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Research, News & Views from ASR for the week to May 25th, 2018
ASR Economics Weekly. New Italian government: containing a crisis from Michael.
Markets have woken up to Italian political risk as concerns about the 5 Star-Lega coalition and its commitment to the EU treaties raised their head.
• Similarities with Greece in 2015? Politically there are similarities between the new coalition and the 2015 Greek government: both promised to renegotiate EU treaties and to repeal reforms made in the Eurocrisis; both pitched a populist government against a more mainstream opposition; both countries’ political institutions can act on radical attempts to change policy. But economically, the positions are very different: in 2015 Greece was heavily dependent on a credit line from the EZ whereas Italy runs a current account surplus and the governments primary budget is in surplus too.
• These differences and the relative size of Italy matter. They lower the chances of a protracted standoff and incentivise Merkel / Macron / the EU Commission to contain an Italian government that pursues some of the more Eurosceptic ideas. It is likely that treaties remain non-negotiable, but the EU may ‘allow’ Italy some rule-breaking at the margin.
Implications for the economy and markets?
• Macro: a looser fiscal stance could boost Italian growth short-term, but it could push Italy’s debt ratio up in the longer run. So too, repealing 2011’s pension reform could increase implicit liabilities significantly.
• A containment strategy could limit the downside for risk assets near term, but could also limit the EZ’s ability to make itself more resilient to another crisis – as may become clear at June’s EU Council summit.
• The ‘unfinished nature’ of EZ reform, especially in the banking sector, could expose Italy in a future crisis.
• The March election outcome stemmed from several years of political and economic stagnation. This could persist with another ‘containment strategy’, but could result in a much more radical outturn in the next crisis.
Absolute Surprise Consensus GDP growth forecasts have been downgraded for the EZ and Japan for 2018.
ASR Multi Asset Weekly. Ideas to play the Italian bond sell-off from Stefano.
• The past few weeks have seen a sharp sell off in Italian bonds in response to the new coalition government’s political plans. Rather than ‘backing off’, 5Star and Lega leaders have been dismissing the widening BTP spread to mark their distance from elite financial markets: EZ leaders’ calls for Italy to stick to responsible fiscal behaviour have met with a similar response.
• We expect financial market pressure to remain elevated, but selling BTPs does NOT look to offer the most attractive way to hedge Italian political risk because:
• BTPs look cheap on recent history with 10-year BTP yields in line with average yield levels prior to ECB QE.
• Current long-dated BTP yield levels look attractive to global (esp. Japanese) bond investors.
• The cost of carry and roll from shorting BTPs looks expensive.
• Our monetary analysis suggests that the EZ periphery macro outlook is still looking more positive than the core (in contrast to the outlook prior to the 2011 debt crisis).
So how else might we hedge Italian political risk?
• Our key trade would be to sell OAT/ buy Bund futures. The OAT/Bund spread is trading historically tight given the strong correlation to the BTP/Bund yield spread.
• Another alternative to consider might be to look at 5/10yb BTP yield curve flatteners. The yield curve looks close to an inflection point where further rises in BTP yields would be driven by the front end, consistent with Italy’s worsening sovereign credit risk, driving the curve flatter.
What’s priced in? Market expectations of rate hikes in the US and Canada have risen, with three 25bp hikes priced in in both. High debt ratios / housing issues may mean the BoC struggles to match Fed tightening.
ASR Absolute Essentials from David McBain
Equites. The FTSE 100 remains in a stretched optimism condition. By sector: pessimism on Food, Beverage & Tobacco, Capital Goods and Insurance is still near extended levels: optimism on Energy remains highly stretched.
Bonds. Sentiment, positioning and metal moves provide support for a contrarian bounce in US 10Y Bonds. 10Y yields are likely to face technical resistance in the 3.15%-3.25% area. In the past 20Y, similar US 10Y and TIPS SBI levels were followed by an average 15bps fall in 10Y yields.
FX. US Dollar net short positioning is at the lowest since the start of the year.
Commodities. The degree of optimism on oil at current levels is a near-term risk. Specs’ sizeable net longs in oil were sharply cut in the week to 15th May. Specs cut gold longs.
ASR Investment Strategy. Dollar shortage poses systemic risk for markets from Ian.
