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Research, News & Views from ASR for the week to May 17th, 2019
Trade War: ratcheting up the risks from Michael
• Markets remain somewhat hopeful that the US-China trade deal can be saved, but there are risks to this view given the Chinese confirmation of increasing tariffs on US exports on June 1, while the Democrats have raised pressure on the President to secure big concessions too.
• What might the impact of higher tariffs be? Last year the 25% tariff affected just 9% of US imports from China and 2% of its imports globally so the macro impact was limited.
• But the move from 10% to 25% and the wider list making up the $200bn list suggests a material hit to trade. We calculate that China could lose between $50-84bn in US market share (0.4-0.6% of GDP), while the new list consists of 25% consumer goods (rather than mostly capital goods / industrial supplies) which could have a more immediate effect on prices.
• While the economic impact of the tariffs alone could be manageable, this ignores the dynamic policy reaction to higher tariffs, with China not just imposing counter measures but also being pushed to pursue non-tariff measures such as discouraging consumers to buy US goods.
• Chinese retaliation and failure to secure a face-saving deal could have more difficult consequences. It could raise the risk of tariffs on all Chinese imports ($530bn) – as Trump has threatened- which would raise tariffs to 7.4%, similar to the 1960s. It could put downward pressure on the RMB, compounding the difficult decisions needing to be made by Chinese policymakers – and the temptation of a return to old-style stimulus.
• The window to do a deal is diminishing. The dynamics of the 2nd leg of the trade war could be much more damaging than what has been seen so far.
ASR Multi Asset Strategy.
What next for Oil? 3 key angles from David McBain.
• Geopolitics remains an upside risk for Crude as US-Iran tensions are ratcheted up. The rally in Oil in Q1 was driven by tight supply. In H2, global demand may have a bigger sway over oil prices. PCA analysis suggests that macro factors may be playing a greater role, while work from the NY Fed highlights the importance of demand to 6-monh changes in oil prices. While IMO restrictions on maritime fuels may support crude demand, this could be more than offset by an unfavourable macro backdrop where activity expectations continue to weaken, and activity surprises remain negative: this would be unhelpful for commodities. So, a combination of subdued demand and heightened US production may cap the upside for crude prices. We look for Crude to trade in the $60-80 range on a 12M view with a target of $68 at end 2019.
• Urals Crude looks very overbought vs. Brent Oil on sentiment. Urals crude could be impacted by the IMO rules and with the Urals-Brent spread near the top of its 10y range, the risk of reversal looks high.
• The US Oil and Gas E&P sector has a strong, 80% correlation with WTI Crude. But, the sector has trended lower vs. WTI crude and reached oversold territory on a 13W rate of change basis. In the past 20 years, RoC levels of 18% have been followed by an 8% rise in the US sector / WTI relative on 65% of occasions. It has also been followed by an 11% rise in the S&P Oil & Gas E&P sector in absolute terms on 70% of occasions over 65 days. The uptrend in the US Oil and Gas E&P sector is intact and it looks attractive vs. WTI on momentum grounds.
Absolute Essentials from David McBain
US-China trade tensions are to the fore.
• In FX, optimism on CNY/KRW is stretched as a key resistance area is hit c. 174-75. Sentiment points to a pullback (SBI over 96 has been followed by an average 3.2% fall over 65D on 98% of occasions).
• In equities the reversal in the Hang Seng China Enterprises Index vs. the Kospi looks to have further to run.
• Commodities are seeing weakening sentiment with Industrial Metals near stretched pessimism territory, although Energy commodities look more firmly based. The TR CCI SBI has dropped below 2: in the last 10 years, there has been an average 4.5% rise in the index over the next 65D. Global sector risk aversion fits with recent Metals’ moves.
• Elsewhere, pessimism is growing on European Cyclicals vs. Defensives. In sectors, Pessimism is stretched on Materials and close to it on Energy while the revival in Healthcare sentiment continues.
ASR Investment Strategy
Continued support for Quality from weak macro from Charles.
We define Quality as high sustainable profitability, using measures such as ROE, ROA, Cashflow/ profits, Earnings volatility and Earnings certainty. We use the classic Fama-French approach of sorting stocks on these measures and then comparing the performance of the top and bottom equally weighted quintiles.
