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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
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 2018 weakness in Equities was driven by valuations not earnings
• Equity valuations remain elevated relative to their own history and bonds
• In a liquidity-driven market there is scope for further multiple contraction
• Valuation-driven strategies likely remain value traps not value trades
• The 10% sell-off seen in Global equities in 2018, left over 20% of Global markets in bear-market territory (-20% from peak to trough) by year-end. As usual, the sell-off was driven by valuations rather than falling earnings, leaving investors wondering whether equities are fundamentally ‘cheap’.
• We do not believe this to be the case. Despite a 4.5 point PE contraction in Global Equities and a 6 point fall in US PEs, multiples remain close to their 10-year averages. Even relative to Bond yields, Equity remain broadly neutral on our 3-year Z-score relative valuation approach.
• Our consistent narrative has been that the sell-off in equities is a liquidity issue. Although the fall in PEs discounts a major deterioration in the mix between growth and inflation, unless the Fed and ECB ease, reducing liquidity risks, or policy uncertainty falls, Equity Risk Premia will remain high.
• Although Eurozone is cheap relative to the US and Consumer Staples PEs are elevated relative to Industrials, we worry that such valuation-driven strategies will give limited upside until policy reverses and liquidity improves
• Thus, while there remains scope for a short-term bounce in equities (already evident), if we are correct and the root cause of this multiple contraction is a global liquidity contraction, then valuations could easily get cheaper.
Research, News & Views from ASR for the week to December 21st, 2018
ASR Economics Weekly.
2019: the alternative year ahead from Dominic and the Economics team
Our 2019 Macro Outlook suggested a difficult macro environment over the coming year, but one that could elicit some stimulus from policymakers. In this piece, we look at three alternative scenarios to our central view: these are all non-negligible risks that could have a material impact on the way financial markets see the world in 2019. They all centre around some sort of policy error. They imply that the risks around are central view are more on the downside and raise the obvious question of whether policymakers have the capacity to respond if the global economy took a turn for the worse.
Could US credit spark the next recession?
• Markets now only expect one further 25bp rate hike over the next 2 years. They seem worried that the Fed could inadvertently cause a recession if they overtighten as they try to soft land the economy. We think US growth will remain above trend in 2019, but our recession profit models are around 30% on a 2-year horizon so it is a non- negligible risk.
• We are particularly worried about US credit. There are several issues: weaker oil prices could undermine the profitability of the shale sector; a sharper slowdown in global growth, perhaps c/o a re-escalation in the trade war, would drag down US activity; as corporate earnings growth falls, we could see downgrades and when credit spreads start to rise so does the unemployment rate.
• We doubt that there is enough global momentum to shrug off a large US credit event. Moreover, in the face of previous downturns, the Fed has cut rates by 500bps. The Fed and particularly the ECB have very little ammunition in the face of another downturn.
Will China let a bank go bust?
• Policymakers still appear focused on de-risking rather than stimulus. New regulations to wind down or right size all zombie companies by end 2020 will likely exacerbate the already rising corporate default rate. The plans to supervise and backstop a group of systemic financial institutions would presumably put a firewall around the key parts of the financial system as defaults spike.
• The question is whether a small bank might be allowed to fail? China’s small banks have weak capital positions and are under pressure to bring loans back on balance sheet while NPLs are trading at only 40% of face value. China introduced a deposit insurance scheme which covers deposits up to CNY500,000 and 99% of depositors. As such the PBoC likely believes it can safely wind down a smaller bank without systemic problems but a) the process is untested; b) given 45% of China’s deposits are with small or medium sized banks, a run on similar banks might be hard to control; and moreover c) China’s smaller banks are deeply entwined with the interbank market and shadow financial system.
• Our baseline forecast assumes policy will become more accommodative and stabilise growth in 2019, but the risks around a bank failure might still prove challenging.
Could the UK tip over the cliff edge?
• Theresa May’s deal faces considerable hurdles, with possibilities of another Popular vote or an Article 50 extension, but the default option is a ‘no deal’ Brexit which could significantly alter the outlook for the UK economy. Non-tariff barriers could mean a sudden stop for trade in goods, causing delays, impacting food and agriculture. UK - EU services trade could also suffer, notably financial services.
