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• But improved profitability of Financials is needed for a sustained Value rally
• Meanwhile the debt load of cheap stocks could move into focus
Research, News & Views from ASR for the week to November 16th, 2018
ASR Economics Weekly. Merkel’s decline puts Europe on edge from Michael.
• In the past decade, Germany politics have been very stable under Angela Merkel. But, recent election results in Hesse and Bavaria have cast this into doubt with support for the 2 largest parties (CDU/CSU and the SPD) fragmenting. Merkel retains the Chancellorship for now but her announcement not to run for CDU leader robs her of an influential position within her party and her role as a constant in European politics will recede. If party delegates vote for one of her rivals rather than Annegret Kramp-Karrenbauer, this could force her out.
• What has characterised Merkel’s leadership? Other than a few big policy shifts, her domestic agenda has been sparse - the decision to observe the Stability and Growth pact and write the balanced budget into law; the volte-face on nuclear power; the acceptance of refugees in 2015. But much of Germany’s service sector remains highly regulated and government investment rates are lower than EZ neighbours.
• In Europe she has favoured an incremental approach, helping to contain each crisis without pursuing long-term solutions that prevent crises from flaring up again. Banking Union remains incomplete and fiscal union is off the table.
• A benign macro backdrop in Germany has made this approach possible. Germany’s export industry has benefited from China’s rise and low inflation has provided cover for her support for QE.
• Merkel’s possible replacements? The two leading candidates are Annegret Kramp-Karrenbauer and Friedrich Merz. They are both pro-EU and fiscally conservative, but neither have held cabinet positions in government, so we do not know how they would respond in a crisis. Her successor could face very different external circumstances if the benign backdrop unravels: China growth has slowed / wage increases have prompted calls for rate normalisation / Italian politics present a greater risk to the EZ than Greece in 2015.
• 2019 could prover to be a much more volatile year for German politics / EZ assets.
ASR Political analysis: the first of two pieces looks at the arguments on how a ‘no deal’ Brexit could happen:
Why a ‘no deal’ Brexit is more likely than you think. Ways that we could have ‘no deal’.
• The UK and the EU27 could simply fail to reach an agreement on Withdrawal: we have passed this hurdle.
• Any deal will be vulnerable to roll back and /or rejection by the UK Parliament: Richard does a close analysis of MP voting. The so called ‘meaningful vote’ on the deal could be lost if just 6 Conservative or DUP MPs vote for it: there may be a handful of pro-Brexit Labour MPs voting with the Government, but given the DUP / the Conservative Eurosceptics / the Conservative Remainers, there is a live risk that a majority for the meaningful vote cannot be found.
• An under-appreciated risk. The maximum threat to the deal could be AFTER it is approved by the UK Parliament in the ‘meaningful vote’, when the Government tries to pass the legislation to implement the agreement. A bill will have to go through both Houses of Parliament over a period of weeks, with scope for some Conservatives to have ‘buyer’s remorse’ / be pressured by their local constituencies to change their mind, as this process draws focus to the most controversial aspects of the deal. The Government could of course look to weaponise the threat of ‘no deal’ if this occurred.
• The risk of the European Council / European Parliament rejecting the deal if the legislation of the UK Withdrawal Agreement proves unacceptable is higher than generally appreciated too.
What is clear from the above is that the risk of a no deal does not go away even if an agreement is reached in the next few weeks.
ASR Multi Asset Weekly. Regime risks for equities from David McBain Equity sentiment.
• The bounce in equity markets should be set against a backdrop of stretched pessimism, based on our Sentiment indicators (SBIs). But sentiment analysis can provide signals beyond contrarian reversals. In the past 19 years, MSCI ACWI SBI levels of below 35 (currently 5) have been followed by an average -1.2% decline in ACWI over the next 65D vs. +2% when it’s SBI is over 60.
• This works looking at the S&P500, EuroSTOXX, FTSE100, Nikkei 225 and MSCI EM indices since 2000, with negative returns when their SBIs are below 35 and notably positive performances when they are above 60 over the next 30 and 65 days. Current negative sentiment for global equities points to further downside risk.
• Macro regimes. The macro regime backdrop remains negative for risk assets, with the unattractive combination of positive Activity Expectations set against still negative Activity Surprises. See HERE re. Equities and HERE for other assets.
• What might the current macro and sentiment regimes imply for equities when viewed together? This analysis suggests a negative backdrop for global equities, as well as for Cyclicals sectors vs. Defensive sectors, which may limit the scope for sustained rallies. See ASR Methodology papers for our Sentiment Indicators, ASR Activity Expectations Indicators and ASR Surprise Indicators.