We have been Overweight Quality which has worked well, but after such a strong performance over the last 12 months, should we still be overweight? Charles reviews the factor within our Framework of Economics, Valuations, Earnings, Positioning and Momentum.
• Economics. The macro backdrop is key for Quality performance. It is the most economically Defensive factor. It tends to perform when equities are under pressure. It is also sensitive to changes in the bond market: falling Treasury yields tend to benefit this factor. Our preference for Bonds over Equities and our central case of muted global growth, with no sign of a synchronised upswing, points to a continued positive environment for Quality.
• Valuations. The greatest headwind to Quality comes from Valuations. High quality stocks are expensive although the valuation premium has fallen in the last 6 months.
• Earnings. High quality stocks have EPS growth rates in line with their historical averages, but low quality stocks are growing faster than usual - as is common in late cycle - so the growth differential is historically low.
• Positioning / exposure. A positive stance on Quality is consistent with our preference for US equities outperforming Asia ex Japan given the heavy US exposure in the Global Quality factor. Concerns about the debt profile of US companies are largely mitigated as the factor is Underweight sectors like Utilities and Telcos which have high debt, albeit is exposed to the rapidly leveraging Healthcare sector.
• Overlaps with other factors. Our Quality factor has a large overlap with Low Vol and Trend momentum which does expose Quality to a risk of crowding.
• Momentum. Factors performance tends to be persistent and so the positive trend of the last 5 years is likely to continue.
While we recognise that Quality is expensive, the macro backdrop remains favourable for Quality, so we keep a positive stance.
My best regards, Verity
• Quality Factor has Rallied Strongly over the Past 12 months
• Valuations for Quality are unhelpful, but Macro remains supportive
• Positive stance kept as we expect Bond Yields to remain low
Research, News & Views from ASR for the week to May 10th, 2019
Absolute Economics Monthly. China: a supply side stimulus, not a revolution from Adam
The current stimulus differs from previous efforts in that it largely targets the supply side of the economy and private firms. Adam addresses 3 aspects of this.
Why policymakers ditched the old playbook.
• China’s growth model is pressing up against a number of constraints. Its savings ratio is in structural decline (demographics pushing down household saving, a shrinking labour force -> upward pressure on wages -> reduced corporate savings as a % of GDP).
• This combined with higher oil prices and weak global manufacturing demand could push the current account into a small deficit this year. This can be funded but another investment focused stimulus would require abandoning the financial de-risking campaign and financial sector opening which would be politically difficult.
• The PBoC has used the financial sector opening to push reforms to improve the efficiency of capital allocation. This is having some success (aggregate ROI and return on credit have improved): opening the credit floodgates would undermine this progress. There is little near-term impetus for monetary easing given strong real estate investment, while SOE profitability has improved.
• So, there are macro-economic constraints to another round of credit-fuelled, investment led stimulus, while the sectors that would benefit most from this are not showing the signs of distress seen in 2008/2012/ 2015.
A new kind of stimulus favours private firms
• Balance sheet pressure is most evident in private sector companies and local governments. The spike in corporate bond defaults reflects stress in the private corporate sector. This does not stem from weak demand. Private sector profitability has weakened but the stress is more due to a loss of access to credit.
• The PBoC’s ‘three arrows plan’ has tried to improve this and current stimulus measures to lower taxes / reduce compliance requirements should alleviate some of the pressure on profitability.
• We have seen a sharp pick up in credit but, see HERE, we think this is been used to paper over local government’s weak cashflow position, exacerbated by the 10% drop in land sales. This rise in credit looks unlikely to be a prelude to another surge in infrastructure investment.
Not a longer-term policy shift, unfortunately
• Trend growth is likely to slow towards 4% over the next 5 years without more aggressive reforms. Redirecting capital allocation towards private firms, or reforming SOEs could boost the potential growth rate by 1-2 percentage points. SOEs have weak incentives to improve on their own and so far, SOE reform efforts have had mixed results. Still there has been some progress on improving SOE debt sustainability c/o aggressive NPL disposals by state-owned banks.