• Estimates of the economic impact vary but it is likely investment would suffer, prices could rise and the uncertainty could hit consumer confidence.
• From a market perspective, there could be a further rise in risk aversion, with Gilts pricing in a higher inflation premium. A more radical political outcome might also be considered.
ASR Absolute Essentials from David McBain.
Equities. In February we highlighted an unusual alignment of US volatility and equity sentiment, consistent with heightened reversal risk. This week we look at what has happened after similar SBI alignments in S&P500, VIX, Russell 2000/1000 and DJ Transport/Industrials. In the past 20Y these rare episodes were followed by an average 2% rise in S&P500 over 30D, but also saw a median 2% fall over 20D. A risky sentiment backdrop.
Bonds. In a late-August MAS weekly we noted that positive global economic expectations, but negative surprises, was bond and USD supportive. The role of macro further underlined by UST’s re-engagement with US activity surprises. Although sentiment levels are notable, a continued positioning reversal could provide further support.
FX: US dollar index optimism is elevated, but not stretched with aggregate USD net long still at levels last seen in late-2016. GBP/USD sentiment readings are close to stretched pessimism territory and EUR/GBP readings are running at highly elevated optimism levels. Specs made a sizeable increase to GBP net shorts
Commodities. Extended positions in copper provided the backdrop for a reversal in 2018. Crude oil sentiment is above recent lows, but readings are still in stretched pessimism territory. WTI crude net long positions are running at their lowest level since May 2017 after almost two months of sustained cuts.
ASR Multi-Asset Survey. Winter blues as investors begin to capitulate
The ASR MA Survey is a survey of probabilities. It is now in its fourth year. This quarter we had 219 respondents from asset allocators and MA strategists around the world.
Macro outlook? Most bearish on record
Investors have become increasingly confident over the quarter that the macro environment was likely to deteriorate in the coming year: investors think that the US unemployment rate is likely to rise- a 52% probability vs. 40% a year ago; global recession is unlikely but concerns have been building in recent months – now a 35% probability vs. 27% in December 2017; the panel sees a 50% chance of a bear market in US equities at some stage in the next 12 months ( the highest on record).
Asset allocation views: most bearish / least positive on risk assets
Investors have become more bearish on risk assets, or less positive on stocks vs bonds. They still, however, expect stocks to beat bonds so there is not yet capitulation, but confidence has weakened considerably – now a 59% probability vs. a 77% probability in Q4 2016. There is just a 52% probability on Global equity prices moving higher in the next 12 months vs. 61% a year ago: there is reduced confidence that corporate earnings will grow - now a 59% probability vs. 74% a year ago. Investors have never been more negative on US Investment grade credit vs. US Treasuries, US High Yield vs. US Investment grade, Global Cyclicals vs. Defensives and Industrial Metals vs. Gold.
Most notable reversal in views: EM now favoured over DM.
This quarter saw a big reversal in regional preferences. Investors now expect EM to outperform DM over the next 12 months with a 58% probability vs. 50% in September and 47% in June. This is consistent with their bearish view on USD (EM tends to outperform DM in periods of USD weakness). Investors have turned negative on the US dollar: the probability of a rise in USD has declined to 46% from 53% 3 months ago. Investors now expect US equities to underperform the rest of the world: 48% of a US outperformance vs 51% in September. Investors have also become much less confident that US inflation will hit 2% in the next 12 months: they still expect rates to move higher but are less confident about this.
Other high convictions
Some of the highest convictions revolve around government bond yields moving higher in all regions: German 10Y (67%), US 2Y (65%), US 10Y (60%), Japanese 10Y (60%). The panel are confident that VIX will move higher (63% probability). There is strong conviction that core inflation is unlikely to hit 2% in Japan and EZ (30% and 37% respectively).
With thanks to all our clients for their support this year. We look forward to engaging with you in 2019.
Happy Christmas and all good wishes!
Research, News & Views from ASR for the week to December 14th, 2018
ASR Economics Weekly. The 10 most important charts for 2019 from the Economics team.
