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The ASR CANNS (Canada, Australia, New Zealand, Norway and Sweden) may only account for 3.2% of Global GDP but, we believe, will be highly important for global investors to monitor in 2018. High house prices, a build-up of household debt post-GFC, and (for Canada, Sweden and Australia) Banking sectors that are more than 20% of local market cap and 13% of Global Banks, make these markets likely sources of financial market instability in the year ahead. Higher rates, or slowing growth, especially if it is triggered by a China slowdown, will expose their fragility. Despite being a small share of Global GDP, we believe that these markets will provide a strong ‘early warning’ of potential systemic risks for Global markets.
PODCAST: Click to hear Ian’s accompanying podcast (8 minutes)
Research, News & Views from ASR for the week to January 19th, 2018
ASR Economics Weekly
Why protectionism’s bite is worse than its bark from Michael.
Trade policy could become a key issue for investors in 2018. In Q1 we could see the NAFTA negotiations end in failure, the Article 50 Brexit negotiations will come to their ‘business end’ and we might even see a trade war between the US and China. Trump’s State of the Union address at the end of January could outline his trade plans. What could the impact be?
• The growth of Regional Trade Agreements (RTAs) has lowered ‘at the border’ trade barriers, helping reduce the cost of cross border trade. Protectionism’s impact is often assumed to be the reverse of free trade. But we think this approach is flawed.
• RTAs have encouraged greater trade integration and specialization with each economy exploiting its competitive advantage. Disrupting two integrated economies is more damaging than the reverse.
• Imposing trade barriers is disruptive but trade in services is very important for advanced economies and it has been removing non-tariff barriers (NTBs) liked harmonized regulations that has allowed services trade to flourish. For example, the NTBs facing US companies wanting to do business in the EU is equivalent to a 14.7% tariff. For the UK any deal that does not involve staying in the single market (ie no services integration) is a hard Brexit.
• Any prospect of retaliation or other multilateral agreements like WTO falling apart would multiply the impact.
• Trade policy could become an important investment theme as asset prices are sensitive to sudden changes in terms of trade while many corporates, dependent on long thin supply chains will also be vulnerable.
Absolute Surprise. Positive hard data has closed the hard-soft gap in the US. Consensus has reacted to this, pushing up 12m forward GDP forecasts. Data in Asia ex Japan has surprised to the downside in the past 3 months - the Korean and Taiwan ASI are down sharply.
Forecasts. Generally, we are higher than consensus on inflation forecasts across the board. We also remain higher than consensus on EZ growth in particular: consensus has seen upgrades to 2.2% for 2018 and 1.8% for 2019 whereas we look for 2.5% and 1.9%.
Multi Asset Weekly
Technical challenges facing bond and USD bears from David McBain.
We focus on bonds and the dollar from a technical perspective.
Key levels. In an echo of a year ago, US 10y yields are heading to re-test 2.6% which is a notable resistance level: a break above 2.6% would point to a re-test of 3%. Of course, 3% is a key level long-term level – a point which breaks or sustains the 35-year US bond bull market.
• The emergence of stretched pessimism in US and German bonds is consistent with deeply negative relative sentiment on Utilities and Telcos. It chimes with stretched optimism on Crude vs Gold.
• The role of activity and inflation surprises in driving bond sentiment is also increasing: of the two, activity surprises have the stronger correlation with the US 10y yield. The potential for macro surprises to provide a catalyst for swings in US bond sentiment is increasing.
What happened historically following similar strong Activity Surprises and a similar 3m performance by US 10y bonds, Gold and Crude? According to the Market Scenario Analyser (TRIAL here)
• Positive 3m returns on energy and precious metals
• Positive returns by US and German bonds
• A weak performance by Lumber and STOXX 50.
Bond positioning and sentiment. Specs’ positioning in US 10y bonds is not extended, as it is on US 2y, 5y and 30y bonds but sentiment is stretched and in the past 10 years, a move back below an SBI of 95 has been followed by a fall of 11bps over the next 30 days. A similar picture applies to German bunds. Clearly bond momentum is negative but sentiment indicators are consistent with near-term contrarian support emerging for US and German bonds against a backdrop of stretched pessimism.
As for USD, the BOE trade-weighted US dollar index is also dropping to 12m lows, close to an important technical level. It is not far from stretched pessimism levels – near to levels that see a bounce in the dollar index over the next 1-2 months and a consolidation on a 6-month view. USD momentum and sentiment are very negative, but history suggests that this degree of pessimism may be misplaced for H1.
Strategic Asset Allocation Weekly
Equity Valuations are at risk of macro disappointments by David Bowers.
• As Ian argued last week – HERE- equity valuations are in expensive territory, especially in the US: our composite valuation metrics are overvalued, the % of sectors on over 15x or 20x is elevated and US equities look stretched vs a 2.5% 10y Treasury yield.