• There is likely to be some more consolidation in the state sector, but further reforms seem unlikely. Rather there seems a greater move to guide the development of the private sector (allocating protected fields for AI development to each of China’s internet giants). Rather than the state sector becoming more private, the private sector may become more state driven.
Multi Asset Weekly. Three key dollar questions from Chris.
Why the timing of EUR/USD below 1.12?
• Shadow short rates have been useful in signposting the direction of EURUSD. Since the start of 2019, US rates have been flat while EZ short rates have moved from -3% to -4.5%. Certainly, the market pushing back the timing of ECB normalisation has been one driver in the downward drift in EUR/ USD.
• Consensus real GDP and CPI inflation forecasts have fallen more for the EZ than the US for 2019 and 2020.
• There is a close link between EURUSD moves and the Italian-US relative growth momentum and in that context, the EUR has held up well.
• The increase in late April of hedging USD exposure over the following 3 months for EUR based investors also contributed to the move.
Where next for EUR/USD?
• There may still be some risk that EUR/ USD weakens a little further until we see an improvement in nominal Italian growth forecasts and a change in expectations to less ECB monetary accommodation. However, the recent positive surprises in EZ and Italian data leave room for change in EUR/USD sentiment over the medium term. Monetary aggregates (EZ M1 growth at 7%) are also consistent with the idea that the EZ data have scope to surprise positively over the next 2-3 quarters, especially if the China economy stabilises. M3 has also picked up, reflecting a return to net inflows, which is also EUR supportive.
• We see 1.30 as fair value, albeit a major move towards fair value may need to wait for a prolonged risk off period in markets, when the huge capital outflows into US corporate bonds could start to return.
• Significant negative carry providing a hurdle for long EUR/USD: we still prefer to play it by a proxy, long NOK/ CAD, with much less corrosive carry and a spot rate close to the lows of the past 4-5 years.
Is there widespread risk to EM from USD strength?
Over the past year USD exchange rates have been driven more by shifts in expectations about trade wars than the Fed or global growth. While EM assets could face a difficult 4-5 months, we do not envisage indiscriminate selling. Selectivity should be rewarded, so we now focus again on our EM Vulnerability Index (EMVI) as a useful tool. We take profits on long RUB / PLN and reinstate our long RUB / ZAR: South Africa still looks poorly placed on the EMVI (only Turkey has a higher score) with insufficient risk premium built into asset prices while real yields on 10y government bonds are lower in South Africa than Russia. Moreover, South Africa’s bond market is heavily held by foreign investors (39% or a 57% government debt / GDP ratio ca. Russia’s 14%) and the 3.5% current account deficit leaves it dependent on them.
Absolute Essentials from David McBain
Equities. The pullback in the Dow Jones Transportation index is a negative underlying development for the S&P 500. The revival in Eurozone vs. EM equities has further upside. Commodities. Last week’s reversal in Copper has left futures below the 285 support area, with 260 the next target. Aluminium and Platinum are also testing key chart levels. As we noted last week, the gap between metals and EM equities leaves the latter vulnerable. Bonds. TIPS yields’ uptrend is still intact.
ASR / WSJ News flow from Richard. Our Global CNI rose last month to 55.2. Economic Newsflow rose from a low base but is weak vs. history while Inflation Newsflow rose markedly everywhere bar the US.
ASR Investment Strategy UK: Global inflation hedge or the ‘new Italy’? from Ian
• UK Equities have performed well in 2019 YTD, +13% in US$ terms, outperforming all other regions bar the US, albeit coming after a decline of 20% relative (in US$) since the Brexit referendum and 50% since 1998. The UK is now only 5% of the Global index.
• So, what role should the UK have in Global portfolios? With valuations still low and hopes of Brexit resolution rising should they ‘own’ the UK as a long-run recovery story, or simply ‘rent’ for a cyclical trade.
• Economic backdrop. The UK performance since 2016 clearly reflects Brexit, but the UK economic backdrop looks weak with the PMIs close to 2012 and 2015 levels, growth driven by a sharp fall in the savings ratio and a household, corporate and government sector all in deficit.
