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ASR Weekly Wrap from Verity
25 May 2018
: Verity Hunt

Research, News & Views from ASR for the week to May 25th, 2018

ASR Economics Weekly. New Italian government: containing a crisis from Michael.
Markets have woken up to Italian political risk as concerns about the 5 Star-Lega coalition and its commitment to the EU treaties raised their head.
•   Similarities with Greece in 2015? Politically there are similarities between the new coalition and the 2015 Greek government: both promised to renegotiate EU treaties and to repeal reforms made in the Eurocrisis; both pitched a populist government against a more mainstream opposition; both countries’ political institutions can act on radical attempts to change policy. But economically, the positions are very different: in 2015 Greece was heavily dependent on a credit line from the EZ whereas Italy runs a current account surplus and the governments primary budget is in surplus too.
•   These differences and the relative size of Italy matter. They lower the chances of a protracted standoff and incentivise Merkel / Macron / the EU Commission to contain an Italian government that pursues some of the more Eurosceptic ideas. It is likely that treaties remain non-negotiable, but the EU may ‘allow’ Italy some rule-breaking at the margin.
Implications for the economy and markets?
•   Macro: a looser fiscal stance could boost Italian growth short-term, but it could push Italy’s debt ratio up in the longer run. So too, repealing 2011’s pension reform could increase implicit liabilities significantly.
•   A containment strategy could limit the downside for risk assets near term, but could also limit the EZ’s ability to make itself more resilient to another crisis – as may become clear at June’s EU Council summit.   
•   The ‘unfinished nature’ of EZ reform, especially in the banking sector, could expose Italy in a future crisis.
•   The March election outcome stemmed from several years of political and economic stagnation. This could persist with another ‘containment strategy’, but could result in a much more radical outturn in the next crisis. 
Absolute Surprise Consensus GDP growth forecasts have been downgraded for the EZ and Japan for 2018.

ASR Multi Asset Weekly. Ideas to play the Italian bond sell-off from Stefano.
•   The past few weeks have seen a sharp sell off in Italian bonds in response to the new coalition government’s political plans. Rather than ‘backing off’, 5Star and Lega leaders have been dismissing the widening BTP spread to mark their distance from elite financial markets: EZ leaders’ calls for Italy to stick to responsible fiscal behaviour have met with a similar response.
•   We expect financial market pressure to remain elevated, but selling BTPs does NOT look to offer the most attractive way to hedge Italian political risk because:
     • BTPs look cheap on recent history with 10-year BTP yields in line with average yield levels prior to ECB QE.
     • Current long-dated BTP yield levels look attractive to global (esp. Japanese) bond investors.
     • The cost of carry and roll from shorting BTPs looks expensive.
     • Our monetary analysis suggests that the EZ periphery macro outlook is still looking more positive than the core (in contrast to the outlook prior to the 2011 debt crisis).
So how else might we hedge Italian political risk?
•   Our key trade would be to sell OAT/ buy Bund futures. The OAT/Bund spread is trading historically tight given the strong correlation to the BTP/Bund yield spread.
•   Another alternative to consider might be to look at 5/10yb BTP yield curve flatteners. The yield curve looks close to an inflection point where further rises in BTP yields would be driven by the front end, consistent with Italy’s worsening sovereign credit risk, driving the curve flatter.
What’s priced in? Market expectations of rate hikes in the US and Canada have risen, with three 25bp hikes priced in in both. High debt ratios / housing issues may mean the BoC struggles to match Fed tightening.

ASR Absolute Essentials from David McBain
Equites. The FTSE 100 remains in a stretched optimism condition. By sector: pessimism on Food, Beverage & Tobacco, Capital Goods and Insurance is still near extended levels: optimism on Energy remains highly stretched.
Bonds. Sentiment, positioning and metal moves provide support for a contrarian bounce in US 10Y Bonds. 10Y yields are likely to face technical resistance in the 3.15%-3.25% area. In the past 20Y, similar US 10Y and TIPS SBI levels were followed by an average 15bps fall in 10Y yields.
FX. US Dollar net short positioning is at the lowest since the start of the year.
Commodities. The degree of optimism on oil at current levels is a near-term risk. Specs’ sizeable net longs in oil were sharply cut in the week to 15th May. Specs cut gold longs.