• But valuation does not give you timing. Overvalued markets can get, and stay, more overvalued, especially in a world awash with liquidity. The challenge is how long to run with it. High valuations can be sustained by positive macro surprises but if the macro disappoints, then markets are at risk.
What tool can we use to target those macro surprises and the markets’ attitude to them? The ASR Reflation Trade Diffusion Indicator (RTDI - see HERE for the primer). Why?
• The RTDI is a multi-asset composite of ten classic reflation trades. When the RTDI scores +10, all reflation trades have worked over the past 6 months and vice versa. What is clear is that if the RTDI balance remains positive and positive surprises continue, stocks outperform bonds.
• Where to now? The RTDI hit 8 in December. Looking at history, it is more likely to be lower than higher in 6 months and it is plausible - if not inevitable - that it falls into negative territory.
• It is rare for the RTDI to pull back without a period of negative activity surprises. Given expectations have been raised, the risk of disappointment has also increased.
• The RTDI also has a good relationship with the diffusion indicator of the Manufacturing PMI: the RTDI stays positive when there is a broad-based improvement on the PMIs and vice-versa. We believe, however, that is not the level but the rate of change that matters and the risks from current heady PMIs is that they will not last as the EZ business cycle gets challenged by the appreciation of the euro and China growth moderates - as is becoming evident in already soft ASEAN PMIs.
• The most compelling fundamental macroeconomic indicator that suggests the breadth of the global recovery could deteriorate over the next 6 months is global M1 growth: the chart suggests our PMI diffusion indicator could fall significantly by and the RTDI could be in negative territory by mid-year.
Links between the RTDI and Markets from Dorothee.
We use the RTDI to gauge the breadth of the reflationary mindset in markets, to confirm or challenge our views and spot anomalies. Not surprisingly, the RTDI has a strong relationship with the ASR Composite Newsflow indicator, with the Global ERP, with the shifts between Cyclicals vs Defensives. Historically it has had a close relationship with Industrials vs Retail and our Global Sector proxy but in both cases, they have rolled down while the RTDI remains elevated.
Absolute Essentials from David McBain
• Bond pessimism is becoming stretched – see above. Investors should not discount the risk of a near-term bounce in bonds.
• FX Vol has become oversold- EUR/GBP 3M vol has dropped to 12M lows with pre-Brexit 2013/14 vol lows the next target. Current SBI levels are followed historically, by a 16% rise in vol over 65D.
• Equity optimism is stretched on several fronts. The Hang Seng China Enterprises Index SBI last week hit levels that have been followed by an average 3.2% fall over the next 30D on 81% of occasions. Overbought HSCEI also looks stretched vs the KOSPI.
• Other equity markets in stretched optimism include FTSE 100, the S&P 500, while optimism is high on EuroSTOXX and on the Nikkei 225. On sectors, optimism on Materials, Retail and Capital Goods looks stretched; pessimism is extreme on Food & Beverages, Household Products, Real Estate and Utilities.
• USD sentiment is deeply negative. GBP vs USD is close to stretched optimism as specs increased net longs in GBP as well as CAD and AUD: specs are already substantial net EUR long and net short in JPY.
• Oil optimism remains extended and is high on Gold and Copper. Specs’ copper net longs remain substantial.
Best regards, Verity
Research, News & Views from ASR for the week to January 12th, 2018
ASR Economics Weekly from Raph.
Low Eurozone wages: slack is not the answer.
• Low wage growth suggests that slack in the EZ labour market might be larger than we think. We believe that European labour markets are looking increasingly tight.
• We calculate two wage Phillips curves: one using ‘Unemployment’ and one using ‘Underemployment’ which the ECB has highlighted as a better measure of slack.
• Our analysis suggests that both measures of slack have accurately predicted wage growth in the last year. It indicates that low productivity growth and low inflation mostly explain the lack of strong wage growth.
• A further tightening of labour markets should boost wages and core inflation through 2018. We continue to think that the ECB’s forward guidance on rates could come under question later this year.
Absolute Surprise. Our LatAm ASI has picked up slightly but is still deeply negative. The Asia Pac ASI has fallen led by Korea. Our Scandinavian ASI has rolled over.
Multi Asset Weekly from Stefano
Hedging Italian election risks
• BTPs are coming under pressure on growing political risks in Italy (10y BTP yields +35bp on the month) ahead of the Italian election on March 4th: a 5 Star-Lega Nord coalition might reawaken fears of EZ instability.
• These tensions come at a time when ECB BTP purchases are halving to E3.5bn a month while BTP net supply is set to pick up markedly: EZ Q1 bond supply is estimated at E90bn and Italy at E30bn.
• We think that this will all put upward pressure on Euro government bond yields, including BTPs. In 2017 we were positive on BTPs and indeed, the 10y BTP yield spread to Bunds was 80bps tighter into the year end.
• But now the BTP outlook is looking trickier.
