Real Estate
Underweight We would refrain from chasing high yielding real estate stocks higher, and instead we are including them in our high-conviction underweight call list for 2020. The commercial real estate (CRE) sector is a bubble candidate that exemplifies this cycle’s excesses. CRE prices sit at roughly two standard deviations above both the historical time trend and the previous cycle’s peak (not shown). Worryingly, CRE demand is waning. Not only our proprietary real estate demand indicator has sunk recently, but also the latest Fed Senior Loan Officer survey revealed that demand for CRE loans remains feeble. Simultaneously, fewer bankers are willing to extend CRE credit according to the same quarterly Fed survey. Occupancy rates have crested and there are increasing anecdotes of credit quality deterioration. As a result, CRE rents are also failing to keep up with inflation which eats into relative cash flow growth prospects. The supply side build up tilts this delicate balance further into deficit. Non-residential construction shows no signs of abating, with multi-family housing starts still running at an historically high rate of roughly 400K/annum. Finally, interest rate related headwinds will also weigh on this high-yielding sector in coming quarters, especially if the sell-off in the bond market gains steam as BCA expects. The ticker symbols for the stocks in this index are: BLBG – S5RLST – AMT, PLD, CCI, SPG, EQIX, WELL, PSA, EQR, AVB, SBAC, O, DLR, WY, VTR, ESS, BXP, CBRE, ARE, PEAK, MAA, UDR, EXR, DRE, HST, REG, VNO, IRM, FRT, KIM, AIV, SLG, MAC.
Dear Client, In addition to this short weekly report, you will also receive a Special Report on investment themes over the next decade, penned by our colleagues in the US Equity Strategy and Geopolitical Strategy services. The implications for the dollar could be profound, and I hope you will find it insightful. This will be our final publication for the year. We will resume publication on January 10, 2020. Thank you for your readership and wishing you a prosperous New Year. Best regards, Chester Ntonifor Highlights We expect the USD/CAD to fall to 1.20 in the coming months. However, we recommend favoring both the aussie and the euro over the loonie. Stand aside on sterling for now. Feature We expect CAD/USD to gravitate higher in the next few months. In a somewhat hawkish shift, the Bank of Canada kept rates on hold at its last policy meeting. It may however later view this move as a policy mistake, not because the economy was under pressure, but because other central banks have been mostly cutting rates this year (Chart I-1). Upward pressure on the CAD will tighten domestic financial conditions. This will ensure that while CAD/USD may touch 0.80-0.82 cents in the next few months (Chart I-2), it will likely underperform its procyclical peers. Chart I-1Peak ##br##Divergence? Chart I-2Interest Rate Differentials Could Push USD/CAD To 1.20 More recently, Canadian data is beginning to take a surprising turn to the downside. The November jobs report was the worst since the financial crisis. This was the second consecutive monthly drop, with losses spread across both part-time and full-time (Chart I-3). Most importantly, the unemployment rate in Canada has tended to stage powerful V-shaped recoveries, and the rise in November suggests caution (bottom panel). Manufacturing and resources in Quebec, Alberta and British Columbia bore the brunt of the employment declines. Chart I-3Worst Job Report Since 2007 Chart I-4Uneven Housing Recovery Housing remains a pillar of household wealth in Canada, and the recovery in prices remains uneven (Chart I-4). The risk is that this continues to restrain spending in Canada, which has remained weak despite robust wage growth. Nationwide house price growth has slowed to a standstill. A study by the Reserve Bank of New Zealand shows that on average, the elasticity of consumption growth to house price changes is asymmetric to the downside.1 Negative housing shocks tend to hurt consumption by more than the boost received from positive shocks. This makes sense since at very elevated debt levels, leveraged gains are used to pay down debt aggressively, whereas leveraged losses hit bottom lines directly. Housing remains a pillar of household wealth in Canada, and the recovery in prices remains uneven. The increase in the budget deficit next year is mainly due to the increase in pension liabilities (low rates led to lower returns), rather than significant new spending (Chart I-5).2 This means the scope for the BoC to raise rates could be much less compared to other central banks, should the global economy pick up steam next year. Fiscal spending looks much more forthcoming in Europe, Japan and the US (Chart I-6). Chart I-5Projected Federal Budgetary Balance The latest inflation print shows that domestic prices in Canada remain well anchored at the midpoint of the BoC’s target band. However, there are downside risks from the lagged effect of softening producer prices (Chart I-7). Chart I-6Higher Budget Deficits Outside Canada Chart I-7Risk To Canadian Inflation More importantly, terms of trade in Canada have been slowing, especially when compared to its commodity peers (Chart I-8). Rising energy prices, as we expect, will be a tailwind, but the Western Canadian Select discount and persistent infrastructure problems are headwinds. Fiscal spending looks much more forthcoming in Europe, Japan and the US. We favor the aussie over the loonie since the downturn in the Australian housing market appears much further advanced compared to Canada. Historically, policy divergences between the RBA and the BoC have followed the relative growth profiles of their biggest export markets, and the message so far is that the RBA is well ahead of the curve in its dovish bias (Chart I-9). Our expectation is that the recent green shoots in Chinese growth are a prelude to another mini-up cycle, in line with the view of our colleague Jing Sima from BCA’s China Investment Strategy service Chart I-8CAD, AUD, NZD And Terms Of Trade Chart I-9Buy AUD/CAD This week, we are also recommending investors buy EUR/CAD. First, valuations and balance-of-payment dynamics favor the euro versus the Canadian dollar. Second, we estimate there is more scope for long-term interest rate expectations to rise in the euro area than in Canada. This is just a matter of mathematics, since European rates have already fallen to rock-bottom levels. Meanwhile, economic surprises are inflecting higher in the Eurozone relative to Canada (Chart I-10). Chart I-10Buy EUR/CAD EUR/CAD is sitting at the bottom of the upward trending channel that has existed since 2012. On a technical basis, the downside has been eliminated for now. Meanwhile, initial upside resistance rests at the triple top, a nudge above 1.6 (Chart I-11). Chart I-11EUR/CAD Technicals: Limited Downside Housekeeping We were stopped out of our long GBP/JPY trade for a profit of 9.6%. On a tactical basis, we are standing aside for now as volatility could rise, especially amid thin holiday trading. Meanwhile, on a technical basis, EUR/GBP is also due for mean reversion (Chart I-12). That said, our eventual target for GBP/USD is 1.40 for clients willing to stomach the volatility. Chart I-12Tactical Upside For EUR/GBP Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Mairead de Roiste, Apostolos Fasianos, Robert Kirkby, and Fang Yao, “Household Leverage and Asymmetric Housing Wealth Effects - Evidence from New Zealand,” Reserve Bank of New Zealand, Discussion Paper Series, (April 2019). 2 Jordan Press, “Morneau’s fiscal update shows Canada’s deficit increased by billions for next 2 years,” Global News, The Canadian Press, December 16, 2019. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mixed: Markit flash manufacturing PMI marginally fell to 52.5, while services PMI increased to 52.2 in December. The New York Empire State Manufacturing index increased to 3.5 from 2.9 in December, while the Philly Fed Manufacturing index fell sharply to 0.3 from 10.4. On the housing market front, NAHB housing market index increased to 76 from 71 in December. Both building permits and housing starts increased by 1.5 million and 1.4 million month-on-month, respectively in November. The DXY index increased by 0.3% this week following the recent plunge. Various dollar indicators continue to point to the downside, including interest rate differentials, the bond-to-gold ratio, portfolio inflows, and rebounding global growth. We went short the DXY index last week. Stay with it. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mostly positive: Markit manufacturing PMI fell to 45.9 from 46.9 in December, while services PMI increased to 52.4. The trade surplus increased to €24.5 billion from €18.7 billion in October. Headline and core inflation were both unchanged at 1% and 1.3% year-on-year, respectively in November. EUR/USD fell by 0.2% this week. The weaker-than-expected manufacturing PMI releases on Monday were not adequate to alter our positive view on global growth. Both German and Korean exports have been stabilizing, which signals that global trade is on a recovery path. We expect the euro to outperform in the near term and we suggest to play the euro strength via the Canadian dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Manufacturing PMI fell marginally to 48.8 from 48.9 in December. The trade deficit widened to ¥82.1 billion in November. Exports and imports both plunged by 7.9% and 15.7% year-on-year, respectively. USD/JPY increased by 0.2% this week. On Wednesday, the BoJ held its interest rate unchanged. With the key short-term cash rate at -0.1%, and asset purchases already tapering, the BoJ has little room to act. On the fiscal front however, the recently announced stimulus package brightens the Japanese economy’s outlook. We continue to recommend the Japanese yen as a safe-haven hedge. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: Both Markit manufacturing and services PMIs fell to 47.4 and 49 in December. The ILO unemployment rate was unchanged at 3.8%. Average earnings continued to grow by 3.2% year-on-year in October, however this slowed from 3.7% the previous month. Both headline and core inflation were unchanged at 1.5% and 1.7% year-on-year respectively, in November. Retail sales grew by 1% year-on-year in November. The British pound fell by 2.5% against the US dollar this week, erasing the gains from positive election news last week. Meanwhile, the BoE kept interest rates unchanged at 0.75% as widely expected, with two dissenting members that favored a cut. The pound is likely to stay volatile until January 31st, but the ultimate resting spot for GBP/USD is around 1.40. We will stand aside for now, ahead of thin holiday trading. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart I-10AUD Technicals 2 Recent data in Australia have been positive: Both manufacturing and services PMIs fell to 49.5 and 49.4, respectively in December, but the decline was not specific to Australia. 40K new jobs were created in November, including 36K new part-time jobs and 4K new full-time jobs. The unemployment rate fell further to 5.2% in November. The Australian dollar fell by 0.4% against the US dollar this week. In its latest meeting minutes, the RBA stated that “the depreciation (in the Australian dollar) reflected the reduction in the interest differential between Australia and the major advanced economies, and had occurred despite an increase in the terms of trade over this period.” The fact that Australian balance of payments is improving tremendously suggests that the exchange rate is on the cheaper end. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: The Westpac consumer index increased to 109.9 from 103.1 in Q4. ANZ business confidence increased to -13.2 from -26.4 in December. ANZ activity outlook also increased by 17.2% month-on-month in December. The current account deficit widened to NZ$6.4 billion from NZ$1.1 billion in Q3. The trade deficit narrowed to NZ$753 million from NZ$1,039 million in November. Exports rose 7.6% year-on-year, and imports also increased by 2% year-on-year. GDP growth accelerated by 0.7% quarter-on-quarter in Q3, compared with only 0.1% the previous quarter. NZD/USD fell by 0.4% this week. Both hard data and soft data in New Zealand are starting to look up, which is consistent with our positive view on global growth. The New Zealand dollar is likely to outperform along with the economic expansion in 2020. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 201 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mixed: Manufacturing sales fell by 0.7% month-on-month in October. Core inflation was unchanged at 1.9% year-on-year in November. Headline inflation, however, soared to 2.2% from 1.9% in November, mostly attributable to higher gasoline prices. ADP recorded an increase of 31K jobs in November, lower than the expectations of 67K. The Canadian dollar rose by 0.4% against the US dollar this week, post the inflation print. While we believe that the loonie will outperform the USD, it is likely to underperform its petrocurrency peers and other high-beta currencies. Please refer to our front section this week for a more in-depth analysis on the loonie. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: The trade surplus narrowed slightly to CHF 2.2 billion in November 2019, the smallest trade surplus since August. The Swiss franc appreciated by 0.4% against the US dollar this week. In the Q4'19 Quarterly Bulletin released this week, the SNB stated that “the franc remains highly valued, and that negative interest rates and the willingness to intervene counteract the attractiveness of Swiss franc investments and thus ease upward pressure on the currency.” Moreover, the SNB lowered its inflation projection compared with the previous forecast in September. Our bias is that EUR/CHF will appreciate in the coming months, as the SNB stems appreciation in its currency. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: The trade surplus came in at NOK 18.8 billion in November. This is an improvement compared with a surplus of only NOK 5.9 billion the previous month and a deficit of 1.4 billion in September. The Norwegian krone appreciated by 0.6% this week, supported by rising energy prices. WTI crude oil prices are up 16% since the bottom in October this year. The Norges Bank kept its interest rate on hold at 1.5% this week. The still attractive interest rate differential and positive oil outlook both suggest that the krone will be one of the best performing currencies going into next year. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: The consumer confidence index increased to 94.1 from 92 in December. USD/SEK fell by 0.7% this week. On Thursday, the Riksbank raised its interest rate by 25 bps to 0%, abandoning negative interest rates after almost 5 years. The bank also said in a statement that “the conditions are good for inflation to remain close to the target going forward.” Interest rate differentials are moving in favor of the SEK. Moreover, we believe that the previous weakness in the Swedish krona had been mostly led by soft data, while hard data remain resilient. We continue to recommend long SEK as our high-conviction trade for next year. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
China’s October housing market data highlighted three points: housing sales are modestly improving, the pace of housing construction has again deviated from the trend in sales, and housing price appreciation is slowing in Tier 2 and Tier 3 markets. We are…
Highlights China’s PMIs continue to flash a positive signal, but the hard data trend remains negative. There has been a notable improvement in China’s cyclical sectors (versus defensives) over the past month, but broad equity market performance has been flat-to-down. China’s lackluster equity index performance in the face of rising PMIs suggests that investors can afford to wait for an improvement in the hard economic data before tactically upgrading to overweight. Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets versus the global benchmark, favoring the former over the latter. Feature 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, China’s November PMIs were clearly positive, and the rise in the official manufacturing PMI above the 50 mark is notable. However, the odds continue to favor a bottoming in the economy in Q1 rather than Q4, in large part because China’s “hard” economic data has continued to deteriorate during the time that the Caixin PMI has been signaling an expansion in manufacturing activity. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, China’s cyclical sectors have outperformed defensives, which is consistent with the positive message from China’s PMIs. But China’s broad equity markets have been flat-to-down versus the global index over the past month, suggesting that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight (from neutral). Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets, but favor the former over the latter in a trade truce scenario. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Both measures of the Li Keqiang index (LKI) that we track indicated no obvious improvement in Chinese economy activity in October. The BCA China Activity indicator, a broader coincident measure of China’s economy, also moved sideways in October and (for now) remains in a downtrend. Thus, based on the “hard data”, Chinese economic activity has not yet bottomed. Chart 1A Moderate Strength Economic Recovery Will Begin In Q1 The components of our LKI leading indicator continue to tell a story of easy monetary conditions and sluggish money & credit growth (Chart 1). The indicator itself remains in an uptrend, but it is a shallow one that does not match the intensity of previous credit cycles. While the uptrend in the indicator suggests that China’s economy will soon bottom, the shallow pace suggests that the coming rebound in growth will be less forceful than during previous economic recoveries. The uptrend in headline CPI is a notable macro development, with prices having risen 3.8% year-over-year in Oct (the fastest pace in almost eight years). This rise has been driven almost entirely by a surge in pork prices, which have risen over 60% relative to last year (panel 1 of Chart 2). While some investors have questioned whether the rise in headline inflation will cause the PBoC to tighten its stance at the margin, we argued with high conviction in our November 20 Weekly Report that this will not occur.1 Panel 2 of Chart 2 shows that periods of easy monetary policy line up strongly with periods of deflating producer prices, arguing that the PBoC will see through transient shocks to headline inflation. China’s October housing market data highlighted three points: housing sales are modestly improving, the pace of housing construction has again deviated from the trend in sales, and housing price appreciation is slowing in Tier 2 and Tier 3 markets. For now, we are inclined to discount the surge in floor space started, given previous divergences that proved to be unsustainable. The bigger question is whether investors should be concerned about