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Research, News & Views from ASR for the week to January 18th, 2019
ASR Strategic Asset Allocation: Q1 2019 – Cyclically cautious – structurally bearish from Ian and the team.
Our Strategic Asset Allocation piece has 4 sections - Structural Themes: the 3-5-year view for late cycle investing; the Strategic 12m Ahead views; the Key Charts for each asset class; Data: Ranked asset class and Factor returns.
Structural Themes – the 3-5-year view for late cycle investing
2018 challenged most asset classes as Fed tightening led to a liquidity squeeze, resulting in an 11% fall for Global equities, a 6% fall in US equities and a 22% fall in Global SIFIs.
• It is easy to see the attraction of being tactically bullish, but we would ‘sell the rallies’, not ‘buy the dips.
• We expect another year of double-digit declines for global equities.
• The window for a policy response is almost closed. Recession worries are rising.
• The risk is that tight liquidity prompts a series of rolling corrections in risk assets. We are moving into a structurally bearish view. Investors should brace themselves for late cycle investing.
Economics. Our Business Cycle indicator (HERE) has begun to signal the US and Global economies are moving into late cycle, the most difficult phase for risk assets (HERE). Unemployment is key to watch – only small changes may signal a shift to recession. Our US recession risk models continue to rise (now 34%), while pressures are emerging for a more pronounced slowdown in the Eurozone and Japan. Corporate confidence is waning which bodes ill for Capex expectations.
Earnings. Peak cycle tends to see peak margins and peak profits. Moreover, we are entering the late stage of the cycle with the share of profits unusually high and labours’ share unusually low. The likely deteriorating mix between growth and inflation will add to the pressure on valuations. Our earnings models (upgrades/downgrades, global trade, Oil EPS, Industrials vs. Retail) suggest that 2019 Global EPS growth will likely be 3-5% negative.
Valuations. A key point in late-cycle investing is that the starting point for valuations matter. Looking at a variety of measures, equity valuations are cheaper but not cheap (see HERE). The starting point also matters for the sensitivity of markets to policy: from this starting point, the leeway for policy error is limited.
Liquidity. QE reduced macro-vol and encouraged corporate leverage in the decade since the GFC, with BIS data suggesting that total public and private sector debt has risen from 175% of global GDP to near 220%. Debt has risen particularly sharply in the CANNS (Canada, Australia, Norway, NZ, Sweden), increasing the risk of recessions. Our fear is that the shift from QE to QT and the rise in shadow rates is leading to the sharp slowdown in narrow monetary aggregates and the negative shock in the SIFIs. The steady rise in real yields seen since 2015 will likely push the VIX higher but could lead to an extended late-cycle phase with rolling corrections over several years.
Positioning. Trying to anticipate a rotation into risk or value at this stage of the business cycle is dangerous. Both Equities vs Bonds and Cyclicals vs Defensives tend to underperform on a 3y trend basis as the economy slows towards recessions. It is unlikely that risk assets will see a structural reversal until after the end of the next recession. Moreover, Equities are also still over-owned to begin the ‘great rotation’, and previous such rotations started from lower valuations, lower holdings of equities, higher yields and higher ERPs.
Conclusion. Our business cycle analysis shows that without a major reversal in monetary or fiscal policy- likely globally - the cyclical position will deteriorate further. The ASR Bear Market Indicator is up at 40% which has typically guaranteed a bear market. The cycle is turning and 2019 will likely deliver a double digit fall in Equities for the second year in a row. We are in the early stages of late cycle suggesting a more defensive allocation may be required – short term rallies apart – for the next 18 months.
Our Strategic Asset Allocation Investment conclusions – 12m view.
We suggest underweighting Equities, Commodities and Credit, preferring Bonds, Cash, Real Assets.
Major Underweight Equities. Expect an initial risk rally, but we doubt it can be sustained with a deteriorating macro backdrop and tight liquidity conditions. A Fed pause is unlikely to be enough to reverse the liquidity pressure on global equities. The weakness in new orders is impacting corporate sector cash flow growth (-3.7%yoy) which, in the past, has been a signal that EPS growth will follow. We expect Global EPS growth of -3/-5%. (vs. +6% IBES forecast).
Within an Underweight Equity position, Regional equity views: We are modest Overweight US, and move up Japan to modest Overweight too. The EZ is cheapest region by valuation and we raise EZ to Neutral. The UK is cheap, but we maintain our Major Underweight UK and EM and modest Underweight Asia ex Japan.
