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Research, News & Views from ASR for the week to March 15th, 2019
EXTEL SURVEY 2019. As an independent research company competing with the investment banks, success in such surveys does help reinforce our reputation. Could you be kind enough to vote. Here is the hyperlink. www.extelsurveys.com/quickvote . Please could you include a vote for Sales too!
ASR Economics Monthly. A policy response but not enough from the team.
Policy moves in the US and China have buoyed risk assets, but our economic toolkit suggests further slowdown.
• Data disappointment. The global economic slowdown has gathered pace in recent months, with global trade volumes falling an annualised 8% in Q4 and our global activity surprises staying below zero, despite expectations being cut substantially. Some of the sharpest downgrades have been seen in the Eurozone, but trade growth has been particularly weak in Asia and US activity has also slowed with ‘Nowcasts’ from the Atlanta and the NY Fed suggesting growth of 1% in Q1. It has become a synchronised slowdown.
• A policy response needed. The backdrop has underlined the need for a policy response, which has started to arrive in the form of the Fed’s ‘U’ turn and an array of stimulus measures – tax cuts, support for local government financing and injections of liquidity- from China.
• But are these measures enough and at what point might that turnaround happen?
• The Fed; as we wrote HERE the Fed’s U-turn can be understood in three ways – a) Concerns about growth; b) concerns about persistently low inflation; and c) a change in the Fed’s reaction function. Markets have seemed to focus on the first - another Fed ’put’. But just as December’s volatility may have been postponed, so more volatility may be required before the Fed eases outright. The bigger issue for us is the credit cycle. We believe weakness in credit markets ‘spooked’ the Fed. See the Fed’s Financial Stability Report, the Senior Loan Officer’s Survey and anecdotal evidence of firm’s paying down debt rather doing buybacks. All this suggests a turn in the credit cycle, which suggests growth will likely continue to slow this year.
• China. An acceleration in government expenditure in late 2018 and January’s TSF surge led to hopes of further substantial reflationary stimulus. We do not think there is appetite for ‘flood-like’ stimulus in Beijing and fiscal expansion will be more restrained, with any increase in the augmented fiscal deficit likely to be limited to 1.0-1.5% of GDP.
• Europe. Markets were underwhelmed by the TLTRO announcement last week. We doubt these measures are enough. Fiscal stimulus could boost EZ GDP by 0.4% - helpful, but insufficient. Hopes for German fiscal expansion may disappoint without a much bigger shock.
Outlook. Our framework paints an uninspiring picture near term with all 9 of our country leading indicators decelerating, with weakening IP growth. Global real M1 is still weak suggesting downside risk for PMIs and global trade growth looks likely to slow further.
Any signs of an upturn? There are some brighter spots – real M1 is weak, but there are signs of a turnaround; service sector surveys are resilient in the US and EZ; US and German wage growth looks positive supporting consumption. But we still argue that global growth will be subdued over the next 12 months and more of a further policy response is needed to prevent a further slowdown.
ASR Multi Asset Weekly. US credit and Quality stocks - the odd couple from Chris.
Quality time - why outperformance as credit rallies? One characteristic of Quality stocks is low leverage which makes it unusual for Quality to outperform when credit spreads narrow, as has occurred in the US in the post-Christmas rally. One way to rationalise this is that the behaviour of US companies is changing as they start to emphasise debt reduction, capex M&A, buybacks and dividends. But we are sceptical whether this makes sense at an aggregate level as widespread corporate retrenchment would be bad for GDP and ultimately impact aggregate credit returns. This did occur in 2000-02, but we are doubtful whether this can work this time;
o The level of yields provides much less of a buffer for returns.
o The appetite for investors to diversify into credit out of equities is much lower than in the early 2000s: the overall IG corporate bond market was 11% of the large cap equity market then vs. 22% of the size now.
o The 2000-02 Equity bear market was more of a valuation event c/o Tech, than a credit event.
o The current skewed distribution of US corporate sector debt - see HERE where Charles points out that a quarter of US non- financial stocks have interest cover below 2.5x - may yet prove a driver of both equity and lower rated corporate bonds on the downside.
• We continue to favour Quality in both US equity and corporate bond markets, albeit Chris notes Quality short term looks overbought. We prefer IG over HY and within IG, the higher-grade credits over BBB.
• We like Long inflation- linked Treasuries / short US IG corporate bonds (long TIP / short LQD).
• The rally may be a good entry point for outright short US HY position via CDX.NA. HY.
• We stick with long S&P 500 / short Russell 2000 via futures given our concerns about leverage in the Mid and small cap space against a backdrop of further declines in activity expectations.
• But the US Consumer Staples sector has become one of the more highly leveraged US sectors, so we take profits (+7.5%) in our long Staples / short Consumer Discretionary trade.
ASR Absolute Essentials from David McBain
Equities. MSCI World with EM Exposure has failed to sustain a move above its 200DMA. The index faces resistance in the 2280-2290 area. Based on historic correlation, a move higher in USD/KRW is likely be a negative development for Korean equities. Bonds. USD/KRW moves also have strong historic relationships with EM bonds.
