. The Swedish krona fell by 2.4% against the US dollar this week. Manufacturing data is improving in Sweden but the economy remains hostage to COVID-19, compared to Norway. That is weighing on the krona. That said, Sweden is a highly levered play on the global cycle. Therefore, once the pandemic is behind us, the SEK will outperform. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Dear Client From March 18 I will be writing under a new product title, the BCA Research Counterpoint. The aim of the Counterpoint is to generate a high volume of investment opportunities that are unconnected to the business cycle and run counter to the conventional wisdom. For those of you that have followed the European Investment Strategy through the past ten years, Counterpoint will seamlessly continue the same intellectual framework of investment ‘mega-themes’, fundamental analysis, fractal analysis, and sector primacy. The difference is that the investment opportunities will encompass all geographies. To whet your appetite, early Counterpoint reports will introduce new investment mega-themes including: the compelling structural case for cryptocurrencies; why shocks such as the pandemic are inherently predictable; and the structural transformation coming to the global labour market. There will also be an upgrade of the proprietary Fractal Trading System to generate more ideas per week and to boost the win ratio towards 70 percent. As for the European Investment Strategy, it will continue in the very capable hands of my colleague and friend, Mathieu Savary. Mathieu has previously written the Foreign Exchange Service, the flagship Bank Credit Analyst, and most recently the Daily Insights. Moreover, Mathieu is French. So if anyone knows how Europe works (and doesn’t work), it is Mathieu! I do hope you read both products. Best regards Dhaval Highlights If bond yields continue their march higher, the most dangerous earthquake will happen in the global real estate market. If higher bond yields caused even a 10 percent decline in the $300 trillion global real estate market it would unleash a deflationary impulse equal to one third of world GDP This would make any preceding inflationary impulse feel like a waltz in the park. For long-term investors who can ride out near term pain, there are three important conclusions: The ultimate low in bond yields is still ahead of us. The structural bull market in stocks will continue until bond yields reach their ultimate low. Equity investors should structurally tilt towards ‘growth’ sectors that will benefit from the ultimate low in bond yields. Feature Chart of the WeekThe Real Estate Market Dwarfs The Stock Market And The Global Economy In the last couple of weeks, higher bond yields have caused tremors in the stock market. But if bond yields continue their march higher and stay there, the most dangerous earthquake will not happen in the stock market, it will happen in the real estate market. The $90 trillion worth of the global stock market is large, but it is chicken feed compared with the $300 trillion worth of global real estate (Chart of the Week). The big worry is that the valuation of global real estate is critically dependent on bond yields staying low. If higher bond yields caused even a 10 percent decline in global real estate values, it would amount to a $30 trillion plunge in global wealth. Such a deflationary impulse, equal to one third of world GDP, would make any preceding inflationary impulse feel like a waltz in the park. Hence, to anybody worried that we are on the road to inflation, we pose a simple question. How would the world economy cope with the massive deflationary impact on $300 trillion of global real estate?1 The Real Risk Is Real Estate Over the past decade, global real estate rents have broadly tracked nominal GDP, as they should. But real estate prices have massively outperformed rents (Chart I-2). The reason is that the valuation paid for those rents has surged by 35 percent. This ‘multiple expansion’ of real estate which has added $80 trillion to global wealth – broadly equivalent to global GDP – is entirely due to lower bond yields. Chart I-2Real Estate Prices Have Massively Outperformed Rents And GDP Within the global real estate market, the residential segment constitutes 80 percent by value. Commercial real estate accounts for a little over 10 percent, and agricultural and forestry real estate makes up the remainder. It follows that the most important component of the real estate boom has been a housing boom. Given that most homes are owner-occupied, the boom in house prices has boosted the wealth of the ordinary global citizen by much more than the boom in stock prices. Moreover, the 2010s housing boom was unprecedented in its penetration and regional breadth, simultaneously encompassing cities, suburbs, and rural areas across North America, Europe, Asia and Australasia. Even Germany and Japan joined in, making it the most widely participated-in housing boom in economic history. What was behind this synchronised and broad-based housing boom? The answer is the universal decline in bond yields. As the global real estate firm Savills puts it: “Real estate has increased significantly in value, spurred on by the intervention of central banks and their suppression of bond yields” In fact, as the US and China now dominate the global real estate market, the downtrend in the global rental yield has closely tracked the downtrend in the US and China long bond yields. The big danger would be if this downtrend turned into an uptrend, undermining the valuation of $300 trillion of global real estate. To repeat, even a 10 percent synchronised decline in global real estate prices would wipe out $30 trillion of global wealth equal to one third of annual GDP, and it would impact almost everybody. The ‘multiple expansion’ of real estate has added $80 trillion to global wealth, broadly equivalent to global GDP. But where is the pain point? Our answer is that if inflation fears lifted the average US and China 30-year bond yield to 3.75 percent (from 3 percent now), it would constitute the change in trend that would unleash a massive countervailing deflationary impulse from falling house prices (Chart I-3). Chart I-3Higher Bond Yields Would Unleash A Massive Deflationary Impulse From Falling House Prices Waiting For Rationality To Return To Stocks In the stock market, the August to mid-February period was a brief aberration in which stocks rallied in tandem with rising bond yields. But looking at the bigger picture, the bull market in stocks, just as for real estate, is due to lower bond yields (Chart I-4). Chart I-4The August To Mid-February Rally In Stocks Was An Aberration Since 2008, global stock market profits have gone nowhere. Therefore, the only reason that the stock market surged is that the valuation paid for those unchanged profits surged. Just as for real estate, the stock market’s valuation surged because bond yields collapsed (Chart I-5). Chart I-5The Bull Market In Stocks Is Entirely Due To Higher Valuations Taking account of this downtrend in bond yields, the post-2008 boom in valuations is rational. However, as we warned two weeks ago, the continued expansion of valuations while bond yields are backing up means that The Rational Bubble Is Turning Irrational. The point of vulnerability is in high-flying tech stocks. Since 2009, the technology sector earnings yield has always maintained a minimum 2.5 percent premium over the 10-year T-bond yield, defining the envelope of the rational bubble. But in recent weeks, this envelope has been breached, indicating that valuation is entering a new and irrational phase (Chart I-6). Chart I-6The Rational Bubble Is Turning Irrational For long-term investors the pressing questions are: how much higher can bond yields go, and for how long? Our answers are, much less than 1 percent, and not for long – because the deflationary impact on $300 trillion of real estate would eventually force bond yields into a very sharp reversal. The Road To Inflation Ends At Deflation Many people believe that ‘real’ assets such as real estate and stocks perform well in an inflationary scare. But this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income collapses, taking the price of the asset down with it. From the state of price stability, in which most developed economies now find themselves, the creation of inflation is a non-linear phenomenon. Non-linear means that policymakers’ efforts result in either nothing (witness Japan or Switzerland), or in uncontrolled inflation (witness the US in the late 1960s). In fact, can you name any economy that has shifted from price stability to a controlled inflation? If you can, please tell me in an email! When an economy phase shifts from price stability to price instability, the valuations of real assets collapse. This is because the starting valuation needed to generate a given real return during uncontrolled inflation is much lower than during price stability. When an economy phase shifts from price stability to price instability, the valuations of real assets collapse. Chart I-7 should make this crystal clear. During the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But during the uncontrolled inflation of the 1970s, the same starting multiple of 15 generated a real return of zero. To generate a real return of 10 percent, the starting multiple had to sink to 7. This explains why the prices of stocks and real estate collapsed in the 1970s and why they would collapse again in a new inflationary scare. Chart I-7In An Inflation Scare, Valuations Have To Collapse To Generate An Adequate Real Return As an aside, this also explains why so-called ‘financial repression’ – whereby the central bank holds down bond yields while the government generates inflation – will not work. While it is conceivable that a government could corner its government bond market and thereby repress it, it would be near-impossible to repress the much larger asset-classes of stocks and real estate. Once these large and privately priced markets sniffed out the government’s nefarious plan, the valuation of such assets would collapse to generate the previously required real return – the result being an almighty crash in stock and real estate prices. Given that the combined value of such markets dwarfs the $90 trillion global economy, the road to inflation would end at deflation. For long-term investors who can ride out near term pain, all of this leads to three important conclusions: The ultimate low in bond yields is still ahead of us. The structural bull market in stocks will continue until bond yields reach their ultimate low. Equity investors should structurally tilt towards ‘growth’ sectors that will benefit from the ultimate low in bond yields. Fractal Trading System* In a very successful week, short MSCI Korea versus MSCI AC World achieved its 10.6 percent profit target and short tin versus lead quickly achieved its 13 percent profit target. This takes the rolling 12-month win ratio to 60 percent. Given the transition to the new product title, there are no new trades this week. We look forward to introducing the upgraded Fractal Trading System and some new trades in the BCA Counterpoint on March 18. Chart I-8MSCI Korea Vs. MSCI All-Country World* 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 Source: Savills Prime Index: World Cities, August 2020; and Savills: 8 things to know about global real estate value, July 2018. 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 - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed 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