ASR Investment Strategy. Dollar shortage poses systemic risk for markets from Ian.
Ian argues that the buildup in dollar denominated debt and US dollar funding models has created the scope for new systemic risk. For much of the last decade real interest rate differentials largely explained the moves in the US dollar. The 14% fall in the dollar in 2017 saw this relationship break down, leading to a ‘new dollar narrative’ related to Trump / widening current account. But the 5% rise in DXY challenges this ‘new narrative’ and appears to have exposed some of the fault lines.
Systemic not idiosyncratic events. The rise in the US dollar has coincided with an increase in financial stress events - the spike in the VIX, the rise in EM CDS spreads or sudden house price reversals in Sweden and Canada. For us these events are not idiosyncratic but are systemic - all symptoms of a financial system that has become overly dependent on easily available liquidity, c/o QE and especially the availability of dollars to fund an increasing quantity of dollar denominated debt that has built up post the GFC.
High debt, slowing growth and rising real rates are usually a toxic combination.
•   After a long period of low rates, we are seeing global monetary conditions tighten as the Fed raises rates and starts QT. Higher real rates have already seen real money growth slow, putting stress on parts of the system dependent on sustained excess debt.
•   Typically, higher real rates also tend to push asset volatility higher in the coming 2-3 years. The volatility at the start of the year should not be a surprise. Three factors have contributed to this:
     •  The rise in real and nominal rates;
     •  The reduction of liquidity as the Fed started reducing the size of its balance sheet;
     •  The squeeze in the CP markets / Treasuries as domestic and foreign banks moved to be net sellers of bonds and as corporates started to return assets to the US.
All three factors contributed to increased signs of funding stress in OIS and Libor spreads
•   Both the BIS and the IMF have highlighted the degree to which private sector debt has been rising with a significant proportion in foreign currency, especially dollars, bringing with it the risk of currency mismatch in private sector funding models in many economies. This is notable in the FSRs of Canada and Sweden and were highlighted by Ian in his excellent piece on the CANNS economies in January - see HERE. Both EM and DM economies have increased their dollar denominated debt as the US dollar fell, but as the dollar appreciates, the willingness to take on new debt will be more limited.
Who will be most impacted if US rates rise and the US dollar continues to appreciate?
•   Emerging economies (like Turkey, South Africa, Brazil and Colombia) that have taken on large quantities of debt post GFC – see also the ASR Vulnerability index
•   Developed economies - the CANNS (Canada, Australia, NZ, Norway, Sweden) - will be challenged.
•   Dollar strength is implicitly a liquidity tightening (see the BIS paper HERE) and the challenge comes when this dollar debt needs to be rolled over. Financial stress is rising. The last 5 weeks has seen substantial selling of US Treasuries by foreign agencies as EM equities have fallen and CDS and Bonds spreads have widened out.
•   US Credit: stress in EM credit is also likely to seep into US credit - both IG and HY - through H2.
•   Investors should also scour portfolios for assets where dollar funding models are embedded - be it Private Equity or DM Banks - that may also be challenged.

Best regards, Verity

ASR Investment Strategy - Dollar Shortage Poses Systemic Risk
24 May 2018
: Ian Harnett, David Bowers, Charles Cara, Dorothee Deck
Dollar Shortage Poses Systemic Risk for Markets

It is easy to look at events such as the VIX spike, the failure of Anbang, or the rise in Indonesian CDS spreads as isolated events.

However, a key mistake early in the Global Financial Crisis (GFC) was not recognizing the systemic risk in seemingly idiosyncratic events.

We worry that the build-up of dollar-denominated debt, and US dollar funding models, has created the scope for new systemic risk.

As the Fed tightens and moves to QT, the danger is that there will not be enough dollars to go around, leading to something of a ‘dollar shortage’, putting stress on EM debt and US credit.

