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Implied volatility looks ‘oversold’ in many asset classes. We suggest vehicles for hedging various macro scenarios.
EXTEL SURVEY 2019.
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EQUITIES: Japan oversold versus AC World ex-Japan as relative lows hit (P3)
BONDS: US TIPS yields nearing oversold SBI territory (P3)
VOLATILITY: US bond and FX volatility both hit oversold SBI levels (P4)
EXTEL SURVEY 2019.
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Research, News & Views from ASR for the week to March 15th, 2019
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ASR Economics Monthly. A policy response but not enough from the team.
Policy moves in the US and China have buoyed risk assets, but our economic toolkit suggests further slowdown.
• Data disappointment. The global economic slowdown has gathered pace in recent months, with global trade volumes falling an annualised 8% in Q4 and our global activity surprises staying below zero, despite expectations being cut substantially. Some of the sharpest downgrades have been seen in the Eurozone, but trade growth has been particularly weak in Asia and US activity has also slowed with ‘Nowcasts’ from the Atlanta and the NY Fed suggesting growth of 1% in Q1. It has become a synchronised slowdown.
• A policy response needed. The backdrop has underlined the need for a policy response, which has started to arrive in the form of the Fed’s ‘U’ turn and an array of stimulus measures – tax cuts, support for local government financing and injections of liquidity- from China.
• But are these measures enough and at what point might that turnaround happen?
• The Fed; as we wrote HERE the Fed’s U-turn can be understood in three ways – a) Concerns about growth; b) concerns about persistently low inflation; and c) a change in the Fed’s reaction function. Markets have seemed to focus on the first - another Fed ’put’. But just as December’s volatility may have been postponed, so more volatility may be required before the Fed eases outright. The bigger issue for us is the credit cycle. We believe weakness in credit markets ‘spooked’ the Fed. See the Fed’s Financial Stability Report, the Senior Loan Officer’s Survey and anecdotal evidence of firm’s paying down debt rather doing buybacks. All this suggests a turn in the credit cycle, which suggests growth will likely continue to slow this year.
• China. An acceleration in government expenditure in late 2018 and January’s TSF surge led to hopes of further substantial reflationary stimulus. We do not think there is appetite for ‘flood-like’ stimulus in Beijing and fiscal expansion will be more restrained, with any increase in the augmented fiscal deficit likely to be limited to 1.0-1.5% of GDP.
• Europe. Markets were underwhelmed by the TLTRO announcement last week. We doubt these measures are enough. Fiscal stimulus could boost EZ GDP by 0.4% - helpful, but insufficient. Hopes for German fiscal expansion may disappoint without a much bigger shock.
Outlook. Our framework paints an uninspiring picture near term with all 9 of our country leading indicators decelerating, with weakening IP growth. Global real M1 is still weak suggesting downside risk for PMIs and global trade growth looks likely to slow further.
Any signs of an upturn? There are some brighter spots – real M1 is weak, but there are signs of a turnaround; service sector surveys are resilient in the US and EZ; US and German wage growth looks positive supporting consumption. But we still argue that global growth will be subdued over the next 12 months and more of a further policy response is needed to prevent a further slowdown.
ASR Multi Asset Weekly. US credit and Quality stocks - the odd couple from Chris.
Quality time - why outperformance as credit rallies? One characteristic of Quality stocks is low leverage which makes it unusual for Quality to outperform when credit spreads narrow, as has occurred in the US in the post-Christmas rally. One way to rationalise this is that the behaviour of US companies is changing as they start to emphasise debt reduction, capex M&A, buybacks and dividends. But we are sceptical whether this makes sense at an aggregate level as widespread corporate retrenchment would be bad for GDP and ultimately impact aggregate credit returns. This did occur in 2000-02, but we are doubtful whether this can work this time;
o The level of yields provides much less of a buffer for returns.
o The appetite for investors to diversify into credit out of equities is much lower than in the early 2000s: the overall IG corporate bond market was 11% of the large cap equity market then vs. 22% of the size now.
o The 2000-02 Equity bear market was more of a valuation event c/o Tech, than a credit event.
o The current skewed distribution of US corporate sector debt - see HERE where Charles points out that a quarter of US non- financial stocks have interest cover below 2.5x - may yet prove a driver of both equity and lower rated corporate bonds on the downside.