We present 10 charts to track the key themes for 2019 –
• Weaker global growth – driven by tighter global monetary conditions: real M1 has decelerated to a level consistent with a major financial event. Some kind of policy easing looks necessary to ease this stress. Without this, the risk of recession will grow. Our leading indicators point to a broad-based moderation in activity over the next 6-9 months and our commodity-based asset price model has deteriorated further.
• Rising demand for a monetary offset. China’s slowdown looks likely to be more coordinated, sparking further policy easing in 2019. Financial stress is rising: the PBoC will lower interest rates to ease this. We expect US growth to slow next year. The market expects almost no further hikes after the December one, but we doubt the Fed’s tightening cycle is done. The importance of the US dollar in the global financial system has risen, making the global economy more sensitive to US monetary policy. A response from the Fed is necessary. Emerging markets with current account deficits will need to sustain the stabilization in their exchange rates by keeping interest rates high: EM to remain under pressure.
• Persistent political and policy uncertainty. The US has suffered more than China so far in the trade war: trade and technology tensions will persist and Chinese exports will likely feel the impact in 2019. EZ growth looks weak and fears over Italian political risk remain: we think the ECB may need to worry more about when and how to ease, rather than tighten policy. The European Parliament elections next year may not see a populist ‘surge’, but populist problems are likely to persist.
ASR Multi Asset Weekly. Bonds and FX: 2019 themes and trade ideas
Bonds. Outlook for 2019. We expect weaker global growth next year, but USD OIS rates are currently discounting a mere 15bps in Fed rate hikes for 2019. Markets may underestimate the Fed’s resolve to normalize policy rates. But the Fed hiking rates into a weakening US economic outlook and a tight money backdrop would likely cause investors duration risk appetite to increase and drive the yield curve flatter.
• There are 3 factors to support long-dated US Treasuries: a) the worsening global growth outlook; b) the pick-up in safe-haven flows; c) relative value factors - US Treasuries look most attractive to global bond investors. UST yields are already discounting some negative US economic news, but we would recommend a small long duration bias via long 10y Treasuries.
• Do not fight the Fed from too close a distance. We expect the intermediates to keep outperforming but to avoid fighting the Fed from too close a distance, we recommend moving the curve steepening exposure to the 10/30y sector (from the current 7/10y curve steepening positions). The long end is unlikely to flatten much further as the Fed gets close to the end of the rate hiking cycle. Implementation via UST futures.
• OATs – 2019 perfect storm looming. In the last year we have recommended investors hedge Italian crisis risks via selling OATs and buying Bunds. The trade has made money, but spreads have not widened as much as expected. We still like the trade – and not just as a hedge on Italian risks.
• If the Italian crisis spreads to the rest of the EZ bond market, the OAT/Bund yield spread could widen.
• France’s budget deficit will rise to 2.8% of GDP next year and as high as 3.5% on most estimates vs. Germany’s 1%. A widening France/ Germany budget balance gap does not fit with tight OAT yield premia vs. Bunds. France’s 2019 net borrowing requirements could exceed Germany’s by EUR 130bn, which will likely put widening pressure on OAT/Bund spreads, especially given ECB net bond buying will stop.
• OAT inflows from JPY real-money investors and global CBs is unlikely to last: Japanese investors held USD 215bn in French debt, some 11.5% of their DM foreign bond investments.
Currencies. US dollar living on borrowed time. Given interest rate and bond yield moves, the dollar rally has been modest, +5% vs. the other majors albeit is +10% vs. EM. This inability to rally more may reflect 3 underlying trends – a) a gradual waning of the dollar’s reserve currency status b) the gradual evolution of the euro towards behaving like a ‘safe-haven’ currency in similar ways to JPY and CHF. c) post GFC, the importance for currencies of changes in central bank balance sheets as well as interest rates. See HERE and HERE. If we are right on these points / our Economic outlook for 2019 then the underlying dollar negatives will fuel a rise of EUR/USD towards PPP (1.30). However, we see EUR/USD headwinds continuing in Q1 and likely Q2, so we have a neutral tactical view for now.