Absolute Essentials from David McBain
We wrote in our September Asset Allocation document that Brent would struggle to sustain a break above $65-75. We are cautious on Crude longer term. Crude has now reached some key technical levels: $60 for WTI is a notable level while implied crude volatility is overbought. In the past 10 years the combination of current SBIs for crude vol and WTI were followed by an average rise in WTI over 30 days of 10%. Specs have also cut Crude longs. Although WTI momentum is negative, extended pessimism may provide some near-term support as big technical levels are hit. Otherwise.......EUR/GBP hit stretched pessimism as the cross rate hit 0.87: next levels are 0.865 and 0.84. US HY Sentiment is elevated, while US Min vol Sentiment is in stretched optimism territory.
ASR Investment Strategy. Relative attractions and risks of Value from Charles.
Our Value factor is created by combining the following measures - Dividend yield, Book value to price, Trailing Earnings yield, Forward earnings yield and Cyclically-adjusted earnings yield - to get a cheapness score. The performance of Value is the relative performance of the cheap fifth of the market vs the expensive fifth.
• Over the long-run, Value has seen extended periods of out- and under-performance. Over the past few years our Value factors have underperformed. Cheap stocks have underperformed expensive ones and, the valuation of ‘cheap’ stocks vs. ‘expensive’ ones has widened sharply on 3 valuation metrics – Price to book, Forward PE and Trailing PE. Valuations of the most expensive fifth of the market have risen while the valuation of the cheapest fifth has stayed constant or fallen in Europe. Value is looking cheap.
• But the valuation attraction of the cheapest stocks might be tempered by their slower earnings growth or they may be cheap for a reason.
• A key concern is that debt is concentrated in Value stocks globally so could be hurt by rising rates / policy mistake / recession risk. Value underperforming as interest rates and yields rise would be a change from the relationship seen since 2008 when correlations suggest higher yields argue for higher exposure to Value: we would expect a return to the pre-2008 correlation
• Our work suggests that the macro factors that drive Value stocks are rising bond yields, accelerating inflation and commodity prices, faster business activity, credit market performance, rising expectations i.e. a risk-on environment. We expect slower growth, lower oil prices and higher real yields, which will hinder the performance of Value.
• Value globally also has a strong exposure to Financials, Utilities and Telcos and is heavily underweight Tech and Healthcare: we are Underweight Financials, Neutral Tech, Overweight Healthcare. A positive view on Value requires Tech to be challenged and for Financials to reverse their underperformance, which would likely need ROEs to return towards the levels of the early 2000s: we are sceptical of this.
• Value is correlated with Risk but moves oppositely to Growth, Quality and Momentum. It can provide a useful diversification to Quality. We prefer Quality against a backdrop of slower economic growth and weakening EPS growth and are wary on debt-laden Value unless Value is part of a multi-factor portfolio with Quality.
Best regards, Verity
Research, News & Views from ASR for the week to November 9th, 2018
ASR Economics Weekly. Five reasons we remain cautious about global growth from Dom.
The global economy has slowed over this year from over 4% to close to 3% now. Our commodity-based model and our Global LI suggest global growth will slow further over the next few quarters. We see five reasons for this.
1. The lagged effect of higher energy prices is starting to act as a drag on global growth: this has already led to a deterioration in many EM terms of trade putting pressure on their balance of payments – cf Turkey and Argentina. Higher energy prices have also eaten into consumers’ real income growth- contributing to the EZ slowdown through this year and the slowing in manufacturers’ new orders.
2. Global monetary conditions remain tight and are likely to remain a drag on the global economy. The slowdown in global M1 growth has been broad-based, with growth rates now at levels last seen in 2008 which is consistent with the global manufacturing PMI falling below 50. Tighter US monetary policy is having an impact in EM where monetary policy has been tightened to offset the pressure from a stronger dollar. China’s deleveraging campaign has also been a significant source of monetary tightening this year.
3. Ongoing China slowdown. Chinese policy is providing more support to the economy, but it will take time to take effect. The decline in interest rates suggest Chinese M1 growth will turn up in the next few months, but it typically takes 6-9 months before it feeds through to a pickup in the Chinese economy. Moreover, with fiscal policy options limited, it is likely that the upturn will be more modest than in 2016-17 when it finally arrives.