Modest Overweight Bonds. We maintain our bias towards duration trades. The scale of the decline in ISM new orders points to scope for real rates and TIPS yields to fall further, which could help to anchor Treasuries despite the scale of issuance.
Major Underweight Credit. Weaker economic activity signals stress for US credit. Increased levels of debt amongst mid and small caps, and declining quality combined with slower economic growth, will likely raise questions about debt sustainability and the risks of defaults in HY and IG. Credit spreads could rise another 200bpp if growth slows.
Modest Underweight Commodities. Against a slowing macro backdrop, Industrial metals will suffer vs. Precious metals and Agricultural commodities. However, Gold should benefit if real yields fall and the dollar does not strengthen too much, while Oil is likely to rally modestly to the top of the $55-70 range.
Modest Overweight Real Assets. In a risk-off world, where real rates fall, investors are likely to add to Real Assets and Alternatives, albeit the S&P Real Asset index is just a low beta equity proxy (Hedge funds, low beta: Private Equity, high beta). But the latest BlackRock Survey suggesting over 50% of their respondents plan to increase their exposure to Real Assets in 2019. This will boost areas like Infrastructure, but we doubt that investors will get the diversification that they hope for given the illiquidity that they will face longer term.
Major Overweight Cash.
Neutral USD. USD may have a final leg higher vs. EM and commodity currencies but looks to have peaked vs EUR and JPY. We expect to see weakening of USD in H2, as Chinese recovery coincides with softer US growth.
Conclusion: While near-term, we expect the risk rally to continue, until there is a decisive reversal in policy and a boost to global liquidity, Equity returns are likely to continue to disappoint. This is beginning to look like our ’nightmare scenario’ – see HERE (p10) - where we avoid a one-year bear market, but see multiple years of double digit declines. 2018 saw Global equities decline 11%: we should expect similar in 2019.
Long term (5y) Structural Asset Allocation.
Asset class returns and Factor returns.
ASR Economics Weekly. Five trade predictions for 2019 from Michael.
1. Status quo prevails in US-China talks: no end to tariffs, no escalation. We expect to see a target-based deal, with the current tariffs remaining in place while China implements the terms of the agreement.
2. Existing tariffs will continue to bite down on the Chinese economy. Chinese exports to the US slowed sharply in December and slowing US domestic demands suggests this will continue.
3. US-Europe trade tensions are the most likely to escalate. The EU’s trade surplus with the US remains high, there are tensions over ‘insufficient’ defence spending. If the US insists on better market access for agriculture, it could pit France against Germany.
4. Despite ‘no deal’ fear, 2019 will not see a big UK supply shock. We believe the UK Parliament will explore all other options before allowing Britain to leave the EU without a deal.
5. The reaction function of policymakers has become more malign. When the next downturn hits, trade policymakers may protect domestic interests via tariffs and subsidies, at the expense of open borders.
Absolute Essentials: 3 key headwinds for risk rallies from David McBain.
• Any S&P 500 rally will likely face resistance around at its key level: 2600-2630.
• KRW/JPY (70%+ historic correlation with global equities versus bonds) remains in stretched pessimism territory: FX has yet to provide confirmation of a firm move back into risk assets.
• Brent and WTI futures meet resistance around $51-$55: a warning signal for the S&P rally.
ASR Multi-Asset Weekly. 8 key Multi Asset charts from Stefano
Stefano discusses why QT matters. Via tightening in base money, QT has caused US monetary conditions to tighten, adding to the flattening pressure on the curve. He argued HERE that QT has caused the Fed control over short-term rates to weaken. Our models suggest the recent UST rally has been fuelled by safe-haven flows and looks quite rich vs. fundamentals, discounting a deterioration in US activity surprises. He looks at UK stagflation risk and the correlation with Cable and fading ECB QE impact pointing towards a stronger euro.
My best regards, Verity
• US-China trade talks unlikely to yield much progress, but tariff hikes to be avoided
• Europe-US trade tensions could escalate, but UK should avoid ‘no deal’ Brexit
• A downturn could provide a more worrying test for trade policymakers
Research, News & Views from ASR for the week to January 11th, 2019
ASR Investment Strategy. Global equities: No longer expensive - not yet cheap from Ian.
The December sell-off in equities was brutal, taking over 70% of global markets into correction territory and over 20% into bear market territory. As is often the case, the price moves were driven more by changes in valuations (PE multiples -4.5 for Global equities and -6 points for US equities) rather than changes in earnings which remained healthy. So, are equities now fundamentally cheap? We may well be seeing a short-term bounce in equities from oversold levels - see Essentials. But, while equities are clearly cheaper, we are wary that they are not yet offering true value.