Asset managers and asset owners might also look within their portfolios for assets where such dollar funding models are so deeply implicitly embedded that they are less obvious; perhaps within their Private Equity assets.

ASR Weekly Wrap from Verity
18 May 2018
: Verity Hunt

Research, News & Views from ASR for the week to May 18th 2018

ASR Investment Strategy. Six reasons to stay cautious from David.
An unfinished cyclical correction.
•   In the past 6 months, risk assets have done well. Global equities are within 5% of their January highs and the VIX back in the mid-teens. Our Reflation Trade Diffusion Indicator (RTDI) shows that all 10 trades that we track across equities, bonds, commodities and FX have performed in a reflationary manner.
•   We continue to take a more cautious line and believe that optimistic expectations for a synchronised, capex-led, cyclical upswing are being challenged. For us this remains an unfinished correction with 5-10% downside in equities.

Why are we cautious? There are 6 reasons, three are cyclical, three are structural.
Cyclical worries....
1.   We are worried that investors may be underestimating how much monetary policy has already been tightened: US and Chinese 2-year rates are up 160bp and 130bp respectively and 10-year rates are up 110bp in the last 18 months. We have seen a sharp slowdown in real M1 growth which has historically led a slowdown in the global business cycle and the underperformance of stocks vs bonds. The next 3-6 months could see negative surprises for the global business cycle. The added risk is that the Fed continues to tighten into a global slowdown.
2.   We are worried about the micro economic data: the Sector PMIs are already flagging a cyclical slowdown, rather than an acceleration. Particularly striking are the charts for industrial goods, machinery equipment and electronic equipment. They all suggest that the cycle has rolled over.
3.   We are worried that the market may underestimate the drag from the 70% rise in the oil price over the past 18 months. This is putting pressure on real incomes and discretionary spending, while debt-servicing costs are rising. The US will fare best with this backdrop, but oil consuming economies could see a squeeze on spending -> a rise in inventories relative to sales -> pressure on pricing power and EPS growth.
Structural worries…….
4.   We are worried that markets have not got to grips with the end of one monetary regime and the likely transition to a new monetary regime. Central banks expanded their balance sheets by c. $3 trillion in 2017 - almost as much as when QE began in 2009. This is a year of transition from peak QE in 2017 to QT in 2019. There is no certainty on how this will impact real yields or market liquidity. Changes in monetary regime tend to go hand in hand with changes in investment regime. Investment strategies that have worked in the last decade may be challenged. 
5.   We are worried that credit is an accident waiting to happen. Rapid growth in debt tends to be a very good predictor of financial crises. The corporate bond market has grown by 50% in the last 4 years and nearly 50% of the US IG market is BBB rated. Emerging markets have increased their borrowing and EM CDS spreads are rising while we continue to be concerned about the CANNS economies (Canada, Australia, NZ, Norway, Sweden) - see HERE - where household debt, house prices and bank balance sheets have expanded rapidly. If growth disappoints as CBs become less stimulative, credit risks could rise. The timing of this is difficult but watch credit spreads closely if we see a 5-point fall in the Manufacturing ISM in the next 6 months
6.   We are worried about the potential for an escalation in US-China trade tensions spilling into technology - see HERE - and HERE - and challenging business models of companies that have optimised long global supply chains. NAFTA is also at a critical point, while Europe will be hurt by sanctions if they continue to trade with Iran and are stuck in the middle in a US-China trade war, given Europe trades roughly as much with China as it does with the US. Again, a risk that is difficult to time but one with far-reaching implications.
We expect 5-10% downside for equities. The stakes are higher if there is a credit event or trade tensions rise.  

Challenging the Reflation Complacency from Dorothee. See our PRIMER: the RTDI and asset relationships.
Our RTDI is trading at its maximum score of +10. Extreme readings are rare and usually do not persist: a +10 score has only been seen 11% of the time since 1997. We believe investors’ optimism will be challenged and highlight some key charts. Notably, global activity surprises have rolled down sharply from +1.3x sd above its 3-y average to -1.2sd. It is rare for the RTDI to remain positive when global activity disappoints this much. There is a big disconnect between the RTDI and the Global Manufacturing PMI which has also slowed. We believe global activity could weaken, further undermining risk assets.