Ian argues that the buildup in dollar denominated debt and US dollar funding models has created the scope for new systemic risk. For much of the last decade real interest rate differentials largely explained the moves in the US dollar. The 14% fall in the dollar in 2017 saw this relationship break down, leading to a ‘new dollar narrative’ related to Trump / widening current account. But the 5% rise in DXY challenges this ‘new narrative’ and appears to have exposed some of the fault lines.
Systemic not idiosyncratic events. The rise in the US dollar has coincided with an increase in financial stress events - the spike in the VIX, the rise in EM CDS spreads or sudden house price reversals in Sweden and Canada. For us these events are not idiosyncratic but are systemic - all symptoms of a financial system that has become overly dependent on easily available liquidity, c/o QE and especially the availability of dollars to fund an increasing quantity of dollar denominated debt that has built up post the GFC.
High debt, slowing growth and rising real rates are usually a toxic combination.
• After a long period of low rates, we are seeing global monetary conditions tighten as the Fed raises rates and starts QT. Higher real rates have already seen real money growth slow, putting stress on parts of the system dependent on sustained excess debt.
• Typically, higher real rates also tend to push asset volatility higher in the coming 2-3 years. The volatility at the start of the year should not be a surprise. Three factors have contributed to this:
• The rise in real and nominal rates;
• The reduction of liquidity as the Fed started reducing the size of its balance sheet;
• The squeeze in the CP markets / Treasuries as domestic and foreign banks moved to be net sellers of bonds and as corporates started to return assets to the US.
All three factors contributed to increased signs of funding stress in OIS and Libor spreads
• Both the BIS and the IMF have highlighted the degree to which private sector debt has been rising with a significant proportion in foreign currency, especially dollars, bringing with it the risk of currency mismatch in private sector funding models in many economies. This is notable in the FSRs of Canada and Sweden and were highlighted by Ian in his excellent piece on the CANNS economies in January - see HERE. Both EM and DM economies have increased their dollar denominated debt as the US dollar fell, but as the dollar appreciates, the willingness to take on new debt will be more limited.
Who will be most impacted if US rates rise and the US dollar continues to appreciate?
• Emerging economies (like Turkey, South Africa, Brazil and Colombia) that have taken on large quantities of debt post GFC – see also the ASR Vulnerability index
• Developed economies - the CANNS (Canada, Australia, NZ, Norway, Sweden) - will be challenged.
• Dollar strength is implicitly a liquidity tightening (see the BIS paper HERE) and the challenge comes when this dollar debt needs to be rolled over. Financial stress is rising. The last 5 weeks has seen substantial selling of US Treasuries by foreign agencies as EM equities have fallen and CDS and Bonds spreads have widened out.
• US Credit: stress in EM credit is also likely to seep into US credit - both IG and HY - through H2.
• Investors should also scour portfolios for assets where dollar funding models are embedded - be it Private Equity or DM Banks - that may also be challenged.
Best regards, Verity
5Star&Lega have so far dismissed the BTP spread blow up, keen to stress their distance from elite financial markets. Complacency implies that market pressure on Italy could increase further in the near-term. However, valuations and macro suggest selling BTPs may not offer the best way to hedge Italian political risks. We discuss two compelling, uncomplicated ways of replicating a short BTP bias
BONDS: US10Y & TIPS hit oversold levels; EM bonds near SBI lows (P3/9/11)
EQUITIES: Russell 2000 and EuroSTOXX optimism highly elevated (P5/6)
COMMODITIES: Oil optimism stretched as specs cut net longs (P1/15)
5 Reasons for a contrarian bounce in US 10Y Bonds
The move in US 10Y yields above 3% last week has re-opened the debate about the end of the 35 year bull market in bonds. However, it has also increased the potential for a contrarian bounce-back in US bonds: 1) 10Y yields are likely to face technical resistance in the 3.15%-3.25% area; 2) speculators’ net short positioning is still notable; and 3) both US 10Y yields and TIP yields have reached overbought sentiment levels. In the past 20Y similar SBI levels for both were followed by an average 15bps fall in 10Y yields over the next 30 days (see chart).
At the same time: 4) rate rise expectations for this year are elevated; and 5) the rise in bond yields is out of line with the 4½% underperformance of macro-sensitive copper versus gold this year. We noted back in mid-February that US 10Y were oversold as 3% yields drew closer, with yields falling 14bps over the subsequent 6 weeks. Our sentiment measures are again flagging the potential for a near-term contrarian rally in US 10Y Treasuries. Charts p3.