slowing housing prices. Chart 3 shows that floor space sold and property prices have been negatively correlated over the past three years, in contrast to a previously positive relationship. Deteriorating affordability and tight housing regulations have contributed to this shift in correlation, which helps explain why the PBoC’s Pledged Supplementary Lending (PSL) program has been so closely related to housing sales over the past few years. While the growth in PSL injections is becoming less negative, it has not risen to the point that it would be associated with a strong trend in sales. As such, we continue to see poor affordability as a threat to further housing price appreciation, absent stronger funding assistance. Poor affordability will continue to be a headwind for China’s housing market. Chart 2The PBoC Will See Through Transient Shocks To Headline Inflation Chart 3Poor Affordability Will Continue To Weigh On Housing Demand Chart 4Investors Need To See Concrete Signs Of A Hard Data Improvement China’s November PMIs were quite positive, which legitimately increases the odds that China’s economy is beginning the process of recovery. However, we see two reasons to believe that the odds continue to favor a bottoming in the economy in Q1 rather than Q4. First, while they improved in November, several important elements of the official PMI remain in contractionary territory, particularly the new export orders subcomponent. Second, while the Caixin PMI has now been above the 50 mark for 4 consecutive months, China’s hard data has continued to deteriorate since the summer (Chart 4). Given the historical volatility of the Caixin PMI, we advise investors to wait for concrete signs of a hard data improvement before firmly concluding that China’s economy is recovering. Over the last month, China’s investable stock market has rallied roughly 1% in absolute terms, while domestic stocks have fallen about 3%. In relative terms, A-shares underperformed the global benchmark, while the investable market moved sideways. In our view, the underperformance of China’s domestic market reflects increased sensitivity to monetary conditions and credit growth compared with the investable market,2 and a weaker credit impulse in October appears to have been the catalyst for A-share underperformance. Over the cyclical horizon, earnings will improve in both the onshore and offshore markets in response to a modest improvement in economic activity, suggesting that an overweight stance is justified for both markets. But we think the investable market has more upside potential in a trade truce scenario. The outperformance of cyclical versus defensive sectors is sending a positive signal, but investors can afford to wait for better economic data before tactically upgrading. Chart 5A Positive Sign From Cyclicals Versus Defensives Within China’s investable stock market, it is quite notable that cyclicals have outperformed defensives over the past month on an equally-weighted basis (Chart 5). Interestingly, key defensive sectors such as investable health care and utilities have sold off significantly, and equally-weighted cyclicals have also outperformed defensives in the domestic market. The outperformance of cyclicals and underperformance of defensives is consistent with the positive message from China’s PMIs, but the fact that this improvement is occurring against the backdrop of flat-to-down relative performance for China’s equity market suggests that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. China’s government bond yields fell slightly in November, potentially reflecting expectations of further modest easing. Our view that monetary policy will likely remain easy over the coming year even in a modest recovery scenario suggests that Chinese interbank rates and government bond yields are likely to range-trade over the coming 6-12 months. We expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. Chinese onshore corporate bond spreads eased modestly over the past month. Despite continued concerns about onshore corporate defaults, the yield advantage offered by onshore corporate bonds have helped the asset class generate a 5.4% year-to-date return in local currency terms. Barring a substantial intensification of the pace of defaults, we expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. The RMB has moved sideways versus the US dollar over the last month. USD-CNY had fallen below 7 in October following the announcement of the intention to sign a “phase one” trade deal, but the move ultimately proved temporary given the deferral of an agreement. We would expect the RMB to appreciate following a deal of any kind (a truce or something more), and it is also likely to be supported next year by improving economic activity. Still, it would not be in the PBoC’s best interests to let the RMB appreciate too rapidly, because an appreciating Chinese currency would act as a deflationary force on China’s export and manufacturing sectors. As such, we expect a modest downtrend in USD-CNY over the coming year. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report "A Guide To Chinese Investable Equity Sector Performance," dated November 27, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Portfolio Strategy Interest rates are one of the most important macro drivers of overall equity returns via valuations. BCA’s view of a selloff in the bond market is a key factor underpinning most of our 2020 high-conviction calls. A 50bps to 75bps rise in the 10-year Treasury yield in 2020, as BCA predicts, will have significant knock on effects on sector selection. Recent Changes There are no changes to our portfolio this week. Table 1 Feature As 2019 draws to a close, this week we reveal our high-conviction calls for the coming year. But before proceeding, a brief market comment is in order. As 2019 draws to a close, this week we reveal our high-conviction calls for the coming year. But before proceeding, a brief market comment is in order. We remain perplexed by the market’s euphoric rise and near total neglect of weak profit growth fundamentals. This “hope rally”, as we have characterized it in the recent past, may have some more legs with the traditional Santa Rally around the corner, but the set up for stocks could not be more treacherous for 2020. Importantly, we deem the risk of not getting a Sino-American trade deal to be significantly greater than a relief rally in case of a successful deal. Most of the positive trade-related news is already reflected into equities. This complacent backdrop is reminiscent of the early 2018 SPX catapult to 2,870 as back then the fresh fiscal easing package was all priced into stocks in the first 20 trading days of that year. Chart 1 vividly depicts this euphoric melt-up in stocks with the longest dated VIX future trouncing the squashed front month VIX future. While this ratio is not at the stratospheric level hit in late-December 2017, it hit a wall recently forewarning that equities are skating on thin ice. Chart 1VOL... Similarly, speculators are net short vol, but a snap can occur at any time. This is eerily reminiscent of February 2018. Since 2017, this vol positioning measure has consistently troughed prior to the SPX peak on three occasions and a “four-peat” likely looms (vol net spec positions shown inverted, bottom panel, Chart 2). On the profit front, sector earnings breadth is sinking like a stone confirming the negatively anchored S&P 500 net EPS revisions ratio (Chart 3). We doubt that 10% EPS growth for calendar 2020 is even plausible, especially given the looming steep deceleration in equity retirement that we highlighted recently.1 Tack on the mighty US dollar, and profit headwinds abound. Chart 2...A Coiled Spring Chart 3No Earnings Pulse Market internals are also screaming that something is off in the equity markets. Small caps are trailing large caps, transports are at stall speed, weak balance sheet stocks are underperforming strong balance sheet stocks, the median stock as per the Value Line Geometric Index is far from all-time highs and high yield bonds (especially CCC rated) are also not confirming the SPX breakout (Chart 4). Importantly, the CBOE’s S&P 500 implied correlation index, which gauges “the expected average correlation of price returns of S&P 500 Index components, implied through SPX option prices and prices of single-stock options on the 50 largest components of the SPX”,2 is rising again over the 40% mark, underscoring that stocks are more and more beginning to move in tandem. Historically this has been a negative omen (implied correlation index shown inverted, top panel, Chart 5). Chart 4Watch Market Internals Chart 5Reflation No More? Downtrodden M&A activity is also firing a warning shot. A steep divergence of M&A deals from stock prices is atypical at this late stage of the business cycle (middle panel, Chart 5). In fact, out Reflation Gauge comprising the greenback, oil prices and the 10-year Treasury yield has taken a turn for the worse, signaling that economic surprises will likely suffer the same fate (bottom panel, Chart 5). All of this, warns that the risks of a significant pullback in the SPX are rising. What follows is four high-conviction overweight and four underweight calls. Similar to last year, we are using BCA’s view of a selloff in the bond market is a key factor underpinning most of our 2020 high-conviction calls.3 While last year this was offside, the collapse in the 10-year US Treasury yield from 3% last December to 1.75% currently offers a better backdrop for this view to pan out. A 50bps to 75bps rise in the 10-year Treasury yield in 2020, as our BCA house view predicts, will have significant knock on effects on sector selection.4 As a reminder, interest rates are one of the most important macro drivers of overall equity returns via valuations (10-year Treasury yield shown inverted, Chart 6). Moreover on a sector basis, the ebbs and flows of the risk free asset directly influence utilities, real estate, financials, consumer discretionary and tech growth stocks or more than half of the S&P 500’s market capitalization. Chart 6Priced To Perfection What follows is four high-conviction overweight and four underweight calls. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com S&P Managed Health Care (Overweight) We upgraded the S&P managed health care group to overweight in April shortly after Bernie Sanders re-introduced his revamped “Medicare For All” bill. Despite the recent explosive run up in relative share prices – partly owing to the drop in Elizabeth Warren’s odds of winning the Democratic candidacy and partly given her watering down of her “Medicare For All” take up plan – we are adding this health care sub-group to our high-conviction overweight call list. HMOs are finally raising prices at the steepest rate of the past fifteen years and while such breakneck pace is unsustainable, profit margins are set to expand smartly (Chart 7). The profit margin backdrop is enticing for health insurers for another reason: labor cost containment. CEOs have been extremely prudent refraining from adding to headcount. One final profit margin booster is the rising 10-year Treasury yield, as roughly 10% of the industry’s operating income is tied to “investment income”. In other words, as insurers receive the premia they typically invest it in Treasurys and that explains the high EPS and margin sensitivity on interest rate moves. Thus, if BCA’s bond view materializes, it will prove a tonic to both margins and profits. With regard to technicals, relative share prices are not as oversold as they were mid-year, but remain below the neutral zone still offering investors a compelling entry point to this position (bottom panel, Chart 7). The ticker symbols for the stocks in this index are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG. Chart 7S&P Managed Health Care S&P Machinery (Overweight) A tentative up-tick in EM data in general and China in particular along with improving operating metrics signal that the US/China trade war wounded machinery stocks deserve a high-conviction overweight status for 2020. In more detail, the budding recoveries in the EM and Chinese manufacturing PMIs herald a brighter outlook for relative share prices. China’s fiscal and credit impulse also signals that a bottom in relative share prices is likely already in place. If this leading indicator proves accurate in the coming months, then relative share prices can reclaim the early-2018 highs. On the operating front, the new orders-to-inventories momentum has traced a bottom. Assuming that the Chinese manufacturing PMI reading stays on an upward trajectory, machinery demand will make a durable comeback. None of these green shoots are reflected in sell-side analysts’ bombed out relative profit and sales growth expectations (bottom panel, Chart 8). The ticker symbols for the stocks in this index are: BLBG – S5MACH – CAT, DE, ITW, IR, CMI, PCAR, PH, SWK, FTV, DOV, XYL, IEX, WAB, SNA, PNR, FLS. Chart 8S&P Machinery S&P Banks (Overweight) The expected price of credit, still pristine credit quality, and a looming reacceleration in credit growth all argue for including the S&P banks index in our high-conviction overweight list. Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market. As the bond sell-off gained steam, the bank outperformance phase also caught on fire. BCA’s view for next year calls for a 50-75bps selloff in the 10-year Treasury yield, further boosting the allure of bank equities (top panel, Chart 9). Beyond the rising price of credit, credit growth is another key industry profit driver. 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. The upshot is that bank credit growth will likely reaccelerate in the first half of 2020 (third panel, Chart 9). 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. Despite all this enticing news, bank valuations remain anchored near rock bottom levels and a resurgent ROE is signaling that there is a long runway ahead for relative bank valuations (bottom panel, Chart 9). 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. Chart 9S&P Banks Long Large Caps/Short Small Caps (Overweight) The large cap size bias is our sole hold out from last year’s high-conviction list despite getting stopped out and booking a handsome 9% profit. Today we recommend reinstating a large cap size bias. This call actually represents a slight hedge on BCA’s overall higher interest rates view for next year. Financials comprise 13% of the SPX, but the weight jumps to 18% in small cap indexes. Thus, if the rising interest view is off the mark, the large cap bias will provide an offset. Relative forward profit growth favors mega caps and by a wide margin. One key factor underpinning this increasing profit gap is the massive profit margin divergence (Chart 10). Tack on the fact that index providers omit negative forward profits from their index EPS calculations and the narrative that small caps have cheapened versus large caps falls flat on an adjusted basis. Why? Because a large number of small caps have negative forward EPS. Moreover, we recently created a relative employment proxy that is firing on all cylinders. Not only is the small business labor market crumbling according to the latest NFIB survey, but hard data also suggest that nonfarm private small business payroll employment has ground to a halt. Finally, small caps are debt saddled compared with large caps and small cap b/s have actually been degrading of late (Chart 10). Chart 10Long Large Caps/Short Small Caps S&P Homebuilding (Underweight) We downgraded homebuilders to underweight in late-October, and today we are adding it to our high-conviction underweight call list. Most, if not all, positive profit drivers are already reflected in relative share prices. Specifically, the drubbing in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders. Now that interest rates are moving in reverse, more pain lies ahead for the S&P homebuilding index (Chart 11). Worrisomely, consumers’ expectations to purchase a new home plunged anew last month according to The Conference Board’s survey, and that demand softness will weigh on housing starts and ultimately homebuilding revenues (Chart 11). Adding insult to injury, new house selling prices are losing ground to existing home prices, but such discounting is no longer boosting volumes as new home sales market share gains have stalled. Already, S&P homebuilding sales are contracting and the risk is that deflation gets entrenched in this construction industry (Chart 11). Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR. Chart 11S&P Homebuilding S&P Semi Equipment (Underweight) While year-to-date chip equipment stocks are the best performing index in the SPX, we deem them a mania, and include them in our high-conviction underweight basket for 2020. The top panel of Chart 12 shows this irrational exuberance that has permeated the semi equipment universe is similar to the dotcom era excesses. Back in the late-1990s relative profit growth was sky high, but today it is flirting with the zero line, warning that gravity will pull these stocks back down to earth (second panel, Chart 12). The contracting ISM manufacturing survey signals that relative share price momentum running at a breakneck pace is unwarranted. The same holds true for relative forward profit and revenue growth expectations, especially given the ongoing contraction in global semi sales (middle panel, Chart 12). This deficient demand for semis and therefore semi equipment manufacturers is also apparent in deflating DRAM prices, our industry pricing power proxy. Historically, relative profit expectations and pricing power have moved in lockstep and the current message is to fade sell-side analysts’ buoyancy. Net earnings revisions have slingshot from extreme pessimism to extreme optimism during the past quarter and are vulnerable to disappointment (bottom panel, Chart 12). In sum, lack of profit growth, deficient industry demand, perky valuations and extremely overbought conditions all suggest that the mania in the S&P chip equipment index will likely turn into a panic next year. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC. Chart 12S&P Semi Equipment S&P Utilities (Underweight) Heavily indebted utilities are a high-conviction underweight call for next year. · Relative share prices and the 10-year Treasury yield are closely inversely correlated. Now that the risk free asset is having a more competitive yield, investors will likely start to abandon this niche defensive sector. The jury is still out on the final outcome of the Sino-American trade war. However, there has been a decisive change of heart in US exporters and the ISM manufacturing survey’s new export orders subcomponent reflects an, at the margin, improvement in the US/China trade relationship. This bodes ill for safe haven utilities stocks (Chart 13). Utilities command a 19.4 forward P/E multiple representing roughly a 10% premium to the broad market, but their forecast EPS growth rate at 5% trails the SPX by 400bps. Our composite relative Valuation Indicator has surged to one standard deviation above the historical mean, a level typically associated with recession (Chart 13). On the operating front, natural gas prices are contracting at the steepest pace of the past four years, and electricity capacity utilization is in a multi-decade downtrend, warning that the relative profitability will remain under pressure in 2020. The implication is that this crowded trade is at risk of deflating, especially if the breakout in bond yields gains steam as BCA expects. The ticker symbols for the stocks in this index are: BLBG – S5UTIL– PPL, PNW, ATO, PEG, FE, EIX, AEE, SO, SRE, AEP, XEL, DTE, EVRG, WEC, AES, CMS, LNT, ED, NRG, D, AWK, DUK, ETR, EXC, NEE, CNP, NI, ES. Chart 13S&P Utilities S&P Real Estate (Underweight) We would refrain from chasing high yielding real estate stocks higher, and instead we are including them in our high-conviction underweight call list for 2020. The commercial real estate (CRE) sector is a bubble candidate that exemplifies this cycle’s excesses. CRE prices sit at roughly two standard deviations above both the historical time trend and the previous cycle’s peak (not shown). Worryingly, CRE demand is waning. Not only our proprietary real estate demand indicator has sunk recently, but also the latest Fed Senior Loan Officer survey revealed that demand for CRE loans remains feeble. Simultaneously, fewer bankers are willing to extend CRE credit according to the same quarterly Fed survey (Chart 14). Occupancy rates have crested and there are increasing anecdotes of credit quality deterioration. As a result, CRE rents are also failing to keep up with inflation which eats into relative cash flow growth prospects. The supply side build up tilts this delicate balance further into deficit. Non-residential construction shows no signs of abating, with multi-family housing starts still running at an historically high rate of roughly 400K/annum (Chart 14). Finally, interest rate related headwinds will also weigh on this high-yielding sector in coming quarters, especially if the selloff in the bond market gains steam as BCA expects. (Chart 14). The ticker symbols for the stocks in this index are: BLBG – S5RLST – AMT, PLD, CCI, SPG, EQIX, WELL, PSA, EQR, AVB, SBAC, O, DLR, WY, VTR, ESS, BXP, CBRE, ARE, PEAK, MAA, UDR, EXR, DRE, HST, REG, VNO, IRM, FRT, KIM, AIV, SLG, MAC. Chart 14S&P Real Estate Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “Gasping For Air” dated November 18, 2019, available at uses.bcaresearch.com. 2 https://www.cboe.com/micro/impliedcorrelation/impliedcorrelationindicator.pdf 3 Please see BCA The Bank Credit Analyst Monthly Report, “OUTLOOK 2020: Heading Into The End Game” dated November 22, 2019, available at bca.bcaresearch.com. 4 Ibid. 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 Monetary policy settings should continue to sustain the expansion,… : Tight monetary policy is a precondition for a recession. Although the line separating tight from easy is a matter of judgment, current Fed policy is squarely accommodative. … and the building blocks of GDP confirm that recession is not an imminent threat: A robust labor market and fortified household balance sheets should continue to support consumption; the fixed investment outlook is okay as long as trade tensions don’t wreck business confidence; and the fiscal taps are likely to remain open throughout 2020. Housing will not get in the way of the economy or the markets: Mortgage rates have fallen since we examined housing dynamics in a two-part Special Report this time last year, and residential investment will increasingly reflect it. We project that the beginning of the next recession is about two years away, and that the equity and credit bull markets still have room to run: We are not perma-bulls, but there’s no evidence that the long bull run is about to end. Feature We view the study of key cycles – the business cycle, the credit cycle, the monetary policy cycle and the sentiment cycle – as an essential element of investment strategy. The monetary policy cycle has been especially critical throughout the long expansion and bull market because it has held sway over the business cycle and the credit cycle since the crisis. We have also found that it exerts a powerful influence on equity returns: for six decades, stocks have done very well when policy is easy, but they have failed to generate positive real total returns when it’s tight. There is far more to investment returns than monetary policy, but a simple strategy of embracing risk during easy-policy phases of the fed funds rate cycle and limiting exposure to it when policy is tight has been a big winner over time. Although the fed funds rate cycle has been an especially valuable input in our process, it relies on an estimate. The equilibrium, or neutral, fed funds rate cannot be directly observed. We can only infer when the target fed funds rate crosses above or below it by observing actual economic performance. We continually review real-time data to gauge whether our equilibrium estimate is in the ballpark. As a formal check on that estimate, we regularly examine the building blocks of GDP for insight into where the business cycle is going. We update our review of the GDP equation in this report, and conclude that the expansion should remain on track over the next six to twelve months. We also provide an update on housing a year after our dedicated Special Reports on the topic, finding that it is unlikely to derail the expansion. The GDP Equation – Consumption As we all learned in Introductory Macroeconomics, GDP is the sum of consumption (C), investment (I), government spending (G) and net exports (X-M). As net exports are insubstantial in the comparatively closed US economy, US GDP growth reduces to the weighted sum of growth in consumption, investment and government spending, with consumption accounting for two-thirds of growth and investment and government spending accounting for one-sixth each. GDP = C + I + G Month-to-month moves in real retail sales and personal consumption expenditures (PCE) are volatile, but both series have recovered from their late-2018 softness to get back to their mean for this cycle, somewhat below the means of the previous two expansions (Chart 1). The activity supports our constructive take at the time of our initial review of the GDP equation in April,1 but the choppy series do not provide much insight into the consumption outlook. Looking forward involves examining households’ income prospects and balance sheets to project the money that will be coming in, and consumers’ ability and willingness to spend it. Chart 1Consumption Has Been Holding Up Well Labor market conditions drive household income, and they remain quite tight. The number of unfilled job openings continues to exceed the number of unemployed workers (Chart 2), indicating that demand for employees remains strong. An elevated quits rate indicates that employers are competing fiercely to meet that demand, even to the point of poaching employees from one another (Chart 3). Our payrolls model projects that employment growth will stay close to its pace of the last several years (Chart 4, top panel), as small businesses have ambitious hiring plans (Chart 4, second panel), temporary employment is still growing (Chart 4, third panel), and the 26-week moving average of initial unemployment claims is only slowly beginning to rise (Chart 4, bottom panel). Chart 2With More Jobs Than Workers, ... Chart 3... Employees Can Seek Out Greener Pastures Chart 4Payrolls Will Keep Expanding Wages are already growing around 3% year-over-year, and the tight labor-market backdrop should promote further gains. With employers forced to bid up wages to attract a shrinking pool of available workers, we expect that wage growth will peak somewhere above 3.5% before the cycle ends. Humans’ ability to see into the future does not extend beyond six to twelve months, but we are confident that more households will be working by the middle of 2020 than are working now, and that they’ll be earning more, in real terms. Households don't have to spend their income gains, but they're in a comfortable position to do so after several years of building up savings and working down debt. Households won’t necessarily spend all of their income gains. They may choose to direct them to paying down debt or increasing savings. Their balance sheets suggest they don’t have a need to do so, however, as the savings rate is back to early ‘90s levels above 8% (Chart 5, top panel), nearly all the debt as a share of GDP that they took on in the last expansion has been worked off (Chart 5, middle panel), and their aggregate debt service burden is lower now than it has been at any point in the last 40 years (Chart 5, bottom panel). Not only do households face little pressure to save their coming income gains, they have plenty of capacity to borrow to augment them. Chart 5Household Finances Are Solid The GDP Equation – Investment And Government Spending Investment accounts for just a sixth of GDP, but its volatility gives it a greater likelihood of tipping the economy into a recession than either consumption or government spending (Chart 6). Per the surveys we use to anticipate capital expenditures, the change since April is mixed. Small business capital spending plans as reported in the NFIB survey have ticked up and remain elevated (Chart 7, top panel), while capex intentions from the regional Fed manufacturing surveys have continued to slip and are only around their historical mean (Chart 7, bottom panel). We expect that the trade negotiations will exert a powerful near-term pull on corporate capex; if the US and China reach some sort of accord, capex should