• PEs remain close to their 10-year averages, despite the scale of the falls.
• Relative to bond yields, equities are not clearly cheap: US Bond/Equity valuations are not back to the lows of the last decade and are only neutral on our 3-year Z-score models vs. Treasuries or TIPS.
• The bigger problem is that valuations are constrained by the deteriorating outlook for the mix between growth and inflation although the decline in PEs is discounting a further worsening in the consensus view of that mix.
• They are also likely to be constrained by the ongoing tightening in liquidity conditions. For us, until we see the Fed and the ECB join the PBoC in easing policy and real M1 shows signs of recovering, downside risks to PEs will remain. Value driven strategies may prove to be value traps.
• So too, while policy uncertainty remains elevated, Global Equity Risk Premia are likely to remain elevated. The Japanese ERP is now above GFC levels, but the global ERP is below the 2008 and 2012 levels.
• It is also worth noting that while our 3-year Global valuation metric is looking more attractive, this tends, as we saw in the 2000s and 2008, to be early in giving a ‘buy’ signal and suggests that scope for upside exists when the economic outlook / liquidity conditions improve.
• By region...When that occurs, it will be Eurozone equities rather than Emerging markets that will be the beneficiary of any value rally.
• By sector, Global Defensives are not yet at peak valuations either, so we stay overweight Consumer Staples vs Industrials.
To conclude, equities can have a short-term bounce but, in our view, valuations do not yet support a strategic investment case, so until policy reverses and liquidity improves, we are wary.
ASR Economics Weekly. China’s stimulus: sooner but not larger from Adam
One of our key themes in our 2019 outlook is that increased Chinese fiscal and monetary easing would stabilise demand by mid-year. China’s Central Economic Work Conference and a key speech by PBoC governor Li Gang clarified the details / scope of the stimulus.
• On the fiscal side, local governments will issue more bonds (the main debt-financing channel for infrastructure projects) and there will be additional tax cuts at the central government level.
• The NPC confirmed on December 29 that the schedule will be brought forward so up to CNY1.39trn in bonds can be issued by local governments before their budgets are finalised in March. The scope of this stimulus is as expected of c. 1% of GDP, but it has come earlier than anticipated. Assuming the full allotment is used, M1 growth should rise by more than 5 percentage points in Q1. Obviously, this will be helpful near term, but overall fiscal support this year is still likely to be less than in 2015 (or 2012 or 2009), and the central government‘s focus on tax cuts, rather than increased expenditures, implies a lower fiscal multiplier. Still it should help growth to stabilise by mid-year.
• So too, the PBoC is focused on providing liquidity support and announced it would lower the RRR by 100bps over coming weeks along with ‘three arrows’ to support private firms through bank lending, albeit banks still need to manage their risk profiles, bond issuance and equity financing. We are wary that the boost to private sector credit may fall short of best hopes.
• We continue to believe that the PBoC will eventually lower its policy rate (now the 7-day reverse repo rate). Typically, a property market slump has been required for the PBoC to cut rates which could develop over coming months.
We thus expect the economy to slow further through Q1, but the grounds are being laid for growth to stabilise by mid-year albeit a sharp rebound is unlikely.
ASR Multi Asset Weekly. 2019 Cross-Asset themes and trade ideas from the MA team
This is the second part of the Multi Asset team’s ideas for 2019. The first part focused on currencies and bonds. We now look at cross-asset ideas involving DM credit, equities, commodities and FX vol.
Credit versus Equities: regional differences
• In a difficult 2018, EUR High Yield corporate debt was a particularly poor performer, looking at local currency returns relative to realised volatility: EZ HY benefitted from ECB QE so that by H2 2017, EZ HY traded at the same yield as US 30y Treasuries – but they suffered with the prospect of that support being withdrawn. EZ implied equity vol spent much of the year at a lower level than might have been expected given the poor performance of EUR credit. So, we would now favour High Yield Corporate bonds over Equities in the Eurozone. Possible implementation: + HY ETF (IHYG) and hedge this by + VSTOXX futures.
• We have the opposite bias in the US: we favour large cap US equities over HY bonds (vol adjusted) because a) the credit cycle looks more mature in the US than in the EZ b) US market-cap weighted indices have a higher weight in Quality stocks. Also, c) there is a skewed distribution of debt within the US corporate sector, not apparent elsewhere.