4. Some moderation in US growth but ongoing Fed tightening. The US has been the standout performer, but the tightening in financial conditions will contribute to a moderation in US growth over the next two quarters, while fiscal policy will also be progressively less supportive. Still, the slowdown does not look sufficient to prevent the labour market tightening further encouraging the Fed to continue to raise rates. The pressure from tighter US monetary policy looks unlikely to let up anytime soon
5. Caution on Italy and its effect on the EZ. We are concerned that the tensions between Rome and Brussels could escalate further: the Italian banks could be a casualty of this standoff if Italian bond spreads widen further and feed into higher bank funding costs and higher lending rates to the Italian private sector. The ECB may be reluctant to provide cheap funding too quickly so the situation in Italy looks likely to get worse before it gets better.
ASR Investment Strategy. Probability of a US bear market: rising but not critical from Ian and Dominic.
Over 50% of global equity markets remain down more than 10%, i.e. in correction territory and over 10% of markets are down more than 20%, i.e. in bear market territory, the key question is whether this is just a ‘pause that refreshes’ or whether this will morph into a fully-fledged US bear market. We provide a helpful new framework for assessing the timing of a US bear market.
• To minimise the obvious dangers of false positives, Dom used the ‘Area under the Receiver Operating Characteristic Curve ‘ approach in his excellent work on US recessions - see HERE. It was the approach used by the BIS for their Early Warning Indicators of Banking crises - see their easy primer HERE.
• We adopt the same methodology, identifying critical variables, lag structures and thresholds both for corrections and for bear markets. We used 39 variables - some key macro variables that Dom used for his recession models plus valuation, momentum and equity specific variables and tested all 39 variables with 36 months of potential lead against the S&P500 since 1965.
• Our Correction Early Warning Indicator model suggests the US market appears close to a correction phase (20/39 have exceeded critical values, 7/11 of those with the shortest lead times have exceeded theirs).
• Our Bear Market Early Warning Indicator model: only 11 of the indicators are above critical threshold levels and have optimal signals of > 15 months (albeit 14 are within 0.5sd from critical levels).
• Typically, we would see a higher proportion of signals flashing red prior to a bear market emerging.
• It was also reassuring that our ASR Composite Equity Indicator (CEI) with its 5 pillars (Economic, Earnings, Valuations, Liquidity, Momentum) had a high ROC accuracy score.
• We used the results to create 1 and 2 year ahead probit models. The 1 year ahead Bear Market probability has come down, but the 2 year ahead Bear Market probability is already at 33%.
Conclusion. The ROC approach is useful for creating Early Warning Indicators and probit models for Corrections and Bear markets. The model confirms that the US appears close to a correction phase and the risks of a bear market are rising, but not enough of the variables are beyond their critical values to justify shifting from a cautious stance, to a bearish stance, yet. We will particularly monitor critical levels for our 12m US recession indicator, the scale of yield curve flattening and the ASR 5 pillar CEI to shift to a bearish stance. In this correction phase, we would ‘Sell the rallies rather than buy the dips’ – see HERE.
ASR Multi Asset Weekly. US debt fears falling on deaf ears? from Chris.
Why has credit held up so well as equities fell? Chris argues that a) US corporate bonds have been out of favour with investors for a while so lacked the ‘frothy’ aspect of some equity sectors going into October. Both HY and IG ETFs had been seeing outflows in 2018, while b) credit may also have been helped by soft issuance in Q3 (gross issuance of HY and IG fell 18% and 28% yoy respectively in Q3). So technical reasons best explain why credit held up better last month, albeit absolute returns were negative.
The outlook for credit. Prefer US HY to US IG; prefer EUR IG to US IG; Neutral EUR IG to EUR HY.
• Our long-standing medium-term fundamental concerns re. the US corporate sector remain intact See HERE.
• Within credit, we have been cautious on US IG vs HY and this has worked well (US HY +1.1% vs. IG -4.0% ytd). On a 3-6 month view we still prefer US HY to IG: US growth may slow but HY does not usually become an attractive short until recession comes onto a 12m horizon (see Dicing with debt) and we see this as a low probability (although it rises on a 24m view).
• So, the focus is likely to remain for now more on downgrades, as opposed to default risk. 2018 has seen downgrades rising for IG (the worst year since 2011) which is not limited to the BBB part of the IG market. As the NACM Survey also suggests, the underlying weaknesses of the US corporate sector have not been washed away by a few quarters of strong real GDP growth
• European credit. Foreign investors have been heavy buyers of US IG, but European IG yields now look more attractive to US IG once hedging costs are taken into account and US investors can get a yield pick-up on EUR IG hedged back into USD for the first time since 2012 with lower duration risk.