FX. The USD/KRW cross-rate is poised at a key technical inflection point as it tests key trendline resistance. USD/KRW implied vol has also hit SBI levels of below 0.5. In the past 10Y this was followed by an average 2.7% rise in vol over 30D and 12% rise over 65D, up on 84% of occasions. Commodities. Aluminium has reached stretched pessimism territory versus Copper: Scope for a near-term rally in the relative.
ASR Investment Weekly. Why this rally is unlikely to be a 1998 or 2016 rally re-run from Ian.
While recognising that equities were oversold pre-Christmas, the rally since then in Global and US equities has still challenged those of us that are cautious. Investors are looking to 1998 and to 2016 for positive parallels to the recent rally. We think such hopes will be disappointed for three reasons.
• The scale and capacity for policy response is much smaller. In 1998 US rates were cut by 75bps (from 5.5% to 4.75%). The dollar fell by 9% and rates were cut in 10 out of 12 major economies in response to LCTM. So too the fiscal and monetary ease by China now looks to be half that seen in 2015-16: Adam expects (HERE) greater RRR cuts but fiscal easing of 1-1.5% of GDP vs 3-3.5% then. What is also missing is the scale of ECB and BoJ QE which added $2trn to CB balance sheets, equivalent to a 1.5% fall in Japanese shadow rates and almost 4% in EZ shadow rates offsetting the rise in US rates that triggered the sell off.
• Valuations of Equities vs. Bonds were clearly cheap in the 1998 and 2015-16 periods. The 3y Z score of the Bond/Equity yield ratio fell below -2, giving a clear buy signal. In 1998, bond yields fell by 150bp in 6 months and global PEs fell by 5 points: in 2015-16, bond yields fell 50bp and PE ratios fell 3 points. Today the Bond/ Equity yield ratio score is in neutral territory close to zero. Also, in previous episodes credit spreads had widened by 300bp before the rally began so there was scope for credit to rally with equities.
• Hope of global economic recovery boosting Cyclicals. In 1998 and 2015-16, Cyclicals and Financials dominated Defensives as expectations of economic recovery - escape velocity - rose. In 2016, this helped to shift the economy back into mid-cycle. In the recent rally Cyclicals have outperformed by only 4% and Financials have underperformed.
We believe that the economic, policy and valuation backdrop is very different and less supportive than in 1998 and 2015-16. For the rally to persist we need enough policy easing to boost the outlook for corporates to avoid increased stress on earnings, capex, employment and credit particularly given Increased debt levels. Without much more policy easing we worry that risk assets will be challenged again.
My best regards, Verity
• Investors are looking to 1998 and 2016 for parallels to the recent rally
• However, we doubt these comparisons will be valid for three key reasons
• The scale of, and capacity for, policy easing is less than was the case in those episodes
• Valuations remain close to recent averages, rather than obviously cheap as they were then
• Reaching the ‘escape velocity’ needed to boost Cyclicals and Financials looks unlikely
Research, News & Views from ASR for the week to March 8th, 2019
ASR Economics Weekly Fed policy: put, pause or pivot? From Dom.
The Fed’s U-turn between its December and January meetings has prompted a rebound in risk appetite, but it still remains unclear what motivated such a dramatic shift. For us, there are 3 ways to understand the Fed’s shift:
• The slowdown in growth may have spooked the Fed. The Nowcasts have slipped towards 1% c/o a weaker global economy / the waning of fiscal stimulus / the federal government shutdown / the tightening in financial conditions. Certainly, the latter was important. The sell-off in credit was interpreted as a sign that monetary policy had hit neutral sooner than expected and some easing could be necessary should the economy slow. The fed might now want to support risk appetite. This is the ‘put’ and is consistent with how bond markets are behaving.
• Uncertainty about inflation. The Fed might be worried that inflation has failed to hit its 2% target, with structural concerns about the slope of the Phillips curve / the stability of inflation expectations to the fore. The January meeting indicated that several FOMC members would only support higher rates if inflation was higher than their baseline outlook. These concerns could justify a longer-term ‘pause’.
• The Fed’s shift could have been the result of a more permanent change in its reaction function - a ‘pivot’. The Fed is reviewing its policy framework through the course of the year. It looks likely that it will move away from a ‘point’ inflation target of 2%, with the aim of trying whatever replaces it as potentially providing more flexibility when the next downturn arrives: December’s volatility could have promoted an informal shift away from the 2% target. See Bernanke’s blog post on some of the alternatives.
It is likely that all three motivations have played a part in the Fed’s shift. We now think that these concerns will keep the Fed on hold for the remainder of the year. But money markets are pricing in some easing. If the earnings outlook deteriorates, equities and credit could face some challenges. If the bond market is wrong and the Fed resumes its tightening in 2020, rising rates could wrongfoot the bond market. Either way, a renewed challenge to risk assets could emerge.
Multi Asset Weekly. ECB Toolbox tested from Stefano.
