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Research, News & Views from ASR for the week to March 23rd, 2018
ASR Economics Weekly
US recession risks: 2019 is starting to look troubling from Dom.
• The US business cycle expansion is set to become the second longest on record but how much longer can the cycle last? Economists like to look at the yield curve slope as a good predictor of recessions, as it has a good track record (the spread between long and short-term interest rates turning negative ahead of every post war recession bar one), but this time there are doubts about its reliability as a forecasting tool given the distortions of QE.
• A new ASR early warning indicator for a recession. We have developed a stylized guide to the conditions that precede a recession using Receiver Operating Characteristic (ROC) curve analysis: various indicators will breach certain pre-established thresholds in the run up to recessions – beyond these thresholds the probability of recession increases.
• The good news: the probability of a US recession in the next 12 months is low.
• But, some indicators (notably truck sales, initial jobless claims, the output gap, the unemployment gap and the VIX) are suggesting a recession is possible in 2019. It is not pre-determined, however. It hinges on the Fed behaving as it has in the past. An approach to policy that’s more “rules-based” could push rates to “restrictive” levels (i.e. above 3%) to slow the economy and counter the impact of the fiscal stimulus. In the past, this is the point that something ’breaks’ (maybe credit?) and recession beckons: that could be in 2019.
ASR Multi Asset Weekly
Exploiting cheap USD rates vol from Stefano.
USD fixed-income implied volatility looks cheap historically and vs. realised vol. Stefano shows how this can be traded.
• US fixed income volatility has cheapened back to historically low levels with USD 3m10y swaption normalised implied vol at c. 4bps /day despite the underlying yields staying elevated. There is scope for yields-vol recoupling going forward. The CFTC data shows specs running a substantial net short in US Treasuries: if bond yields fall - clearly the ‘pain trade’ - rates volatility is likely to pick up.
• But Fed rate hiking and excess supply (see HERE) also suggest volatility could bounce in a rising yield scenario.
• So, buying US rates vol looks an interesting trade, working in a fixed income rally and in a sell-off.
• How to implement this? Long volatility exposure can be struck via buying either UST option straddles or USD 3m10y swaption straddles.
• Structure. (Bloomberg indicative pricing) – Buy USD 3m10y swaption straddles struck at 2.94% for 2.25cts net premium. We assume the delta of the position is hedged daily.
ASR Multi Asset Survey for Q1 2018 from David and Dorothee. Our 14th Survey with 200+ participants.
Overview. At first glance this appears to be another positive Survey. Those polled put:
• A 58% probability on equities being higher a year from now.
• A 66% probability of stocks beating bonds.
• A 70% probability of corporate earnings growth being positive helped by a return of pricing power.
• A 67% probability of US core inflation exceeding 2% a year from now.
• A 75% and 70% probability of 2 and 10-year yields being higher.
• A 60% probability that EM will outperform DM equities.
But beneath the surface the panel is less reassuring. Confidence has taken a knock since December and the underlying enthusiasm has weakened.
• The probability that equities are higher a year from now is down from 61% to 58%.
• The probability that equities beat bonds fell from 70% to 66%.
• The probability of an improvement in the business cycle fell from 47% to 43%.
• The probability of stronger earnings growth dropped from 74% to 70%.
• The probability of valuations being higher turned negative falling from 54% to 48%.
• The probability that VIX is higher in the next 12 months is 65%.
• There was another decline, 56% to 51%, in investors’ conviction that US IG would outperform US Treasuries
Two new questions this month:
• How likely is it that Asian equities will outperform European (59%): we prefer EZ equities over Asia ex Japan.
• How likely is it that the spread between US Treasuries and German Bunds will narrow (60%).
Key highlights. Three takeaways.
• As detailed above, the positive view on key questions like stocks beating bonds and direction of equity markets are weaker than 3 months ago. The fundamentals have taken a turn for the worse with the implied probability of a stronger business cycle down at 43% - no longer the ‘escape velocity’ enthusiasm of December. This in turn has raised doubts on earnings growth, valuations and the preference for Cyclicals vs Defensives. We share these concerns about global growth - see Challenges to the low volatility world, and we recently downgraded equities vs bonds. See also No smoke without fire, Risk returns, Equity valuations at risk from Macro disappointment.