Chart of the Week: Rising oil prices on the back of positive supply-side news have also undermined bond sentiment. However, here too indicators are becoming stretched, with the Brent oil SBI hitting overbought levels. WTI is also stretched versus Gold. While crude’s momentum is positive (50, 100 and 200DMAs are all rising), the degree of optimism on oil at current levels is a near-term risk.
Research, News & Views from ASR for the week to May 18th 2018
ASR Investment Strategy. Six reasons to stay cautious from David.
An unfinished cyclical correction.
• In the past 6 months, risk assets have done well. Global equities are within 5% of their January highs and the VIX back in the mid-teens. Our Reflation Trade Diffusion Indicator (RTDI) shows that all 10 trades that we track across equities, bonds, commodities and FX have performed in a reflationary manner.
• We continue to take a more cautious line and believe that optimistic expectations for a synchronised, capex-led, cyclical upswing are being challenged. For us this remains an unfinished correction with 5-10% downside in equities.
Why are we cautious? There are 6 reasons, three are cyclical, three are structural.
1. We are worried that investors may be underestimating how much monetary policy has already been tightened: US and Chinese 2-year rates are up 160bp and 130bp respectively and 10-year rates are up 110bp in the last 18 months. We have seen a sharp slowdown in real M1 growth which has historically led a slowdown in the global business cycle and the underperformance of stocks vs bonds. The next 3-6 months could see negative surprises for the global business cycle. The added risk is that the Fed continues to tighten into a global slowdown.
2. We are worried about the micro economic data: the Sector PMIs are already flagging a cyclical slowdown, rather than an acceleration. Particularly striking are the charts for industrial goods, machinery equipment and electronic equipment. They all suggest that the cycle has rolled over.
3. We are worried that the market may underestimate the drag from the 70% rise in the oil price over the past 18 months. This is putting pressure on real incomes and discretionary spending, while debt-servicing costs are rising. The US will fare best with this backdrop, but oil consuming economies could see a squeeze on spending -> a rise in inventories relative to sales -> pressure on pricing power and EPS growth.
4. We are worried that markets have not got to grips with the end of one monetary regime and the likely transition to a new monetary regime. Central banks expanded their balance sheets by c. $3 trillion in 2017 - almost as much as when QE began in 2009. This is a year of transition from peak QE in 2017 to QT in 2019. There is no certainty on how this will impact real yields or market liquidity. Changes in monetary regime tend to go hand in hand with changes in investment regime. Investment strategies that have worked in the last decade may be challenged.
5. We are worried that credit is an accident waiting to happen. Rapid growth in debt tends to be a very good predictor of financial crises. The corporate bond market has grown by 50% in the last 4 years and nearly 50% of the US IG market is BBB rated. Emerging markets have increased their borrowing and EM CDS spreads are rising while we continue to be concerned about the CANNS economies (Canada, Australia, NZ, Norway, Sweden) - see HERE - where household debt, house prices and bank balance sheets have expanded rapidly. If growth disappoints as CBs become less stimulative, credit risks could rise. The timing of this is difficult but watch credit spreads closely if we see a 5-point fall in the Manufacturing ISM in the next 6 months
6. We are worried about the potential for an escalation in US-China trade tensions spilling into technology - see HERE - and HERE - and challenging business models of companies that have optimised long global supply chains. NAFTA is also at a critical point, while Europe will be hurt by sanctions if they continue to trade with Iran and are stuck in the middle in a US-China trade war, given Europe trades roughly as much with China as it does with the US. Again, a risk that is difficult to time but one with far-reaching implications.
We expect 5-10% downside for equities. The stakes are higher if there is a credit event or trade tensions rise.
Challenging the Reflation Complacency from Dorothee. See our PRIMER: the RTDI and asset relationships.
Our RTDI is trading at its maximum score of +10. Extreme readings are rare and usually do not persist: a +10 score has only been seen 11% of the time since 1997. We believe investors’ optimism will be challenged and highlight some key charts. Notably, global activity surprises have rolled down sharply from +1.3x sd above its 3-y average to -1.2sd. It is rare for the RTDI to remain positive when global activity disappoints this much. There is a big disconnect between the RTDI and the Global Manufacturing PMI which has also slowed. We believe global activity could weaken, further undermining risk assets.
ASR Economics Weekly
A CEE change in German wage inflation from Dom.