• The mix of the market. Happily, the UK market is not all about the UK economy given 75% of sales come from outside the UK. London listings for non-UK companies have made the market more cyclical and more currency sensitive: Financials, Resources and Industrials make up 60% of the market vs. 40% in 1992.
• UK valuations remain at risk from macro and policy uncertainty. Valuations are cheap on a P/B basis (below 0.7x) and Dividend yield (4%) basis, but the pay-out ratio is high and the ROE is below 10%. The difficult domestic economic outlook is likely to deliver a disappointing growth and inflation mix. Policy uncertainty persists, as Election risks rise, depressing valuations.
• Increased cyclicality makes UK Equities an ‘inflation hedge’ in Global portfolios. Unless Commodities, Banks and ‘Value’ make more sustained gains, the UK remains unlikely to sustain any meaningful outperformance.
• Still some major longer-term issues: 1) The UK has more dollar-denominated debt exposure than China:. 2) the willingness of the UK to devalue its way out of trouble is reminiscent of Italy in the 1980s: 3) if the UK is outside the EU, we expect fewer international companies will want to list in London.
• We still think that the UK remains a market to ‘rent’ not ‘own’.
My best regards, Verity
• UK Equities have performed well in 2019 YTD
The 13% gain in US$ terms comes after losing 20% relative (in US$) since the Brexit referendum and 50% since 1998
• Global investors are looking at what role the UK might have in their portfolios
With valuations still low and hopes of Brexit resolution rising should they ‘own’ the UK as a long-run recovery story, or simply ‘rent’ for a cyclical ‘alpha’ trade
• UK valuations remain at risk from macro and policy uncertainty
A clouded domestic economic outlook is likely to deliver a disappointing growth and inflation mix. Policy uncertainty persists, as Election risks rise, depressing valuations
• Increased cyclicality makes UK Equities an ‘inflation hedge’ in Global portfolios.
Unless Commodities, Banks and ‘Value’ make more sustained gains, the UK remains unlikely to sustain any meaningful outperformance
• However, UK Equities still face several major longer-term issues:
1) The UK has more dollar-denominated debt exposure than China.
2) the willingness of the UK to devalue its way out of trouble is reminiscent of Italy in the 1980s.
3) If the UK is outside the EU, we expect fewer international companies will want to list in London.
• Our conclusion is that the UK remains a market to ‘rent’ not ‘own’
Research, News & Views from ASR for the week to May 3rd, 2019
ASR Economics Weekly
A Phillips curve-ball for US credit from Dom.
• We continue to believe the global economy is in the ‘late’ stage of the business cycle, but the lack of inflation so far has challenged that view. The lack of any obvious inflation means markets now seem to expect the cycle to extend far longer than previously thought.
• The persistently low level of US inflation has been particularly striking. Core CPI is back below 2.5%, Core PCE is back below 2.0% even as unemployment falls to a 50yr low and GDP growth is above potential.
• Why have we not seen more pricing pressures? Some people believe there’s more slack in the labour market. Some believe the Phillip’s curve is more convex than originally thought. But clearly the Phillips curve has weakened.
• However, while the link between unemployment and inflation has weakened, the link between unemployment and wage growth has held up well, as illustrated by our ASR wage growth tracker. This tracker comprises seven measures of wage growth and enables us to look at Phillips curve relationships over a longer time span.
• The view that the inflation Phillips curve has flattened but the wage Phillips curve has held up has important implications- a) If the Fed continues to run the economy ‘hot’, and if that strategy is successful, real wage growth will pick up, supporting consumer spending and potentially tempting discouraged workers back into the labour market. b) If productivity growth remains subdued, it also implies that the labour share of income (which has been unusually depressed in recent years) could pick up.
• Any squeeze in the corporate profit share may create other problems. Who is likely to suffer?
• Companies are struggling to pass on higher wage costs because of the changing structure of corporate America. There are a small number of dominant companies with pricing power and a number of loss-making start-ups financed by capital markets. But, in the middle, there’s a layer of companies that have little pricing power but are faced with increasingly tight labour market conditions.
• Their margins are under pressure, and this could lead to holding off hiring and capex. Credit risks are likely to rise, given their greater leverage, and medium-term this could reinforce the trend towards greater concentration within the corporate sector.