• Investors are braced for tighter US monetary policy, supported by a rise in the probability of US core PCE exceeding 2%. But this is not seen as a show-stopper for equities.
• There is a major rethink on US corporate credit, with rising scepticism that US HY can beat US IG or US IG can beat US Treasuries. We share this view and have written extensively about the risks around credit - see The fundamental challenges to corporate credit, and Credit: attractive hedges in the US and EZ, along with our piece on the risks in Canada, Australia, Sweden in particular and from last year, but still relevant, US corporate sector: debt and disruption.
Our MA Survey Optimism Indicator is the average of 9 probabilities across Macro, FI and Credit, Equities and Asset Allocation, is at its lowest level since December 2014 in line with the levels in September 2015 and June 2016. Investors’ uncertainty is at its highest since the Survey began in December 2014.
Where the panel is different from history – longer run context
• The panel thinks US equities are unlikely (46%) to outperform the rest of the world: but they have done, 57% of the time in the last 20 years (and 80% of the time in the past 10 years. Investors are starting to capitulate as this is up from 42% 3 months ago.
• The panel sees a 40% chance of EZ core inflation hitting 2%: this has not happened in the last 10 years.
Investor clusters. An AI based analysis suggests that there are 3 distinct groups in the market – some 54% are in the ‘Steady growth’ camp, some 31% are in the ‘Slower growth’ camp and 15% are in the ‘Credit risk’ camp. The latter feels closest to the ASR view.
Conclusion. The latest survey touches on many of ASR’s investment themes / recommendations: the risk of growth disappointment, the risk of persistent Fed tightening, the risk that the volatility genie is now out of the bottle, and our growing concern around US corporate credit. The explosive growth in corporate bonds (the market has almost doubled in 4 years), the unevenly distributed rise in leverage and the ratings dilution (almost 50% of IG bonds are BBB rated) is particularly vulnerable to weaker growth/earnings and higher interest rates.
Absolute Essentials from David McBain.
Equities. Sentiment is stretched on the FTSE 100: below 7100, the next target is 6920. Russell 2000 positioning poses a risk with high sentiment and high net long positioning. Optimism on EM remains elevated.
Bonds. Pessimism on US 10Y is no longer stretched: specs have cut their US10Y net shorts. Bunds have pulled back from last week’s stretched pessimism levels. US HY vs IG no longer in stretched optimism.
FX. A month ago in Essentials we noted that while USD/JPY was oversold near-term on sentiment, its technical profile remains negative and a move down to the 104-105 area looks likely in the medium-term. The technical profile of EUR/JPY has also deteriorated, with the cross-rate dropping below key 131.5 support and its 200DMA. If 130 support fails to hold, we would look for a move down to 127.8.
Commodities. USD weakness has helped offset the hit to Gold which remains above its 100 and 200DMAs, and its $1305 support area. Gold vol sentiment is
Best regards, Verity
Research, News & Views from ASR for the week to March 16, 2018
ASR Economics Weekly. The fundamental challenges to US credit from Dom
• The US non-financial corporate sector has levered up through this expansion with the ratio of gross debt to income nearing the peak of the previous 3 cycles - peaks seen in the recession when profits had already declined sharply.
• Most of the leverage has been financed via the corporate bond market.
• Yet, US corporate credit has, so far, been resilient to the challenge of higher equity market volatility and rising interest rates, with credit spreads remaining tight. To some, this has reinforced the bullish case - strong earnings growth, tax cuts to come combined with low interest rates and tight credit spreads making the cost of servicing debt manageable, especially giving the ‘terming out’ of most companies’ debt profile.
Chris highlighted some of the challenges facing IG credit - HERE - the deterioration of average credit ratings, rising hedging costs putting off overseas investors etc.