• Earlier this year we preferred EUR IG to EUR HY but since August we have held a neutral view between the two: 350-400bp HY OAS spreads are not good value for investors with a 5-year horizon, the near doubling of spreads does suggest that a major part of the distortion from ECB QE has been corrected.
ASR Absolute Essentials from David McBain
Equities: Last week the VSTOXX SBI moved above 96: since 1999 this has been followed by an average 1.8% rise in the EuroSTOXX50 over 30D and a 4% rise over 65 days. This would suggest a move to re-test resistance around 3300. Bonds: Pessimism is again notable on UST 10Y while pessimism is also marked on Gilts. FX: US dollar optimism has backed away from stretched levels but remains elevated as Speculators’ modestly increased their USD net long. Net shorts in EUR & GBP were increased while modest cuts were made to AUD net short.
Commodities. Industrial metals have hit stretched pessimism levels versus Precious metals. Industrial metals as a grouping are now testing key support but momentum trends point to risk of further downside.
ASR/WSJ Newsflow Indicators from Richard. The Composite Newsflow indicator rose to 65.3 in October vs. 62.7, driven by the Labour market and Monetary policy components i.e. both were tightening, presenting headwinds for corporates. The Economics Newsflow declined to 41.5, with notable weakness in EZ and China.
Best regards, Verity
• Clients are keen to know if the correction will morph into a US bear market
• Minimising the risk of ‘false positives’ in our models is critical
• We use the Receiver Operating Characteristics (ROC) approach to do this• The probability of a bear market is rising but remains below ‘critical’ levels
Research, News & Views from ASR for the week to November 2nd, 2018
ASR Economics Monthly. NAFTA and the weaponization of trade agreements from Michael.
Markets reacted positively to the newly negotiated NAFTA - now USMCA - with the final deal omitting some of the ‘poison pills’ that the US had previously insisted upon. It needs to be ratified but we can draw some conclusions from the agreement’s text, as it is likely to be used as a template for US trade deals with other countries.
• The new agreement has important implications for the Autos sector with the North American content requirement raised from 62.5% to 75% and up to 40% of this content required to be made by workers earning more than $15 an hour, bringing extra costs. See HERE. Perversely, this may discourage production in the US as companies may just find it cheaper to pay the tariff.
• The USMCA also contains some controversial clauses, the most significant being Article 32:10, the option to terminate the agreement if one partner signs a trade deal with a ‘non-market economy’. Obviously, the NME with the greatest market reach is China and US insistence on this clause is part of its ongoing trade war with China.
• So how will much larger economies like Japan or the EU, much less reliant on the US for trade, react to such a clause. It could mark a major shift in US policy and how China is treated by ROW.
• It suggests US pressure on Chinese commerce will persist i.e. this is a strategic, not simply a tactical move. It suggests that this is not about a trade war but rather a strategy of China containment. It could herald a more bipolar economy, or it could isolate the US, if Japan and the EU reject Article 32:10.
• Whichever outcome wins out, zero-sum outcomes in economics do not tend to be positive. China contributed substantially to global growth through the 00s and the first half of this decade. Policies designed to limit China’s rise will likely come at the expense of economic growth and development with wide reaching geo-political implications.
ASR Investment Strategy Still selling the rallies not buying the dips from Ian
October was a torrid month for investors exposed to Equities (-7.6%), Oil and Hard Commodities. However, some investors have decided to ‘buy the dips’, believing that the sell-off was about rising bond yields and high valuations in Tech and some disappointment in FAANGS earnings. We disagree.
• The equity sell-off has been much more than Tech: Tech is only the 6th worst global sector and the 4th worst US sector vs maximum levels of the last year. The worst performers globally have been Basic Resources, Industrials and Financials.
• There are much broader concerns about global, not just Tech, earnings with sharp cuts to 12m forward forecasts in recent weeks suggesting that EPS growth will be well below the 10% aggregate forecast – likely close to zero. Frankfurt airfreight/Korean exports point to a significant earnings slowdown too.
• We still see this as being more about Liquidity than Earnings. Concerns about the macro outlook and global earnings, in our view, are the result of tightening global liquidity: our ‘flash estimate’ of global Real M1 has slowed further to 2.8% on a 6m annualised basis, pointing to further downside risks for economic activity and for risk trades. See all the M1 relationships HERE
• Tightening liquidity and the SIFIs. This liquidity stress is increasingly evident in the pressures in the SIFIs and Asset Managers: even with the rally of the last few days, the SIFIs are still 25% below their 2018 peak, 30/39 are down more than 20%, 17/39 are down more than 30% and 8 US SIFIs are down 20% or more. We are also seeing real assets being challenged, especially Real Estate and Illiquid assets (listed PE companies have lost close to 15% since September): the recent weakness in Tech may be partly explained by asset managers selling their ’winners’ to meet fund outflows.