After the Fed pivot and some weak EZ data, EUR benchmark bond yields have fallen sharply, led by the 10-year sector. Both lower EUR yields and the flatter EUR curve suggest investors have been asking for additional ECB policy stimulus. In our view the ECB toolbox looks inadequate to offset a tightening in EZ monetary conditions. There are 3 possible ‘tools’ for the ECB to consider:
• Strengthening policy rate guidance by extending the commitment to unchanged policy rates until next year. But, the EONIA curve is already very flat suggesting limited room for this to be effective.
• TLTROs. Some EUR 723bn long-term ECB bank loans were outstanding as of February. The rollover of existing TLTROs is unlikely to impress markets / make ECB policy any looser.
• Removing negative rates / tier reserves system. The ECB could raise the 40bops negative depo rate to ease pressure on banks’ interest margins. There has been much discussion about the impact of policy rates – see the IMF, BIS. The National Bank of Belgium – HERE - argued that keeping policy rates negative over a prolonged period has cumulative negative effects on banks’ profitability and bank lending. After 5 years of negative rates, raising rates may not cause monetary policy to tighten but it would likely spark communications issues for the ECB. Alternatively, the ECB could extend the tiered reserves system - keeping inter-bank lending rates anchored to the negative depo rate level while waiving the 40bps levy on banks excess liquidity.
• We unwind our EUR long duration bias – take profits on receiving the EUR 2 / 7 / 30 fly spread: 11bps profit.
ASR Absolute Essentials from David McBain.
• MSCI Japan is nearing oversold sentiment levels versus AC Asia ex Japan: in the past 20Y similar levels were followed by average 2.5% rise in the relative over 65D.
• The Brazil CDS has hit oversold sentiment levels and EM FX sentiment is also nearing SBI lows; a sustained rally in both would be consistent with EM assets coming under pressure.
• Low implied volatility is still a key feature across assets: the G7 FX vol SBI dropped to levels have been followed by an average 14% rise in volatility over 65D, up on 92% of occasions.
ASR Newsflow Report
The ASR/WSJ Global Composite Newsflow Indicator (CNI) was unmoved in February at 54.2. Within the six sub-components: Economic, Earnings, Revenues and Inflation were higher: Labour Market and Monetary Policy declined. Our China CNI experienced a modest rebound this month, perhaps reflecting coverage of government stimulus efforts. However, it remains consistent with downside risk to Chinese business confidence and Chinese trade over coming months.
ASR Investment Strategy Investing in the Brexit Endgame from Charles and Richard.
• A Brexit delay request is likely in all scenarios. We see a 30% chance that the Withdrawal Agreement is approved on March 12th, but a higher chance that it is passed at a subsequent attempt. We expect an extension to be granted but anything bar a short technical extension is likely to come with conditions attached. A longer extension raising the risk of Brexit reversal could push Eurosceptics in to voting for the Agreement.
• A second Referendum remains unlikely: if the Withdrawal Agreement is rejected multiple times, the chance of a referendum would rise but ultimately, we believe it would likely require a change of government and therefore an election, with the accompanying risk of a Corbyn government, to take place.
• There is a very low likelihood of no deal, but it cannot be completely ruled out.
• The UK equity market has lagged Global equities this year despite hopes of a softer Brexit. The international sales exposure of the FTSE100 is 74% and for the midcap FTSE 250 is 47%, so stronger sterling has hampered performance.
• Given these exposures, we do not think the FTSE 250 / FTSE 100 trade is a good proxy for Brexit risks.
• Our UK Domestic and International indices provide a better Brexit proxy; they pick the largest 100 companies in the FTSE 350 which have more than 50% and less than 50% UK sales respectively. We then use a tilt weighting methodology to calculate each stock’s weight.
• The relative performance of our UK Domestic vs. International indices does pick up the Brexit shifts in Sterling with greater sensitivity.
• The Domestics stand on 12.3x (a 12% discount to the pre-referendum rating), having bounced from a low of 10.5x, just before the first meaningful vote but down from 14.0x in early 2016. They are on a 15% discount to other Domestic peers globally – a rerating from a 25-30% discount in 2016/17. The International stocks have also de-rated and stand on 14.0x.
• Whilst UK domestics have underperformed Internationals, the valuation gap between the two has narrowed. To us UK Domestics no longer look cheap given EPS contracting at 5% vs. 10% growth in Internationals’ earnings (albeit both may actually deteriorate further).
• Unless relative Activity expectations for the UK rise vs Global Activity expectations – in our view unlikely - we see little scope for Domestics to outperform Internationals. We also remain cautious on the fundamentals of the UK economy (triple deficits, growth driven by falling savings ratio all suggesting weaker GBP medium term). We are Underweight UK equities and prefer Internationals to Domestic stocks from here.
Multi Asset Survey. Our Survey is now in its 4th year and provides a useful benchmarking tool for investor expectations and probabilities over the next 12 months. Do participate!My best regards, Verity
• Brexit delay highly likely; Withdrawal Agreement likely to pass eventually
• Second referendum remains unlikely without a new Government
• Earnings of UK Domestic stocks now falling
• Discount of UK Domestic stocks has narrowed, but outlook dim – so remaining cautious
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