• We continue to favour Quality in both US equity and corporate bond markets, albeit Chris notes Quality short term looks overbought. We prefer IG over HY and within IG, the higher-grade credits over BBB.
• We like Long inflation- linked Treasuries / short US IG corporate bonds (long TIP / short LQD).
• The rally may be a good entry point for outright short US HY position via CDX.NA. HY.
• We stick with long S&P 500 / short Russell 2000 via futures given our concerns about leverage in the Mid and small cap space against a backdrop of further declines in activity expectations.
• But the US Consumer Staples sector has become one of the more highly leveraged US sectors, so we take profits (+7.5%) in our long Staples / short Consumer Discretionary trade.
ASR Absolute Essentials from David McBain
Equities. MSCI World with EM Exposure has failed to sustain a move above its 200DMA. The index faces resistance in the 2280-2290 area. Based on historic correlation, a move higher in USD/KRW is likely be a negative development for Korean equities. Bonds. USD/KRW moves also have strong historic relationships with EM bonds.
FX. The USD/KRW cross-rate is poised at a key technical inflection point as it tests key trendline resistance. USD/KRW implied vol has also hit SBI levels of below 0.5. In the past 10Y this was followed by an average 2.7% rise in vol over 30D and 12% rise over 65D, up on 84% of occasions. Commodities. Aluminium has reached stretched pessimism territory versus Copper: Scope for a near-term rally in the relative.
ASR Investment Weekly. Why this rally is unlikely to be a 1998 or 2016 rally re-run from Ian.
While recognising that equities were oversold pre-Christmas, the rally since then in Global and US equities has still challenged those of us that are cautious. Investors are looking to 1998 and to 2016 for positive parallels to the recent rally. We think such hopes will be disappointed for three reasons.
• The scale and capacity for policy response is much smaller. In 1998 US rates were cut by 75bps (from 5.5% to 4.75%). The dollar fell by 9% and rates were cut in 10 out of 12 major economies in response to LCTM. So too the fiscal and monetary ease by China now looks to be half that seen in 2015-16: Adam expects (HERE) greater RRR cuts but fiscal easing of 1-1.5% of GDP vs 3-3.5% then. What is also missing is the scale of ECB and BoJ QE which added $2trn to CB balance sheets, equivalent to a 1.5% fall in Japanese shadow rates and almost 4% in EZ shadow rates offsetting the rise in US rates that triggered the sell off.
• Valuations of Equities vs. Bonds were clearly cheap in the 1998 and 2015-16 periods. The 3y Z score of the Bond/Equity yield ratio fell below -2, giving a clear buy signal. In 1998, bond yields fell by 150bp in 6 months and global PEs fell by 5 points: in 2015-16, bond yields fell 50bp and PE ratios fell 3 points. Today the Bond/ Equity yield ratio score is in neutral territory close to zero. Also, in previous episodes credit spreads had widened by 300bp before the rally began so there was scope for credit to rally with equities.
• Hope of global economic recovery boosting Cyclicals. In 1998 and 2015-16, Cyclicals and Financials dominated Defensives as expectations of economic recovery - escape velocity - rose. In 2016, this helped to shift the economy back into mid-cycle. In the recent rally Cyclicals have outperformed by only 4% and Financials have underperformed.
We believe that the economic, policy and valuation backdrop is very different and less supportive than in 1998 and 2015-16. For the rally to persist we need enough policy easing to boost the outlook for corporates to avoid increased stress on earnings, capex, employment and credit particularly given Increased debt levels. Without much more policy easing we worry that risk assets will be challenged again.
My best regards, Verity
• The recent outperformance of Quality stocks in the US is in line with ASR expectations – but we didn’t expect it alongside narrower credit spreads
• One narrative to rationalise this combination points to major BBB credits announcing de-leveraging plans at the expense of more shareholder-friendly activity such as buybacks/dividends/capex
• But is this is a ‘trick’ that can sustain credit returns at the index level if the de-leveraging trend broadens out? We suspect not as retrenchment would hit GDP
• Credit’s resilience in the 2000-2002 equity bear market is misleading
• Looking for credit spreads to re-widen; recommend short US HY via CDX
• Recommend taking profit on long US Consumer Staples vs. short Discretionary due to Staples' high net debt. Still like short Russell 2000 vs. long S&P 500. Volatility’s medium-term uptrend hampers Momentum
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