• We recommend taking a small profit on long BTP/short OATs and initiate short OATs/long Bund as a hedge on the Italian election risk – a cheap, non-negative carry, long volatility proxy. The trade can be struck by bond futures so it is also easy to implement.
In equities, a number of DM and EM market indices are now exhibiting stretched optimism, including the S&P500. Elsewhere, crude oil and palladium optimism is also extended.
Equity Strategy Weekly from Ian.
Global Equities: Over-valued and over-hyped
Global valuations are looking increasingly stretched.
• Global equities have gained 25% in the last 12 months and almost 300% since 2009. This compares to earnings growth of 18% and 53% respectively, so that valuations have risen, with Global Trailing PEs now at 19.9x, last seen briefly in 2010 and prior to that 2002.
• Rather than rely on a single valuation measure, we tend to look at 6 valuation measures (PE, DY, PCF, PBV, EV/ Sales, EV / EBITDA) compared to their recent history (normalized using a 3y Z score). On this basis the pace of valuation expansion is close to that seen in the Tech bubble of the early 2000s. So, global equities are moving into overvalued territory.
Earnings growth has provided support, esp. for non-US equities.
• In the last 12 months earnings growth has contributed 18% of the 25% return for Global Equites with valuations and dividends contributing 3.6% and 3% respectively, which is unusual: valuation changes typically contribute 70% of returns in a rolling 10y period. Earnings growth has been a strong driver in EZ, Japan and Asia ex Japan.
• The problem now is that we need earnings growth to be sustained: this looks difficult, given our earnings model suggests only low single digit earnings growth.
US Valuations are looking extreme.
• However, earnings have played a limited role in the US, and as a result the US has seen significant PE expansion in the last 2 years, and is now trading on a CAPE of 32x and a trailing PE of 25.2x (vs. World ex US on 17.2x), higher than at any point other than the Tech bubble in the last 70 years, including the Nifty Fifty period. If there is a valuation issue, this will be most evident in the US.
• At these levels, US equities are very dependent on Goldilocks persisting. Certainly, high US PEs have been supported by a more benign trade-off between growth and inflation (our Golden Ratio) than at any time since the 1960s. The problem is that if unemployment goes lower and we see more wage inflation than activity, the Golden Ratio will fall: if growth falters, the benign activity backdrop for equities will be challenged.
Equities and bond yields.
• QE, low bond yields and the search for yield have all supported equities but what level of bond yields will undermine equities? As the late 1950s and early 1960s showed, low rates are not enough to stop quite sizeable corrections. It is at the point at which the cyclically adjusted earnings yield, the long bond yield and short rates converged that earnings yield rise when bond yields are rising. In the 1960s that was 4.5%: in the current cycle, that might occur at 3%.
• On a more tactical time-frame, using our 3y Z score approach, US equities are already looking expensive relative to US Treasuries, suggesting short-term risks of equity reversal.
• If bond yields push on to 2.75% and then head to 3%, not only would the near 40-year bond bull market come to an end, so would the relationship between bonds and equities: at that level investors would look to bonds for income, not equities, with big ramifications for bond proxies.
Conclusion: The rise in US valuations is putting stress on the ability of US and global equities to make big further gains, especially if liquidity becomes more constrained and economic activity in any way moderates. While 1998 suggests it is possible for PEs to go higher, optimism is taking markets to levels that are hard to sustain and put long term returns at risk: US PEs of 25x have seen 5 and 10-year annualised returns of only 3-4%. We remain defensively positioned: overweight US (it likely suffers first, but not worst); and Japan (likely benefit from a weaker currency and vs. Asia ex Japan).
Absolute Essentials from David McBain.
• Equity optimism is stretched on a number of indices (S&P500, FTSE100, Nikkei plus several EM markets) with the AC World SBI at levels consistent with near-term reversal risk.
• The Topix has moved above 1800, notably without the help of a weak JPY. This lifts the index above the 1780 resistance area with 2050 the next medium-term target.
• Specs are very biased to weak JPY vs USD – there is scope for contrarian support for JPY.
• By sector, optimism on Materials and Retail is relatively stretched; pessimism is stretched on Utilities, Insurance, Food & Beverages and Real Estate.
• In bonds US 10Y Treasuries are close to sentiment lows and specs have cut their net shorts. Pessimism on Bunds and Gilts has increased.
• There is deep pessimism on USD with optimism elevated on GBP, EUR and CAD vs. USD. There was a big increase in specs’ EUR net longs
• Specs are positioned for more Copper and Oil upside. But Commodities as a group are at key technical levels - stretched sentiment (e.g. Crude and Gold) is consistent with a pullback.: SBIs of over 99 have been followed historically by an average fall of 1.5% in the Bloomberg Commodity Index over the next 30D. A break in the Index above 2Y highs would mark a shift to a more positive technical footing – one to watch.
Best regards, Verity
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