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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
US fixed-income implied volatility looks cheap both historically and vs. realised volatility. We argue US rates vol has potential to rise both in a fixed-income market rally and in a sell-off. Given the lack of liquid ETF and future markets, investors buying US rates vol would need to trade via Treasury options or short-dated USD interest rate options.
YEN: USD/JPY SBI near lows; but momentum points to 104-105 retest (P1/3)
GOLD: Gold volatility looks well placed to pick up on a 1-2M view (P4)
EQUITIES: Russell 2000 positioning risk; FTSE 100 nears key support (P5/6)
USD/JPY close to oversold … but still at risk of further downside
A month ago in Essentials we noted that while USD/JPY was oversold near-term on sentiment, its failure to find support at its 2017 lows pointed to a re-test of 105 in the medium-term. While USD/JPY did find some support, its technical profile remains negative, with the cross-rate below declining 50, 100 and 200D moving averages. Stretched pessimism may provide some near-term support, but a move down to the 104-105 area still 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. As we have noted previously, continued yen strength has wider market implications. Most notably, it may act as a drag on Japanese equities vs. the rest of the world in local currency terms. Charts on p3.
Chart of the Week: Dollar weakness has helped offset the hit to Gold from a less supportive US real yield backdrop (see chart). While Gold has backed away from late-January highs, it remains above its 100 and 200DMAs, as well as the key $1305 support area. However, sentiment indicators do point to potential for a pick-up in Gold volatility on a 1-2M view: SBIs are at levels that since 2009 have been followed by an average 10% rise in the CBOE Gold Vol index over the next 30D (see p4). This week’s Fed meeting is important for Gold as well as the dollar.
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
• We introduce two simple valuation tools for EM sovereign credit risk. The first one looking for discrepancies between bonds and CDS spreads. The second one highlighting inconsistencies between sovereign credit risk spreads and fundamentals, as proxied by the ASR Vulnerability Index.
• Our analysis highlights an attractive, non-negative carry way of hedging EM debt cheapening risks via South Korea vs. Chile 5-year CDS premia.
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