Absolute Essentials from David McBain
• S&P500 optimism remains in a stretched condition but David highlights there are several other key levels to watch.
• Optimism on EM plays within the World index is nearing stretched levels as the index heads towards historic highs. A gap has opened up between EM equity plays and Industrial metals, which are showing signs of losing momentum.
• The contrarian revival in EZ equities vs. EM equities may well run further.
• Optimism is stretched on USDKRW, although momentum looks positive medium-term. It is also a negative for Korean equities, which are testing key support levels vs. MSCI USA ($ terms). While the relative is oversold near-term, a support break could see as much as 25% downside before the next major support level.
ASR Multi Asset Weekly.
Credit, rate and sovereign bond ideas from Stefano.
1. Replicating USD HY shorts via a non-negative carry proxy. We have discussed the vulnerabilities in US credit, HERE, but the timing of a US credit cheapening is difficult: a 100bps/year negative carry is a big issue in running a short USD HY exposure. Investors looking to short US HY should consider selling US 5-year breakevens, which has a small positive carry.
2. Revisiting the long Gilts/ short Bobl idea. See HERE. We like the potential of this trade. The ECB is desperate to prevent monetary conditions tightening, but the BoE is biased to raise policy rates further. This looks at odds with the UK/EZ monetary picture (UK monetary conditions much tighter than in EZ), while weak growth in real corporate non-financial money and UK survey activity data suggest economic weakness and the need for the BoE to ease, not tighten. One can express the same idea via buying 5-year Gilts / selling 10-year Bund futures (high correlation to the original spread and offering flat carry & roll).
3. UST 5/30s curve bull flatteners: carry enhancing idea. The UST 5/30y curve is now looking steep given the inverted shape of the 2/5y sector. With USD rates implying good chances of a Fed rate cutting cycle starting soon, we believe falling UST yields would drive the 5/30y yield curve flatter. USD 5/30y conditional curve flatteners via receiver options offer a carry-enhanced variant to our 5/30y curve flatteners idea.
4. Riksbank tightening/ECB easing is an unusual combination. Additional rate hikes are embedded in the Riksbank central forecasts, while Draghi hinted at scope for the ECB to cut rates. This unusual decoupling has driven the EUR/SEK 1y1y rates spread into negative territory. The beta-adjusted spread is trading at an extreme and spread widening positions could offer an attractive way of fading the Riksbank rate hiking push.
5. Korea Treasury bonds supported by FX basis players. See HERE. Korean Treasury bonds look attractive. The KRW FX basis adds a substantial yield pick-up to KTBs from a foreign investor perspective. FX hedged KTB buying looks to be one of the best carry trades in global government bonds.
ASR Investment Strategy
Earnings season unlikely to trigger upgrades from Charles
• Global equities are +15% since the start of the year. The earnings season for Q1 is well underway, with about half the results in the US, and a quarter of the European ones, reported.
• US sales have been in line, while net income has been 2.2% ahead of (substantially downgraded) forecasts, with twice as many positive surprises as negative ones. This is better than expected but still weaker than the typical average surprise of 4% over the last 5 years.
• By sector, US Banks and Healthcare, which have lagged the rally, have seen positive surprises while US Tech, which has driven the market higher, has seen an earnings miss of 3.7%. Oil has seen the biggest earnings miss of 12%.
• We have seen a sharp contrast between the results of International and Domestic US stocks with Domestics’ earnings beating by 6% and Internationals’ missing by over 5%, as analysts failed to factor in the stronger USD and slowdown in Asia and Europe. This theme of weak Oil and weak Internationals has been echoed, so far, in Europe.
• Market reactions. There have been many more companies beating by a little, than missing. The market has been harsh to those that missed, with 69% subsequently underperforming.
• So, managements have little incentive to push guidance up. The Revisions Ratio has improved but is still negative, at -15%. Our model for revisions based on 3m and 12m equity price changes explains about 60% of the change in the Revisions Ratio since 2002. Given the rise in share prices, the Revisions Ratio should be positive for Global equities and closer to 20% for the US, not negative. True, managements have little incentive to upgrade, but markets are anticipating upgrades which may not materialize.
My best regards, Verity
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