Dissecting the Microeconomic cycle. See HERE for our look at the Sector PMIs. All 12 of the global manufacturing sectors have recorded a decline in their PMI levels over the past 3 months.

ASR Economics Weekly
A CEE change in German wage inflation from Dom.
•   Eurozone core inflation missed expectations in April, dipping to 1.1% yoy: much of the decline was due to the timing of Easter and May could see inflation rebound but in general, underlying inflation has been subdued, despite an economy that has grown rapidly and an output gap that has closed. 
•   Why has EZ core inflation stayed so low? The sluggishness of wage growth, or specifically unit labour costs, appears to be the key reason for this. In EMU’s first decade, peripheral wage inflation offset weakness in Germany but in the last decade, the reverse has not been true. Post the GFC, the peripheral economies had their own problems to deal with, but German wage growth has been sluggish despite strong growth and an unemployment rate of 3.4%. 
•   Germany is not alone in seeing its Philips curve break down in the last decade - the US, UK and Japan have all seen low unemployment and slow wage growth. Technology could be restraining wage growth in Germany, with its more flexible labour market allowing non-traditional working arrangements to prosper - see HERE- along with globalisation: the threat of offshoring jobs to Eastern Europe was important in the late 90s/early 2000s in German labour unions moderating wage demands. See the CER paper HERE.
•   But, the threat of offshoring looks to be weakening. Protectionism is threatening cross-border supply chains. Unemployment has fallen to very low levels in Poland, Hungary and Czechia, triggering a sharp pick-up in wage growth and Germany’s unions have become more combative: last week the IG Bau union achieved a 6% pay increase for 800k German construction workers.
•   EZ core inflation could remain subdued for a few months yet before picking up through H2. If early signs of strengthening German wage growth are confirmed, a more sustained rise in core inflation will look likely in 2019.
Absolute Surprise. Both our Global Activity Surprise and Inflation Surprise indicators fell this week.

ASR Absolute Essentials
Equities / FX. Sentiment is driving some Equity / FX relationships which could provide key positioning signals. Some USD/JPY resistance around 110 (and its 200DMA) suggests its sentiment rally may be losing some momentum. Any renewed yen strength would likely act as a drag on Japanese equities vs ROW. AUD/CAD is already oversold on sentiment: in the past 10Y, similar SBI and 20D% rate of change levels was followed by an average 1.8% rise in the cross-rate over 30D. GBP/USD is now testing 1.35, with 1.32 the next support area below that. While stretched FTSE 100 optimism is a near-term risk, further sterling weakness may prove a tailwind for the index to re-test historic highs around 7760.
Bonds. Sentiment for US 10Y Treasuries remains negative despite specs continuing to cut their net short positions. US high yield has hit stretched optimism levels versus Investment Grade. Sentiment is not a headwind for the Italy-German 10Y spread which is now testing a potential trendline resistance area.
Commodities. Crude sentiment is elevated but not extreme but specs are cutting their net longs. Copper and Gold sentiment is relatively positive but not stretched. Specs cut their Silver net shorts. 

regards, Verity

ASR Investment Strategy - Six Reasons to Stay Cautious
17 May 2018
: David Bowers, Ian Harnett, Dorothee Deck, Charles Cara
Six Reasons to Stay Cautious

An Unfinished Cyclical Correction 
Looking back at the past six months, risk assets have done well, consistent with a strong reflationary environment. We do not expect that to continue. We still believe we remain in the midst of an unfinished cyclical correction.
We worry that: 
(1) monetary policy has been tightened more than investors realise
(2) some key microeconomic indicators have already rolled over
(3) oil prices have gone from being a tailwind for growth in 2016/17 to being a headwind
(4) we have already begun to transition from peak QE to QT
(5) credit has become excessive
(6) trade tensions represent an under-appreciated tail risk. We expect stocks to underperform bonds over the next six months as investors adjust to a more modest growth trajectory.