• Lack of policy adjustment. Trump urging Powell to cut rates may actually slow the process of the Fed easing monetary conditions, so this liquidity squeeze may persist. In the past, either policy rates or shadow rates would have typically fallen where key financials were under stress but with the Fed engaging in QT and the ECB in tapering, that looks less likely near-term. See Clarida HERE.
• Looking at Growth vs Value may miss the point. At this stage of the cycle we often see factor confusion as cyclical stocks get viewed as ‘Growth’ due to their recent strong earnings and vice versa. The big rotation from Growth to Value is unlikely to take place without either a regime shift in economic activity, inflation or monetary conditions. It is evident that Cyclical sectors are underperforming Defensives and that Quality and Min-Vol as well as Value are beating Growth. It is worth noting that normally when Min Vol outperforms Quality, Treasury yields would have fallen 50-100bp.
• Regional rotation is only just impacting US leadership. Despite all the focus on the US, the US market is down just 1.5% from the peak in early October and is modestly higher than a month ago. There have been signs on investors moving into EM (albeit not Asia ex Japan on a relative basis) but we are wary c/o valuations EM PEs of 12.8x vs. 11.8x in 2016, Price/book at 1.7x vs. 1.3x) , the fact that the recent easing in Chinese policy reflects deeper stress in the Chinese economy, (especially in Real Estate which has borrowed heavily in US dollars) and the role of the dollar (for a sustained EM recovery, we need a weaker dollar). Near term, the Fed looks unlikely to switch to a less hawkish stance which may support the dollar.
• For us, the dollar is a key cause of the stress as it directly squeezes global liquidity conditions and makes funding dollar debt harder – see HERE.
• Conclusion: 2/3rds of the 68 markets we monitor are in correction territory and 1/5th in bear market territory. We maintain our cautious bias until we see more fundamental change in the policy bias or a weaker dollar: China is reacting but, as yet, the ECB and the Fed are not. If this is a liquidity story, we would ‘sell the rallies’ not ‘buy the dips’.
Absolute Essentials from David McBain
Equity breadth has deteriorated (only 5% of the 41 markets we cover have SBIs >50) which is a poor technical backdrop but there is clearly scope for contrarian rallies, although the scale of the rally may be limited by tightening liquidity. We are at key technical levels on EuroSTOXX 50, Kospi, European small vs. large caps, while the falls in Chinese Tech suggest SOX is at risk medium term: a break below 1236 suggests a re-test of the 1100 level. USD optimism is elevated but not extreme: GBP and AUD look close to oversold vs. USD.
ASR Multi Asset Weekly. Fear the Fed - key US Treasury charts / views from Stefano.
We wrote HERE that financial markets looked vulnerable to Fed policy tightening into already tight US monetary conditions. Indeed, US real M1 looks set to fall below 1% yoy in October, while Fed Fund rates have climbed to the same level as the interest rate that the Fed pays on US banks’ excess reserve balances, again pointing to tight monetary conditions. We focus on 3 aspects of the US Treasury outlook:
US Treasuries macro and Fed backdrop
A deterioration in the US macro backdrop may not be an obvious driver to lower bond yields. Some of our macro charts suggest that Treasuries are already discounting some deterioration in US activity surprises going forward. While US growth may slow into year end, US core CPI may rise, providing temporary support for UST yields.
US Treasury supply factors.
With maturing bonds rolling off the Fed balance sheet at $50bn a month and a budget deficit rising to 4.7% of GDP in 2019, one might argue that pressure is there for higher yields. Stefano, however, argues that such pressure may be overstated and can be offset by issues, for example, such as the Fed reverse repo operations coming to an end, while the sharp pick up in Treasury bills issuance since the end of QE will likely continue.
US Treasuries relative value aspects
The US Treasury intermediate yields (7-10 year sector of the curve) leading the way lower is typical of phases when a slowing US economy combines with a tighter Fed policy. We expect this to continue. As we argued HERE, unhedged US Treasuries look the most attractive option on a risk/reward basis for non- US global bond investors.
We advise investors to retain a small long duration bias with US Treasury intermediates expected to outperform. Intensifying safe haven flows, as equities come under pressure, are also likely to provide support.
Best regards, Verity
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