Canadian dollar remains vulnerable. We stick with our short CAD vs Long G3 basket: Canadian house prices look extended; the dependency of post-GFC GDP expansion on household consumption and residential investment has been higher in Canada than Australia for example (78% vs 63%); with Canadian oil prices weak, capex is likely to slow further, while the BoC’s tightening since mid-2017 is filtering into the economy.
Sticking with a short bias on Korean dollar and Taiwanese dollar - expensive on an REER basis.
Value matters. New trades. In 2018 cheapness in REER terms did not guarantee a rally but Chris highlights some Asian exchange rates where valuation may not be in line with long-term fundamentals:
• Long MYR vs short THB (Malaysia has attractive real yields, a higher credit rating than Thailand, much uncertainty priced into Malaysia CDS, Thai risks ahead of elections) and
• Long IDR vs. short TWD (Indonesia’s twin deficits under control, policy rate has risen supporting the currency but, given it is an under-levered economy, higher rates may not crush the economy, TWD benefited more than most from foreign investment in equities).
ASR Newsflow from Richard. The Global CNI fell to 59.6 from 65.3. The Economic component weakened further while the Labour Market and Inflation components saw the biggest falls.
Absolute Essentials from David McBain. Gold is at a key technical inflection point. Potential for a continued rebuild of net long gold positioning. Gold calls may be a cheap hedge on slowing global growth
ASR Investment Weekly. Ten Investment Strategy issues for 2019 from David.
1: The Monetary Regime is in Transition. Monetary regimes are important because they define investment regimes. The monetary regime that defined the past decade - QE - is expected to end in 2019.
• US QT and ECB tapering in 2019 will likely see Central Bank liquidity fall, fueling a Global liquidity shortage. The US Fed is also running a very US-centric monetary policy, despite USD-borrowing outside America doubling from $6trn to $12trn, making the Global economy more US rate sensitive.
• This US dollar borrowing was likely facilitated by $3trn of US unrepatriated profits built up over the previous decade. Trump tax cuts encouraged the repatriation of these ‘techno-dollars’ exacerbating the dollar liquidity shortage. With global real M1 growth slowing rapidly, significant financial stress is emerging. With all the focus on tariffs and trade, policymakers may not admit that there is a ‘financial crisis’; but Financials are in crisis, as SIFIs are 28% below their 12m highs with their default risk rising. An LTCM-style event might be required to trigger the type of robust policy response that could extend the cycle and the bull market.
2: The Investment Regime in Transition. When monetary regimes change, then so do investment regimes.
• QE created a second ‘Great Moderation’ – low macro vol, low micro vol, low earnings vol, and low interest-rate vol. This favoured a range of investment strategies: Equity Income, Corporate Credit, Tech, Passive over Active and (Unlisted) Alternatives. History suggests these strategies may find the going harder, as QE comes to an end and real short rates rise, leading to increased macro and market vol.
• With cash flow less predictable, US equities will face greater challenges.
• Stress in US corporate credit will likely rise. High debt burdens will eventually put pressure on Central Banks to accommodate higher nominal growth in the monetary regime that succeeds QE.
• For 2019, we expect inflation to stay low but longer term, inflation vol. may make a comeback.
3: The US-China Regime in Transition. Next year may be the year that redefines US-China relations.
• This is about much more than tariffs. It is about whether the US can accept the consequences of a doubling in the Chinese economy by 2030, or whether it will attempt to obstruct China’s development by trying to cut China out of the global economy in another ‘Cold War’. The multi-decade squeeze on US labour’s share of national income risks pursuit of the latter. The implications for trade, technology, global supply chains, outsourced business models and for Europe have barely begun to be explored. But China’s size is starting to challenge US monetary hegemony. We may have a dollar-centric financial system, but we now have a China-centric manufacturing system. China’s share of world trade now exceeds that of the US. As China grows, US monetary policy becomes less appropriate. Hong Kong could end up being the flashpoint.
• Uncertainties around European Politics and whether stress moves from Italy to France are a concern.
And …. The Nightmare scenario. Rather than a cathartic correction into bear market territory that would elicit policy responses, the nightmare would be a slow grind down – never enough to get a ‘panic’ response from policymakers, but over 3 years still sees equities off 40%, as occurred from the mid- 60s to mid- 70s.
Best regards, Verity
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