•   Challenging the Reflation Complacency: ASR’s Reflation Trade Diffusion Indicator (RTDI) Revisited
•   Dissecting the Microeconomic Cycle: Latest Global Sector Purchasing Manager Surveys

ASR Weekly Wrap from Verity
11 May 2018
: Verity Hunt

Research, News & Views from ASR for the week to May 11th, 2018

ASR Economics Weekly. Smartphone economics: micro goes macro from Ben.
•  Global trade slowed in Q1: air freight growth has slowed in Asia and Europe; the inventory cycle looks to have turned and the PMIs have moderated from high levels. 
•  As David highlighted in his note on the Sector PMIs, the turn down in the Tech sector PMIs has been striking, with very weak new export growth. Recent earnings reports suggest that Apple and the smartphone cycle could be playing a part: although Apple’s Q1 earnings beat expectations, the volume of iPhone sales disappointed and there is evidence of inventory build. Apple specifically have been running down production of its current suite of products in preparation for new models later this year. 
•  More generally, smartphone sales started to decline in late 2017, for the first time on record.
•  Work from the IMF has highlighted how important the smartphone cycle has become for the global business cycle with complex supply chains across Asia, making production and trade across many Asian counties (China, Korea, Taiwan, Malaysia, Singapore) highly correlated to the new tech cycle. So, smartphone release dates become key, which of course adds to the problem of any ‘seasonal adjustment’.
•  This inventory adjustment looks to have further to run through mid-year.

ASR / WSJ Newsflow Indicators from Richard.
•  The ASR/WSJ Global Composite Newsflow Indicator (CNI) of macro activity rose in April to 62.5 from 61.8.
•  But, the Global Economic component fell sharply to 45.8 from 49.5, the 3rd month of decline. It ties closely with the IFO World Economic Climate Index which also dipped. The Economic Newsflow is suggesting that global growth is past its best.
•  Other Newsflow components were more upbeat. Corporate Earnings up to 67.2 from 65.9; Global Revenues Newsflow at 67.8 from 66.8 (albeit down on 3 months ago); Global Inflation Newsflow up to 68.4 from 65.7 although sharply down on its high; Monetary Policy Newsflow at 77.7 from 75.4, implying monetary conditions are tightening at an increasing rate.

ASR Multi Asset Weekly. Opportunities in SEK and in UK curve from Chris and Stefano.
Selling the Swedish krona’s bounce.
•  Background: The Swedish krona has looked cheap for a while, depressed by super-easy monetary policy – a negative Riksbank policy rate since Q1 2015 plus QE. For most of 2016 and 2017 there seemed good reasons to expect a rally on the argument that the Riksbank could not stay so dovish given 5% average nominal GDP growth, strong exports, rising house prices, high household debt/GDP issues and headline and core CPI in Q3 moving above 2%. But, the Riksbank did stay dovish and in Q4 the bulls capitulated, and SEK took over from EUR and JPY as the funding currency of choice for some carry trades. We wrote in November – HERE- about the tricky backdrop for the Riksbank and SEK in 2018 given the missed opportunities to begin the policy normalisation process combined with weaker exports, falling house prices and rising inflation, with scope for SEK to weaken further This is what has happened in the last 6 months.
•  Where are we now? Short-term, SEK is now very oversold technically, looking at Sentiment and the 13 week change in the Riksbank’s Effective Exchange Rate Index. It has started to bounce and this could run further. To be sustained, the Riksbank needs to sound less dovish and upgrade its inflation outlook. While markets may have underestimated the impact of the weak krona on inflation, we suspect that investors would soon question how sustainable any rise in rates could be, given weak housing markets /high household debt.
•  How to play the outlook? We want to prepare for a short-term bounce in SEK vs EUR while also preparing for another leg down in the krona further out. We remain nervous over Sweden’s housing market (price to income still 2.4sd above the 30y average), high household debt and debt service ratios over 10%. The BIS has highlighted these problems while the Riksbank itself is concerned about banking sector vulnerability arising from high exposure to property loans and foreign currency borrowing. See HERE also. Slower Chinese growth, rising rates or a rising USD could all trigger problems. SEK is likely to take the strain.
•  Trade: with EUR/SEK at 10.53, we would buy a 6-month knockin option with a call strike at 10.65 based on a barrier knockin level of 10.30, costing 46bp.
Receive GBP 6-month into 2/7/30s fly via payer options from Stefano.
We are cautious on the UK economy: the money data suggest further weakness in the UK manufacturing PMI to come and BoE rate hike expectations have also moved down with little more than 1 BoE hike discounted. Stefano puts forward a trade idea - 
•  The GBP 2/7/30s fly looks cheap vs rate levels. We recommend receiving the GBP 2/7/30s fly via payer options as potentially offering an asymmetric way of positioning for lower UK yields.
•  If GBP rates fall, the historical directionality suggests the fly should also fall.
•  If GBP rates rise, the investor gets protection from several factors: (i) the 5bps upfront premium (ii) the fly looking cheap vs. rate levels; (iii) the trajectory suggested by the low level in the USD 2/7/30s fly spread.
Here for the Trade Structure