pick up, but if tensions worsen, corporate confidence will decline and capex may outright contract. Our base case calls for a modest détente around a Phase 1 agreement, so we do not expect that investment will break down, but it is the most vulnerable component of GDP and we are watching it closely. Chart 6Investment Is The Swing Factor Chart 7The Capex Outlook Is Only Okay, ... Government spending, on the other hand, doesn’t merit a whole lot of attention right now. It is a stable series that accounts for a modest share of GDP and for most of the postwar era, it was reliably countercyclical, shrinking when times were good and expanding when times were bad (Chart 8). The gaping divergence between the federal deficit and economic performance bodes ill for Treasuries and the dollar over the long term, but it shows that there’s no appetite for reining in federal spending ahead of the most hotly contested election campaign in recent memory. State and local spending accounts for about 60% of all government spending, and the strong labor market will boost state receipts, which come from income and sales taxes, while steady home price appreciation will support property tax receipts (Chart 9), keeping municipal coffers full. The longer-term implications of the debauched federal budget are unpleasant, but government profligacy will help sustain the expansion through the end of next year. Chart 8... But The Fiscal Party Rages On Chart 9Home Price Gains Will Fill Local Government Coffers Housing Residential investment finally broke out of a six-quarter string of detracting from GDP growth last quarter, though its drag in the first half of the year was modest. Residential investment may not exert the sway over the economy that it did earlier in the postwar era when the suburbs were being created from scratch, but its interest rate sensitivity makes it a good proxy for the effect of monetary policy on the economy. Housing has picked up as mortgage rates have fallen, and rates’ lagged effect suggests that more gains are in store (Chart 10). A high level of affordability should keep the momentum going (Chart 11), and new household formations continue to outstrip housing starts (Chart 12, top panel), at a time when inventories (Chart 12, middle panel) and vacancies (Chart 12, bottom panel) are historically low. Chart 10The Full Effect Of Lower Rates Is Yet To Be Felt Chart 11Affordability Is High, ... Chart 12... And Supply Is Tight We continue to believe that housing poses no threat to the expansion. New home sales should pick up as builders address the undersupply of homes for first-time and first move-up buyers. The cap on itemized deductions imposed by the December 2017 revision to the federal tax code does not appear to have had a material impact on regional sales activity, and the relationship between top marginal income tax rates2 and home price appreciation since the tax act passed is weak (Chart 13). The bottom line is that residential investment is more likely to boost fixed investment over the next year than it is to detract from it. Chart 13Post-Act Home Price Appreciation Among 20-City Case-Shiller Constituents Investment Implications The underlying elements of the GDP equation support our monetary policy-driven assessment that the expansion will keep chugging along. A robustly healthy labor market will support wage gains, and household balance sheets have firmed up enough to allow consumers to spend their increased income. Surveys indicate that fixed investment does not present a major economic headwind, and positive trade developments could turn it into a tailwind. Government spending will be well supported through 2020. It would be consistent with history if this bull market didn't end until it made one more big push higher. Recessions and bear markets coincide, so the equity bull market should persist until the next recession is in sight. Spread product should also continue to outperform Treasuries and cash, especially while lenders are desperately seeking incremental carry. We reiterate our broad recommendation to overweight equities and spread product, while underweighting Treasuries, and urge investors with more conservative mandates to remain at least equal weight equities and spread product. Excesses in the real economy or the financial markets are a recession prerequisite, and it is quite possible that the excesses that precipitate the next recession will not emerge until after stocks make another significant move higher. We want to be positioned to participate in that move, which would be consistent with bull markets’ established tendency to sprint to the finish line. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 8, 2019 US Investment Strategy Weekly Report, “If We Were Wrong,” available at www.bcaresearch.com 2 The 2017 Act capped the amount of state and local tax payments household filers could claim as itemized deductions, severely reducing the federal government’s homeownership subsidy. Residents of states with high income tax rates lost the most from the change, but those states’ housing markets have not yet experienced disproportionately negative impacts.
Falling home prices and relatively tight financing conditions for property developers will likely prevent a recovery in construction activity. There has recently been a pickup in residential property sales. Our research reveals that this has been the…
Real estate activity in general, and property construction volumes in particular, are critical to our thesis of an ongoing growth slowdown in China. The basis is that construction volumes on the mainland have a considerable impact on industrial activity both within and outside China. On the structural front, housing demand is facing major headwinds: Genuine pent-up demand for housing has diminished. Most Chinese households already own at least one property. Based on a recent survey conducted by The Economic Daily,1 nearly 97% of households surveyed own at least one residential property. Last year’s China Household Finance Survey (CHFS), conducted by Southwestern University of Finance and Economics of China, showed about 68% of new homes sold in China’s urban areas in the first quarter of 2018 were purchased for the purpose of investment. In addition, the living area per capita in China’s urban areas has risen to 40 square meters as of the end of last year – larger than in South Korea and Japan. Other structural impediments include low affordability, slowing rural-to-urban migration, demographic changes and the promotion of the housing rental market. The government has been repeatedly stressing that China will not use the property market as a short-term economic growth-booster this time. The authorities will also continue to prevent speculative housing demand. Between late 2015 and 2017, the People's Bank of China undertook outright monetization of excess housing inventories via the Pledged Supplementary Lending (PSL) program. So far, even though the Chinese economy has already slowed considerably, the government has not injected much stimulus into the property market. On the contrary, the government has drastically reduced the number of slum-reconstruction units as well as its PSL injection this year. This year, the government has also started a new long-term project of renovating residential buildings built in 2000 or earlier. The projects involved include adding parking lots, elevators, fiber cable installments, electricity/gas line improvements, and so on. This renovation program will likely delay property purchases from those owners who were considering purchasing new properties instead of living in the older residential buildings. Chart II-1Property Sales In China: A Sustainable Recovery? From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity: First, Chart II-1 shows there has recently been a pickup in residential property sales. Our research reveals that this has been the result of aggressive promotion strategies – price reductions – implemented by many real estate developers. Among the promotions being offered by many developers are “buy one property, get the second one at half price,” “buy a house and get a car for free,” or “buy a house and get free furniture and decorations.” Local governments have been “discouraging” outright property price declines. Yet, it seems they have allowed implicit price reductions to take place. In cases where outright price cuts cannot be avoided, the authorities try to limit them. Earlier this month, the government of Maanshan, a third-tier city in the Anhui province, released a rule instructing property developers not to lower prices by more than 10%. The outlook for China’s property market and construction activity is downbeat. As a result, official statistics on new housing prices do not truly reflect price pressures in the marketplace. Official statistics show new housing prices are rising at 9% since last year. Nevertheless, many 1st- and 2nd- tier cities are showing price declines in their secondhand residential property markets (Chart II-2). Chart II-2China: Secondary Market Property Prices Are Weak Chart II-3Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction All in all, it seems that falling home prices have begun to spread from 1st tier cities to some 2nd- and 3rd-tier cities. The number of cities reporting declines in residential home prices is on the rise. Second, in theory, falling property prices should discourage new starts and new construction. Falling prices signal that supply is exceeding demand, with producers typically responding by curtailing output. This holds true for any industry. However, the