• We believe that HY may bear more of the strain than the S&P500 in Sharpe ratio terms: Tech and Healthcare with low debt ratios make up more than a third of the S&P500. This ties in with our preference for Quality and our Long Large Caps vs Small caps (the latter being sensitive to wider credit spreads given higher debt ratios). We think it is premature to worry about EZ corporate debt given growth/ratings trends and relatively accommodative ECB monetary policy.
FX implied volatility looks cheap versus US Equity vol.
A comparison of implied volatility across asset classes shows US bond and G7 FX vol looking low relative to US equity vol. The G7 FX vol index is being held down largely by subdued EUR/USD implied vol. We like short VIX / long EUR vol , not only because EUR vol is relatively depressed but because it could work in a world where the VIX falls and there is downward pressure on USD or in a world where financial market stress gets worse and the EUR adopts some more ’safe-haven’ characteristics (like JPY and CHF) given it is turning into a net creditor currency. For those nervous of having a short VIX of any kind, we think EUR/USD calls are attractive.
Long commodities versus Equities as a late cycle play.
The low level of implied volatility for some commodity groups – especially precious metals and grains – is notable. We discussed HERE, the attractions of gold calls. But is there a case for favouring commodities vs. equities at this stage of the cycle? Certainly, commodities are overdue a bounce in relative terms versus global equities. The relative return line is unusually dislocated from the 10y moving average: when it was similarly stretched in 1987 and 1999, it did mark the start of a period of outperformance for commodities. Moreover, we are now into ‘late cycle’ according to our Business Cycle indicators which is the one of the four phases that, on average, sees outperformance for commodities vs. equities. Oil prices are also oversold from a technical perspective. We would play this via a short in Canadian equities vs. a global commodity index.
ASR Absolute Essentials. Six key charts as risk-off becomes stretched from David McBain.
Equities. S&P 500, Nikkei 225 and EuroSTOXX have hit stretched pessimism levels. Sentiment readings on global equities versus bonds have fallen to SBI levels that were followed by an average 4.8% avg. rise in the relative since 2009. Bonds. ASR Market Risk Indicator is at a level which is negative for Bonds vs Equities. US HY has hit stretched pessimism levels versus IG: since 2004, sub-0.5 SBI levels have been followed by an average 2.9% rise in the relative over 30D. Commodities. A broad-based sell-off in activity-exposed commodities has seen Copper, Aluminium, Cotton hit stretched pessimism territory. Crude oil sentiment is off its lows.
ASR Newsflow. Composite Newsflow tumbles again from Michael.
The Global CNI fell sharply in December to 55.2 from 59.7. It was broad-based but of the 6 sub-components, the Global Economic indicator was notable, falling to 26.2 in December, its lowest point for almost a decade, and the 2nd biggest month-on-month drop since August 2007. In a possible sign of relief, the direction of the Monetary Policy NewsFlow looks to have turned.
My best regards, Verity
• The ASR/WSJ Global Composite Newsflow Indicator (CNI) fell in December to 55.2, from 59.7 in November.
• The Global CNI experienced its second consecutive fall of more than 5pts in December. While the CNI has belatedly caught up with its coincident indicator, the Global Manufacturing PMI (Chart 1), the scale of the drop is still significant. The indicator has only fallen at such a rate over two months twice in its 28-year history.
• The drop has been broad-based, only the Labour Market indicator avoided falling for two consecutive months. And, as the dark red shading in Table 1 illustrates, many of the recent falls represent 2 standard deviation events.
• Of the six sub-components, the Global Economic indicator deserves a special mention. It fell to 26.2 in December, its lowest point for almost a decade, and the second biggest month-on-month drop since August 2007. At a regional level (charts available on request), weakness can be seen across all regions. But the fall in the US, where the strong economy has until recently been considered an outlier, is worrying.
• The Composite NewsFlow Indicator is not yet at a level consistent with a contraction in the global economy, but the developments of the past two months are concerning. Five of the CNI’s six sub-components fell for the second consecutive month. The Global Economic NewsFlow is now at its lowest level in nearly a decade. In a possible sign of relief, the direction of the Monetary Policy NewsFlow looks to have turned.
• Fiscal policy is loosening already, with muni bond issuance coming early in 2019
• Interest rate cuts should follow liquidity support and macroprudential easing
• The economy is likely to slow further through Q1 but stabilize by midyear
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