Absolute Essentials. Degree of SEK and AUD pessimism provides support from David McBain.
Equities. Since the Cap Goods sector SBI hit stretched optimism in February, the sector has seen a 4.5% reversal and has now reached excessive pessimism levels, breaking its 2015-2018 uptrend. Bonds. Sentiment for the US 10Y has improved but remains negative, Specs continued to cut their net short positions. In Europe, pessimism on both Bunds and Gilts has receded. EM bond sentiment continues to weaken.  FX. AUD weakness has chimed with that of EM currencies. While momentum is negative, AUD/USD is nearing oversold levels and the key 0.75 support area. AUD/CAD is already oversold. Commodities. Crude oil optimism remains elevated, but specs have cut their large net longs. 

ASR Investment Weekly. Beating earnings expectations is no longer enough from Charles
•  This has been the strongest US earnings season since 2010, with three quarters of companies beating quarter end expectations, total reported earnings 9% higher than expectations, giving a Q1 EPS growth rate of 24%. US companies typically beat by 3% while 33% of stocks surprised by more than 10%.
•  By sector, the earnings season has been driven by Tech (14% beat) and Industrials (9.7% beat) although the highest beat was Retail (18% beat c/o of Amazon). Basic Resources and Utilities saw negative surprises.
•  Sales have been broadly in line with expectations (a mere 1% beat). Clearly analysts under-estimated the positive one-off impact of tax reforms on earnings.
•  But how has the market reacted? Investors have been unimpressed. The S&P500 has been flat through the peak earnings season, likely due to the tax driven nature of the surprises and the 22% rally of last year leaving valuations (if not the analysts) discounting much of the rise in earnings.
•  Charles shows the relationship between the EPS Surprise and the stock price reaction in the following 2 days. The statistical relationship is very weak. This is part of a longer-term trend. Until around 2005, a quarter of stocks that beat would underperform: in the last few seasons almost half of the companies with earnings beats have seen their share price underperform. About 60% of those that missed estimates are punished but this figure is more stable. So, it is important for companies not to miss expectations but share prices are not boosted if they beat. This may all be a function of higher valuations pricing more in; other factors such as balance sheet strength are becoming more important; and investors may be concerned this is as good as it gets for this economic cycle (as Caterpillar suggested).
•  The earnings season seems not to have changed analysts’ views of underlying growth rates: EPS forecasts were raised by 20% c/o tax reforms but expectations for sales and EBITDA have been left unchanged.
•  Elsewhere globally, Europe’s earnings so far are 2-3% ahead of expectations, having seen downgrades in the last year and thus more realistic expectations. Japan, with only a third of results announced, has seen earnings some 12% lower than expectations: analysts look to have got ahead of themselves with strong upgrades in H2 2017, missing the slowdown in activity and the impact of the stronger Yen.

Best regards, Verity

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