We have 2 fundamental issues with the bull case on credit–
• The business cycle. The last 12-18 months have been ideal conditions for credit with good earnings and GDP growth, but only modest rises in real rates and inflation expectations. The ECB’s QE programme has also helped to hold down term premia in the developed world. But, this sweet spot is coming to an end: tighter monetary policy (a more hawkish Fed), softer growth taking the edge off profits growth and rising term premiums as QE winds down could prove to be headwinds through 2018.
• The distribution of debt within the US corporate sector (see our work HERE and HERE): some companies have little debt, high cash and strong profitability but there is a long tail of companies with more debt, modest or no cash and weak profitability. The low level of aggregate debt servicing costs conceals the long tail of companies that are struggling to cover their interest payments.
• Of our sample of 3000 listed non-financial companies, those with an interest cover of <1.0 account for 22.7% of companies and 14% of total debt outstanding while those with an interest cover ratio of <1.5 account for 18% of the debt. A 1% rise in rates or a 10% decline in EBIT could push that to nearer 25%. This includes both zombie companies and those companies losing money today but promising high growth in the future. This is symptomatic of the ‘search for yield’, with risk being underpriced and loose underwriting standards. Weaker growth and higher real rates could lead investors to re-appraise the risks they are taking in extending credit to these companies.
Absolute Surprise. Our US ASI continues to fall, with housing market data disappointing, dragging down the global ASI. The European ASI dropped into negative territory for the first time in 2 years with France and Scandinavia seeing data disappoint.
ASR Multi-Asset Weeklyfrom Stefano
We introduce two simple valuation tools for EM sovereign risk
• Framework 1 looks for discrepancies between bonds and CDS spreads to provide directional views and relative value opportunities.
• Framework 2 highlights inconsistencies between sovereign credit risk spreads and fundamentals, as proxied by the ASR Vulnerability Index (click here for methodology)
Trade Idea example: Selling South Korean CDS protection vs. buying Chile CDS protection could offer an attractive way of hedging risks of cheapening EM debt (before initiating, we would wait for the spread to bounce back to a 10bps positive level).
Absolute Essentials from David McBain.
• EuroSTOXX50 has reversed from oversold sentiment levels, but momentum remains negative and the rally may face resistance c.3460.
• Sentiment remains supportive for EMU vs. Japan in local currency terms.
• US10Y pessimism is notable, though not extreme.
• SBI readings on Bunds have dropped into stretched pessimism territory.
• USD/JPY has bounced back from oversold levels.
• EUR/USD net long positions remain sizeable.
• Crude Oil sentiment continues to fall from recent highs.
• Gold sentiment improves as it moves towards the $1400 key level.
ASR Investment Strategy Weekly. Why we prefer EZ equities over Asia ex Japan from David, Dorothee and Charles.
Over the past 3, 5 and 8 years the equity market performance in the Eurozone and Asia ex Japan has been broadly similar in common currency terms. Their respective market caps are also broadly similar (13-14% of global market cap). In the past year EZ equities have underperformed Asia ex Japan by 2% despite looking cheap on our composite valuation measure: according to our last MA Survey, this is expected to continue through 2018. We are currently neutral on EZ equities and modest Underweight on Asia ex Japan equities. Why?
• Using our 6 variable composite valuation framework, EZ equities look very undervalued vs. Asia ex Japan, at 2.1sd below their 3-year average, a level last seen in January 2008.
• By country: Germany, the Netherlands, Spain followed by France and Belgium look cheap. Hong Kong and China followed by Thailand and India look expensive.
• By sector: 7 sectors look undervalued in EZ vs.asia ex Japan - Chemicals, Telcos, Retail, Construction, Food & Beverage, Healthcare and Real Estate. In Asia ex Japan, Tech (understandably) and Travel and Leisure look especially overvalued vs. EZ, followed by Banks and Autos.
• In the past 12 months reported EPS growth in USD in EZ has been 32% vs. 29% for Asia ex Japan. Forward EPS growth for EZ is 8% vs. Asia ex Japan is 13% but we think this gap is insufficient to justify the scale of the valuation discrepancy.