intricacies of property developers in China may be different. Chart II-4Building Construction Data Is A Broader Measure Than Commodity Buildings Specifically, property developers have been pre-selling aggressively since 2017 while slowing their completion process due to lack of financing (Chart II-3). Such financial constraints arose due to their rapid expansion in the past 10 years. Having already incurred enormous amounts of leverage, they have resorted to pre-sales as another source of funding. Property developers are currently under pressure to deliver those units that were pre sold about two years ago. Will they be able to secure new funding and ramp up construction? Or will they default or delay delivery of houses? It may well be different for each developer. The ones with strong balance sheets and access to financing will build and deliver. The weakest ones will default, while the average ones will likely delay delivery. Hence, it is difficult to gauge construction trends in the next six months in the residential property market. Even so, it is unlikely to be very strong given the industry is highly fragmented, and many small and medium and even some large developers are financially weak. Finally, there is a large gap between the two construction activity datasets – both published by the National Bureau of Statistics. These datasets are referred to as “commodity buildings” and “building construction” (Chart II-4). “Commodity buildings” – i.e., those developed by real estate developers (the equivalent of homebuilders in the US), are only a subset of “building construction.” The “building construction” dataset is more comprehensive. It includes not only “commodity buildings” but also buildings built by non-real estate developers. For example, companies, universities, and various organizations that can construct both residential and non-residential buildings for their own use. Both datasets include residential and non-residential buildings. From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity. Chart II-5 illustrates that “building construction” floor area started, under construction and completed are all shrinking. They are much weaker than floor area started, under construction and completed of “commodity buildings.” Chart II-5Building Construction Is In Recession Chart II-6Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity The take-away from these datasets is as follows: Construction activity in China goes beyond property developers and “commodity buildings” statistics do not always paint the complete picture. Companies and organizations have dramatically curtailed their construction activity. Combined with tight financing conditions for real estate developers, this heralds a downbeat outlook for construction activity. Bottom Line: While short-term fluctuations in construction activity are impossible to gauge in China, the cyclical outlook remains negative. The current round of stimulus has avoided the property market, and real estate bubble excesses have not yet been wrung out. This is why we remain negative on China’s construction outlook and continue to recommend underweighting property developers relative to both the A-share and investable equity indexes. Falling steel, iron ore and industrial commodities prices confirm that construction activity in China remains weak (Chart II-6). Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1 The Economic Daily, administratively managed by the Ministry of Communication, is one of the most influential and authoritative newspapers in China. It is an official outlet for the government to publicize its economic policies.
Highlights Analysis on the Chinese property market is available below. In the Philippines, domestic demand is set to accelerate at the hands of the government’s fiscal boost. The current account deficit will widen and the peso and local bonds will likely sell-off. This warrants an underweight stance in this interest rate-sensitive bourse. A new trade: Pay 2-year swap rates. The outlook for China’s property market and construction activity is downbeat. Financial market plays leveraged to mainland construction activity remain at risk. The Philippines: The Cycle Is Turning The relative performance of Philippine equities against the EM benchmark is moving inversely to the direction of relative (Philippines minus EM) local bond yields (Chart I-1). When local Philippine bond yields drop versus those of other EMs, this bourse outperforms, and vice versa. Likewise, Philippine share prices in absolute terms exhibit a negative relationship with local bond yields (Chart I-2). The rationale behind this high sensitivity in share prices to local interest rates is the large presence of banks and property stocks in the Philippines' bourse. Banks account for 20% and real estate stocks another 21% of the local stock exchange. These sectors benefit in a falling interest rate environment and suffer during periods of rising rates. Chart I-1Philippines Vs. EM: Relative Stock Prices And Bond Yields Chart I-2Philippine Stocks Are Inversely Correlated To Domestic Bond Yields Our underweight position in Philippine equities has not played out because the economy has slowed much more than we had expected, which has also coincided with collapsing US Treasury bond yields. Consequently, Philippine local bond yields have plummeted, supporting the stock market’s absolute and relative performance. Chart I-3Philippine Growth Slowed Due To A Slump In Government Spending Chart I-4Negative Fiscal & Credit Impulse Stabilized The Current Account Deficit The growth rate of the Philippines has decelerated markedly due to sharp slowdowns in both government spending and bank loan growth (Chart I-3). In fact, the combined bank loan and fiscal spending impulse has plunged, leading to a major slowdown in domestic demand, which in turn has stabilized the current account (Chart I-4). The latter effect has supported the currency and allowed the central bank to cut rates. A budget deadlock on a number of items delayed the approval of the 2019 budget, causing government spending to plunge in the first half of 2019. In short, it was unintended fiscal tightening that has wrong-footed our view on the direction of the macro cycle, and consequently Philippine financial markets. Government spending has been instrumental in driving fixed capital formation since President Rodrigo Duterte came to power in May 2016. Philippine local bond yields have plummeted, supporting the stock market’s absolute and relative performance. Going forward, the macro cycle is set to reverse: Chart I-5Philippines: Signs Of A Growth Rebound Government expenditure will rise substantially – infrastructure spending in particular – lifting imports. The 2019 budget was approved back in April, and the House of Representatives has given the green light to extend the shelf-life of the current 2019 budget. Moreover, the fiscal 2020 budget, now approved by Duterte, entails 12% nominal growth in government expenditures in general and 14% growth in capital/infrastructure spending in particular. Duterte will oversee 100 flagship infrastructure projects estimated to cost 4.3 trillion Philippine pesos, or 24% of GDP. More than half of these projects are either ongoing or will commence construction in the next six to eight months. The larger infrastructure expenditure will encourage bank lending. Overall, domestic demand will revive considerably, causing the current account deficit to widen. Importantly, the expected fiscal boost will come on top of already strong consumer spending. The marginal propensity to spend among households and companies is already improving, confirming domestic growth acceleration (Chart I-5, top panel). In particular, both vehicle and machinery sales are recovering (Chart I-5, middle panel). Narrow and broad money impulses have bottomed (Chart I-5, bottom panel). Stronger imports amid still-depressed exports due to sluggish global demand will lead to a widening of the current account deficit. We expect the peso to resume its depreciation. Renewed currency weakness and a domestic demand revival will put a floor under inflation. The central bank is headed by Governor Benjamin Diokno, the former Budget Secretary and an associate of populist President Duterte. The odds are that the central bank will not hike interest rates in the face of a rising current account deficit and modestly rising inflation. This will reinforce currency depreciation. Finally, domestic bond yields are set to rise. A widening fiscal deficit has historically coincided with higher domestic bond yields (Chart I-6). Odds are it will not be different this time. Besides, Philippine banks have been relentlessly purchasing government bonds because credit demand from companies has been sluggish (Chart I-7). As private credit demand begins to recover and banks accelerate their loan origination, they will become net sellers – or will at least ease their pace of government bond purchases – pushing yields higher. Chart I-6Rising Fiscal Deficit Is Bad News For Bonds Chart I-7Philippine Commercial Banks Have Been Purchasing Government Bonds En Masse Bottom Line: Unintended fiscal tightening has slowed domestic demand, narrowed the current account deficit, supported the currency and induced a drop in local bond yields. This has allowed the Philippines’ interest rate-sensitive bourse to outperform the overall EM equity index. Going forward, the macro cycle is set to reverse. This cycle is about to reverse due to strong fiscal expansion: Domestic demand and imports will grow briskly, and the current account deficit will widen considerably. Widening twin deficits will lead to material currency depreciation and higher domestic bond yields. Investment Recommendations Continue shorting the Philippine peso versus the US dollar. 