• Eurozone core inflation missed expectations in April, dipping to 1.1% yoy: much of the decline was due to the timing of Easter and May could see inflation rebound but in general, underlying inflation has been subdued, despite an economy that has grown rapidly and an output gap that has closed.
• Why has EZ core inflation stayed so low? The sluggishness of wage growth, or specifically unit labour costs, appears to be the key reason for this. In EMU’s first decade, peripheral wage inflation offset weakness in Germany but in the last decade, the reverse has not been true. Post the GFC, the peripheral economies had their own problems to deal with, but German wage growth has been sluggish despite strong growth and an unemployment rate of 3.4%.
• Germany is not alone in seeing its Philips curve break down in the last decade - the US, UK and Japan have all seen low unemployment and slow wage growth. Technology could be restraining wage growth in Germany, with its more flexible labour market allowing non-traditional working arrangements to prosper - see HERE- along with globalisation: the threat of offshoring jobs to Eastern Europe was important in the late 90s/early 2000s in German labour unions moderating wage demands. See the CER paper HERE.
• But, the threat of offshoring looks to be weakening. Protectionism is threatening cross-border supply chains. Unemployment has fallen to very low levels in Poland, Hungary and Czechia, triggering a sharp pick-up in wage growth and Germany’s unions have become more combative: last week the IG Bau union achieved a 6% pay increase for 800k German construction workers.
• EZ core inflation could remain subdued for a few months yet before picking up through H2. If early signs of strengthening German wage growth are confirmed, a more sustained rise in core inflation will look likely in 2019.
Absolute Surprise. Both our Global Activity Surprise and Inflation Surprise indicators fell this week.
ASR Absolute Essentials
Equities / FX. Sentiment is driving some Equity / FX relationships which could provide key positioning signals. Some USD/JPY resistance around 110 (and its 200DMA) suggests its sentiment rally may be losing some momentum. Any renewed yen strength would likely act as a drag on Japanese equities vs ROW. AUD/CAD is already oversold on sentiment: in the past 10Y, similar SBI and 20D% rate of change levels was followed by an average 1.8% rise in the cross-rate over 30D. GBP/USD is now testing 1.35, with 1.32 the next support area below that. While stretched FTSE 100 optimism is a near-term risk, further sterling weakness may prove a tailwind for the index to re-test historic highs around 7760.
Bonds. Sentiment for US 10Y Treasuries remains negative despite specs continuing to cut their net short positions. US high yield has hit stretched optimism levels versus Investment Grade. Sentiment is not a headwind for the Italy-German 10Y spread which is now testing a potential trendline resistance area.
Commodities. Crude sentiment is elevated but not extreme but specs are cutting their net longs. Copper and Gold sentiment is relatively positive but not stretched. Specs cut their Silver net shorts.
Best regards, Verity
EQUITIES: Optimism on FTSE100 and All Ordinaries a near-term risk (P6-7)
FX: Oversold AUD/CAD offers contrarian support to AUD/CAD equities (P3)
POSITIONING: Aggregate USD net short at lowest level for almost 3M (P12)
Stretched FTSE100 optimism; FX/Equity sentiment interplay at work
Global equity sentiment has become more polarised recently, with pessimism stretched on a couple of EM indices, and optimism extended on several indices in Europe and Australia (see charts 82a/b). The interplay between equities and FX is also evident. As we noted last week, AUD/CAD is already oversold on sentiment: in the past 10Y, similar SBI and 20D% rate of change levels were followed by an average 1.8% rise in the cross-rate over 30D. A bounce in AUD/CAD would likely also support a near-term revival in Australian equities vs. Canadian in dollar terms.
Sterling’s recent reversal has been supported by dovish comments out of the BOE at a time when optimism had become over-stretched. GBP/USD is now testing 1.35, with 1.32 the next likely support area below that. While stretched FTSE 100 optimism is a near-term risk, further sterling weakness may prove a tailwind for the index to re-test historic highs around 7760. See charts p3.
Chart of the Week: The failure of USD/JPY to push past 110 (and its 200DMA) in the near-term suggests its rally off oversold sentiment levels may be losing some momentum. This is a notable development, given that renewed yen strength would likely act as a drag on Japanese equities versus the rest of the world in local currency terms. It would also chime with ASR’s recent downgrade of Japan to neutral in an asset allocation framework (see Investment Strategy report here).
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