• Currently there is stretched pessimism on EZ equities relative to Asia ex Japan.
Our preference for EZ equities over Asia ex Japan equities is consistent with our preference for Defensives (EZ has a higher exposure to Staples and Pharma) over Financials (Asia ex Japan has a higher weighting) and Cyclicals. It is also consistent with other factors that may weigh on Asia ex Japan, notably likely disappointment on hopes on synchronised global growth and any deterioration in the inventory to shipment ratio and pressure on pricing power where EZ EPS are better protected.
Spain vs Italy recommendation. We are closing our positive Spain vs negative Italy trade idea. Valuations are similar, as is economic growth, but despite the Italian elections and populist vote, political risk has not risen as much as expected and the spread between Italian and Spanish bonds has not widened.
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Best regards, Verity
Eurozone equities have underperformed Asia ex Japan by 2% in the past year, despite looking very cheap on our composite valuation measure. In this note, we review the reasons why we maintain a preference for Eurozone equities over Asia ex Japan, and highlight potential biases in investors’ minds.
Research, News & Views from ASR for the week to March 9th, 2018
ASR Economics Weekly Eastern Europe – low risk from ECB tapering from Raph.
Raph discusses whether the Eastern European economies could be impacted by the possible end of ECB QE later this year, having a ‘taper tantrum’ as was seen in 2013 when the ‘fragile five’ economies sold off in response to the Fed’s tapering announcement. Certainly, the rise in relative CDS spreads between the CEE countries and the ‘fragile five’ suggests some nervousness about this. Our analysis suggests that the CEE economies’ fundamentals are much stronger than the ‘fragile five’.
We have developed an index to assess the relative vulnerability of emerging markets.
• Methodology. We have identified 24 variables that should capture internal and external imbalances; each variable is scored for all countries at any given time; the sample starts in Q1 2000.
• We then keep 8 variables that have a strong correlation with CDS spreads and average these scores to generate our vulnerability index: a higher number implies greater vulnerability.
• What do these indices tell us? Turkey, South Africa and Brazil remain amongst the most vulnerable countries with macro imbalances at levels similar to or higher than in 2013.
India is the only ‘fragile five’ economy which has seen a meaningful improvement in the imbalances.
• Poland, Hungary, Romania, Czech Republic have seen imbalances fall considerably since 2013: current account deficits have closed or moved into surplus with a steady reduction in external debt, albeit Romania has a deficit but one that is funded through FDI and EU structural funds.
• The stability of the banking systems has improved with banks relying on domestic deposits to fund loans.
• Credit growth is moderate, and the macroeconomic backdrop is strong with low rates of unemployment and inflation. This contrasts with the situation of the ‘fragile five’ in 2013.
Tighter ECB policy may reduce capital flows to CEE as investors rebalance their portfolios putting upward pressure on bond yields. Our analysis suggests that the CEE economies’ fundamentals are much stronger than the ‘fragile five’ and should be more resilient to ECB tapering than the ‘fragile five’ were in 2013.
Absolute Surprise. Our DM ASI has rolled down further c/o weaker than expected surveys in the Eurozone and negative US housing surprises.
ASR Multi Asset Weekly. Credit: attractive hedges in US and EZ from Chris.
After a strong 2017, credit markets have started 2018 on a less sure footing. We have written how we are watching credit closely for contagion from the equity market sell-off in early February. We retain a cautious view on credit but express this differently in the US and the EZ.
US: IG still unattractive.
• We have been cautious on US IG reflecting a backdrop of rising interest rate expectations, tightening global liquidity, the build-up of high levels of corporate debt and the skewed distribution of that debt- see HERE and HERE
• We think IG offers a better short than HY given we are not forecasting a US recession but rather expect tightening monetary conditions via higher policy rates / high real rates.
• US IG’s duration risk is high at 7-9 years vs US HY at c. 4. This has been a problem for total returns over the past 3 months even as spreads have shown little net change.
• But we are also cautious on US IG even if UST yields stabilize given the sharp ratings dilution with the share of BBB-rated debt up from 38% to 53% over the last decade; spreads, adjusted for credit quality, are at pre-GFC levels; the ‘falling angel’ effect will also become more important going forward.
• Moreover, while the overall thrust of US tax reform was positive for IG, there could be unintended consequences given the tax reforms incentivise large corporations to liquidate corporate bond holdings (see HERE) while any tightening by the Fed will also hurt IG.
• Inflows from foreign investors appear to be drying up as the spread of US IG over EZ government bonds looks less attractive once adjusted for the cost of hedging currency exposure.
• While Fed tightening and ECB QE unwinding may lead to asset returns becoming less distorted: in ‘late cycle’ returns from IG tend to be worse than for HY or equities adjusted for volatility.
• Implementation: We would be short / have an underweight IG position. We retain our short IG (LQD ETF) / long TIPS (TIP ETF). We would buy puts on an IG ETF e.g. + puts on LQD.
Eurozone. HY may be a better short than IG despite a less mature cycle than US.
• The bullish case for EZ corporate bonds is that the credit cycle is less mature than in the US and the ECB is still buying. But ECB QE crowded investors into HY pushing down yields to very low levels. There is little difference on IG and HY duration in the Eurozone (5.2 vs 4.4 years) while EZ HY is more sensitive to rate changes than EZ IG.
• A hedge on EZ HY seems appropriate: we would buy protection via the iTraxx Crossover Index. A short on EZ HY is consistent too with a pickup in equity implied volatility.
Absolute Essentials from David McBain
Pessimism on US bonds has backed away from recent extremes but is still notable. EZ equities – both DAX 30 and EuroSTOXX 50 - have reached oversold levels on our SBIs. In FX, USD/JPY is oversold but trade weighted JPY is not yet overbought. Norway’s cut to its inflation target has lent support to NOK: a break above 1.06: the next resistance is 1.0740.
ASR Investment Strategy Weekly. Earnings growth strong but not sustainable from Charles.
The last 3 months has seen a strong acceleration in global earnings growth, supporting equities. But equities look fully valued so, to go further, this earnings growth will need to be sustained. We are concerned this will not be the case –
• In the last 3 months, Global (FTSE World) forward EPS has risen 10% with trailing EPS + 7%: forward EPS growth at 15%. Our top-down earnings models based on activity indicators are not flagging this acceleration suggesting that EPS may be being driven by idiosyncratic drivers rather than stronger activity and better pricing power.
• Breaking down the change in global EPS, the big jump in earnings has been made by the US but seems fairly evenly spread by sector, bar a jump in EPS from Oil & Gas.
• Clearly US Tax reforms are driving the earnings upgrades: he shows how Sales and EBITDA have barely changed their trajectory but forward EPS have risen sharply. Indeed, EBITDA margins have fallen to the low end of their post GFC range.
• We do not believe current rates of earnings growth is sustainable. The tax reforms are a one-off change of rules and a step change in the tax rate but analysts now appear to have incorporated the lower tax rate into forecasts
• We expect EPS growth to return to the underlying, unchanged EBITDA rate of <10%.
• There is also a widening gap between the headline and reported (GAAP) earnings as perhaps, exceptionals are excluded, as managements stretch to meet targets: cashflow is also failing to rise with earnings too.
ASR Multi Asset Survey – please participate HERE! Every quarter we survey more than 200 Chief Investment Officers, Asset Allocators, and Multi-Asset Specialists from around the world. it is a Survey of Probabilities. We want to help investors understand the probability of specific market outcomes within a specific period: what is the likelihood of a certain financial event occurring over the next 12 months? The survey will allow us to compare fund managers’ probabilities with those implicit in the market. We can also identify ‘high conviction” calls.
Best regards, Verity
• Global earnings have accelerated strongly, helping Equities rally
• Driving the acceleration is US Tax Reform
• Underlying earnings growth has hardly changed in the US
• US Earnings quality fallen as cashflows not kept up with earnings
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