2-year swap rates are 48 basis points below the policy rate (Chart I-8). The market will price out rate cuts as the business cycle recovers and the currency depreciates. We recommend a new trade: pay 2-year swap rates. Dedicated EM fixed-income investors should underweight the Philippines in their EM domestic currency bonds and sovereign credit portfolios. Chart I-8The Market Is Expecting Rate Cuts Chart I-9Philippine Equity Market Is Not Cheap Does an upcoming growth revival warrant an overweight stance in Philippine stocks within an EM equity portfolio? As shown in Charts I-1 and I-2, this equity market is more sensitive to interest rates than growth. The growth deceleration did not prevent this stock market from outperforming its EM peers. Hence, higher local bond yields amid renewed currency depreciation will likely lead to a period of underperformance. Finally, Philippine stocks are not cheap in absolute terms or relative to the EM benchmark (Chart I-9). Hence, they will not respond well to rising interest rates. Chart I-10Philippine Property Stocks Will Suffer As Interest Rates Rise Within this bourse, underweight/short property stocks. These stocks are the most vulnerable to rising bond yields (Chart I-10). The key risks to our strategy are lower global bond yields and continuous flows of foreign capital into EM assets in general, and local bonds in particular. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com China: Making Sense Of The Property Market Real estate activity in general, and property construction volumes in particular, are critical to our thesis of an ongoing growth slowdown in China. The basis is that construction volumes on the mainland have a considerable impact on industrial activity both within and outside China. On the structural front, housing demand is facing major headwinds: Genuine pent-up demand for housing has diminished. Most Chinese households already own at least one property. Based on a recent survey conducted by The Economic Daily,1 nearly 97% of households surveyed own at least one residential property. Last year’s China Household Finance Survey (CHFS), conducted by Southwestern University of Finance and Economics of China, showed about 68% of new homes sold in China’s urban areas in the first quarter of 2018 were purchased for the purpose of investment. In addition, the living area per capita in China’s urban areas has risen to 40 square meters as of the end of last year – larger than in South Korea and Japan. Other structural impediments include low affordability, slowing rural-to-urban migration, demographic changes and the promotion of the housing rental market. The government has been repeatedly stressing that China will not use the property market as a short-term economic growth-booster this time. The authorities will also continue to prevent speculative housing demand. Between late 2015 and 2017, the People's Bank of China undertook outright monetization of excess housing inventories via the Pledged Supplementary Lending (PSL) program. So far, even though the Chinese economy has already slowed considerably, the government has not injected much stimulus into the property market. On the contrary, the government has drastically reduced the number of slum-reconstruction units as well as its PSL injection this year. This year, the government has also started a new long-term project of renovating residential buildings built in 2000 or earlier. The projects involved include adding parking lots, elevators, fiber cable installments, electricity/gas line improvements, and so on. This renovation program will likely delay property purchases from those owners who were considering purchasing new properties instead of living in the older residential buildings. Chart II-1Property Sales In China: A Sustainable Recovery? From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity: First, Chart II-1 shows there has recently been a pickup in residential property sales. Our research reveals that this has been the result of aggressive promotion strategies – price reductions – implemented by many real estate developers. Among the promotions being offered by many developers are “buy one property, get the second one at half price,” “buy a house and get a car for free,” or “buy a house and get free furniture and decorations.” Local governments have been “discouraging” outright property price declines. Yet, it seems they have allowed implicit price reductions to take place. In cases where outright price cuts cannot be avoided, the authorities try to limit them. Earlier this month, the government of Maanshan, a third-tier city in the Anhui province, released a rule instructing property developers not to lower prices by more than 10%. The outlook for China’s property market and construction activity is downbeat. As a result, official statistics on new housing prices do not truly reflect price pressures in the marketplace. Official statistics show new housing prices are rising at 9% since last year. Nevertheless, many 1st- and 2nd- tier cities are showing price declines in their secondhand residential property markets (Chart II-2). Chart II-2China: Secondary Market Property Prices Are Weak Chart II-3Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction All in all, it seems that falling home prices have begun to spread from 1st tier cities to some 2nd- and 3rd-tier cities. The number of cities reporting declines in residential home prices is on the rise. Second, in theory, falling property prices should discourage new starts and new construction. Falling prices signal that supply is exceeding demand, with producers typically responding by curtailing output. This holds true for any industry. However, the intricacies of property developers in China may be different. Chart II-4Building Construction Data Is A Broader Measure Than Commodity Buildings Specifically, property developers have been pre-selling aggressively since 2017 while slowing their completion process due to lack of financing (Chart II-3). Such financial constraints arose due to their rapid expansion in the past 10 years. Having already incurred enormous amounts of leverage, they have resorted to pre-sales as another source of funding. Property developers are currently under pressure to deliver those units that were pre sold about two years ago. Will they be able to secure new funding and ramp up construction? Or will they default or delay delivery of houses? It may well be different for each developer. The ones with strong balance sheets and access to financing will build and deliver. The weakest ones will default, while the average ones will likely delay delivery. Hence, it is difficult to gauge construction trends in the next six months in the residential property market. Even so, it is unlikely to be very strong given the industry is highly fragmented, and many small and medium and even some large developers are financially weak. Finally, there is a large gap between the two construction activity datasets – both published by the National Bureau of Statistics. These datasets are referred to as “commodity buildings” and “building construction” (Chart II-4). “Commodity buildings” – i.e., those developed by real estate developers (the equivalent of homebuilders in the US), are only a subset of “building construction.” The “building construction” dataset is more comprehensive. It includes not only “commodity buildings” but also buildings built by non-real estate developers. For example, companies, universities, and various organizations that can construct both residential and non-residential buildings for their own use. Both datasets include residential and non-residential buildings. From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity. Chart II-5 illustrates that “building construction” floor area started, under construction and completed are all shrinking. They are much weaker than floor area started, under construction and completed of “commodity buildings.” Chart II-5Building Construction Is In Recession Chart II-6Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity The take-away from these datasets is as follows: Construction activity in China goes beyond property developers and “commodity buildings” statistics do not always paint the complete picture. Companies and organizations have dramatically curtailed their construction activity. Combined with tight financing conditions for real estate developers, this heralds a downbeat outlook for construction activity. Bottom Line: While short-term fluctuations in construction activity are impossible to gauge in China, the cyclical outlook remains negative. The current round of stimulus has avoided the property market, and real estate bubble excesses have not yet been wrung out. This is why we remain negative on China’s construction outlook and continue to recommend underweighting property developers relative to both the A-share and investable equity indexes. Falling steel, iron ore and industrial commodities prices confirm that construction activity in China remains weak (Chart II-6). Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1 The Economic Daily, administratively managed by the Ministry of Communication, is one of the most influential and authoritative newspapers in China. It is an official outlet for the government to publicize its economic policies. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations