Financial Markets
Feature Everyone’s asset-allocation plans for the year have been disrupted by the novel coronavirus (2019-nCoV). Our view is that, while the virus is serious and will hurt the Chinese and global economy in the short term, it does not change the 12-month structural outlook for financial markets. Once the epidemic is under control (which it is not yet), there will be an excellent buying opportunity for risk assets and for the most affected asset classes. Many commentators have pointed to the lessons from SARS in 2003. Markets bottomed around the time that new cases of the disease peaked (Chart 1). But there are risks with such a simplistic comparison. The US invasion of Iraq happened at the same time – between 19 March and 1 May 2003 – with arguably a bigger impact on global markets. The Chinese economy was much less significant: China represented only 4% of global nominal GDP in 2003 (versus 17% now), 7% of global car sales (35% now), and 10-20% of commodity demand (50-60%). And it is still unclear how similar 2019-nCoV is to SARS: it appears to be spreading more rapidly (Chart 2) but (so far, at least) is less deadly, with a mortality rate of about 2%, compared to 10% for SARS. Recommended Allocation Chart 1The Lesson From Sars Chart 2But Is Novel Coronavirus Different? Nonetheless, the basic theory that markets should bottom around the time that new cases and deaths peak is likely to prove correct. With the number of deaths still growing, however, that is not yet the case. Our advice to investors would be not to sell at this point. The hedges we have in our portfolio (overweight cash and gold) should help to cushion any further downside. But, within a few weeks, assets such as EM equities, airline stocks, commodities, or the Australian dollar should look very attractive again (Chart 3). For the next few months, economic data, particularly from China, will be hard to interpret. In 2003, Chinese GDP was reduced by 1.1% because of SARS, according to estimates by the Brookings Institute.1 The global economy is likely to be more heavily impacted this time, given today’s closely integrated supply chains. On the other hand, most academic research shows that consumption and production lost during an epidemic are later made up. Additionally, the Chinese government is likely to respond with easier fiscal and monetary policy. Once the air clears, we think our thesis that the manufacturing cycle bottomed in late 2019 will remain intact. The data over the past few weeks supports this. In Asia, in particular, PMIs for the major emerging economies are back above 50 (Chart 4). Europe’s rebound has lagged a little but, in the key German economy, indicators of business and investor sentiment have bottomed. Demand in the auto sector, crucial for Europe and Japan, is clearly starting to recover. Data in Europe and EM have generally surprised to the upside recently (Chart 5). Chart 3Some Assets May Soon Look Attractive Chart 4Asian And European Data Picking Up Chart 5Positive Surprises The theory that markets should bottom around the time that new cases and deaths peak is likely to prove correct. To a degree, the new virus gave investors an excuse to take profits in some over-bought markets. The US equity market, in particular, looked expensive at the start of the year, with a forward PE of 19x. But we would dismiss the common view that investors had become too optimistic. The bull-bear ratio is not elevated (Chart 6), with only 37% of US individual investors at the start of January believing that the stock market would go up over the next six months, not particularly high by historical standards – it has fallen now to 32%. Last year, investors took money out of equity funds, despite strong returns from stocks. In the past – for example 2012 and 2016 – when this happened, it was followed by further gains for equities, as investors belatedly bought into the rally (Chart 7). Chart 6Retail Investors Aren't So Bullish... Chart 7...Indeed, They Have Been Selling Stocks On a 12-month investment horizon, therefore, we remain overweight risk assets such as equities and credit, albeit with some hedges. The upside to global growth remains underestimated: the economists’ consensus is for only 1.8% GDP growth in the US and 1.0% in the euro area this year. A combination of accelerating global growth and central banks that will stay dovish should allow equities to outperform bonds over the next 12 months (Chart 8). Chart 8If PMIs Pick Up, Equities Will Outperform Chart 9First Signs Of US Equity Underperformance? Equities: In December, we moved underweight US equities and recommended shifting into more cyclical markets: overweight the euro zone, and neutral on EM, the UK, and Australia. Before the outbreak of 2019-nCoV, this had worked in EM, but less well in Europe (Chart 9). Once the effects of the virus have cleared, we still believe this allocation will outperform as the global manufacturing cycle picks up. But we have a couple of concerns. (1) The recent US/China trade deal will require China to increase imports from the US by a highly unrealistic 83% year-on-year in 2020 (Chart 10). Our China strategists don’t expect this target to be fully met, but think any increase will come from substitution.2 This would hurt exporters in Europe and Asia. (2) The outperformance of euro area equities is very much determined by how banks fare. The headwinds against them continue: the ECB recently decreed that six major banks fall below required capital ratios; loan growth to corporates in the euro area has fallen to 3.2% year-on-year. Much, though, depends on the yield curve (Chart 11). If it steepens, as a result of stronger growth this year, as we expect, bank stocks should outperform, especially since they remain very cheap (the average price/book ratio of euro area banks is currently only 0.65). Chart 10China’s Import Targets Are Unrealistic Chart 11Bank Performance Depends On The Yield Curve Once the air clears, we think our thesis that the manufacturing cycle bottomed in late 2019 will remain intact. Fixed Income: Government bond yields have fallen in recent weeks as investors sought cover, with the US Treasury 10-year yield dropping to 1.55%. While it may test last September’s low of 1.46%, we do not see much further room for global yields to fall. They tend to be highly correlated with manufacturing PMIs, which we expect to rise over the next 12 months (Chart 12). Also, we see the Fed staying on hold this year, not cutting rates twice, as the market is now pricing in. This mildly hawkish surprise should push up rates (Chart 13). We continue to prefer credit over government bonds. Our global fixed-income strategists consider that, from a valuation standpoint, US high yield, and UK investment grade and high yield are the most attractive (Chart 14).3 Chart 12Rates Move In Line With PMIs Chart 13What If The Fed Doesn't Cut Rates? Chart 14US Junk Looks Most Attractive Currencies: Defensive currencies such as the yen, Swiss franc, and US dollar have benefitted from the recent risk-off move. We see this as temporary. Once investors refocus on growth, the US dollar should start to depreciate again (the DXY index did fall by 3% between September and early January). The dollar is a counter-cyclical currency. It is 15% overvalued relative to PPP (Chart 15). It is also very momentum-driven – and, since December, momentum has pointed to depreciation and continues to do so (Chart 16). Chart 15Dollar Is 15% Overvalued... Chart 16...And Momentum Has Moved Against USD Commodities: Industrial metals prices had started to pick up over the past few months, reflecting the stabilization of Chinese growth (Chart 17). How they fare from now will depend on: (1) how sharply Chinese growth slows as a result of 2019nCoV, and (2) how much stimulus the Chinese government rolls out to offset this. Given the degree of decline in some commodity prices (zinc down by 16% since mid-January, and copper by 9%, for example), there should be an attractive buying opportunity in these assets over coming weeks. Gold has proved to be a handy hedge against geopolitical risks (Iran) and unexpected tail risks (the coronavirus), rising by 4% year-to-date. We continue to believe it has a useful place in investors’ portfolios as a diversifier and hedge, particularly in a world of very low interest rates where cash is unattractive (Chart 18). The oil price has been hit by the disruption to air travel in January, but supply remains tight (and OPEC is likely to cut supply further in response to the demand shock).4 As long as economic growth picks up later this year, we see the crude oil price recovering over the coming months. Chart 17Metals Reflect Chinese Growth Chart 18Gold Attractive With Bond Yields So Low Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1 Please see Globalization and Disease: The Case Of SARS, Jong-Wha Lee and Warwick J. McKibbin, Brookings Discussion Paper No. 156, available at https://www.brookings.edu/wp-content/uploads/2016/06/20040203-1.pdf 2 Please see China Investment Strategy Weekly Report “Managing Expectations,” dated 22 January 2020, available at cis.bcaresearch.com 3 Please see Global Fixed Income Strategy Weekly Report “How To Find Value In Corporate Bonds,” dated 21 January 2020, available at gfis.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report “Expect OPEC 2.0 To Cut Supply In Response to Demand Shock,” dated 30 January 2020, available at ces.bcaresearch.com GAA Asset Allocation
Highlights Portfolio Strategy China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Lofty valuations, overbought technicals, declining capex and weak operating metrics, are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Recent Changes Trim the S&P tech hardware, storage & peripherals index to underweight, today. Table 1 Feature The S&P 500 fell for a second straight week and has now given back almost all of the year-to-date gains. While the coronavirus has served as an excuse to sell as we warned last week,1 we are nowhere near in unwinding the extreme overbought conditions in the broad equity market. We are no epidemiology experts, however, what concerns us most is when the news will eventually hit that coronavirus deaths are sprucing up outside of China’s borders. This will likely catalyze more equity selling and a capitulation point will subsequently ensue. Importantly, beneath the surface macro divergences remain wide. The yield curve peaked at the turn of the year. Similarly, the real 10-year Treasury yield crested around the same time and so did the hyper growth sensitive AUD/CHF cross rate all predating the coronavirus epidemic news (Chart 1). Our sense is that the bond market in particular is likely reflecting Bernie Sander’s rise in the polls along with persistently soft economic data. Other indicators we track confirm that the handoff from liquidity-to-growth we have all been waiting for remains on hold. The oil-to-gold and copper-to-gold ratios have no pulse, warning that growth remains elusive (third & bottom panels, Chart 2). Chart 1Souring Macro Predates Coronavirus Chart 2Watch Gold Closely Moreover, in our January 13 report we highlighted that gold was sniffing out two or three fed cuts in 2020, leading the fed funds futures market, as it did in the spring of 2019.2 Since our last update, the fed funds discounter in the coming 12 months has sunk from negative 20bps to negative 42bps (year-on-year change in the fed funds rate shown inverted, second panel, Chart 2). It is disconcerting that despite the sloshing liquidity and de-escalation in the US/China trade war, CEOs remain on the sidelines. The Q4 GDP release showed that non-residential investment is now contracting on a year-over-year (yoy) basis (bottom panel, Chart 3) and has been subtracting from real output growth for three consecutive quarters. Hard data continues to warn that the manufacturing recession is not over as the 15% yoy contraction in non-defense durable goods orders revealed last week (third panel, Chart 3). Equity market internals also warn that the SPX is skating on thin ice. Worrisomely, the Philly semiconductors index (SOX) peaked versus the NASDAQ 100 last year and has been losing steam of late. The equally- versus market cap-weighted S&P 500 and NASDAQ 100 ratios remain near multi-year lows, and small caps are still stalling versus large caps (Chart 4). The implication is that, at least, an indigestion period looms for the broad equity market. Chart 3Ongoing Manufacturing Recession Chart 4Weak Market Internals Netting it all out, there are high odds that the coronavirus epidemic may serve as a catalyst and short-circuit the already frail handoff from liquidity-to-growth, warning that equity market caution is warranted at this juncture. This week we are trimming a key tech subgroup to underweight, and updating a heavyweight basic materials sub-index. To Infinity And Beyond? While we have been neutral the S&P tech hardware, storage & peripherals index and thus participating in the monster rally over the past year, the time is ripe to downgrade exposure to below benchmark. Undoubtedly, relative share prices are extremely extended. The second panel of Chart 5 shows that the relative share price ratio is at the highest level as a percentage of its 200-day moving average since the late-1990s. Shown as a z-score, this technical indicator is stretched to the tune of two standard deviations above the historical mean (third panel, Chart 5). The last three times technical conditions were so overbought, it marked a multi-year peak in relative performance (top panel, Chart 5). Importantly, the forward multiple explains all of the return in this tech sub-group’s stellar relative performance since the 2018 Christmas Eve lows (Chart 6). In fact, stagnant-to-lower relative profit growth subtracted from relative returns over the same time period (bottom panel, Chart 6). Chart 5Up, Up And Away? Moreover, the parabolic move in the forward P/E ratio that climbed from a 25% discount to the SPX to a 15% premium (i.e. a 53% multiple jump), was because the 10-year US Treasury yield plunged by 175 basis points from peak to trough (10-year US Treasury yield shown inverted, Chart 7). Chart 6EPS Have To Do The Heavy Lifting Chart 7Multiple Expansion Phase Has Run Its Course Such enormous easing in financial conditions is unlikely to repeat in the coming twelve months in order to push the forward multiple even higher and sustain the “goldilocks” conditions for the S&P tech hardware, storage & peripherals index. In contrast, BCA’s higher interest rate view is a harbinger of a multiple contraction phase and compels us to trim exposure on this high-flying tech sub group to underweight. Another market narrative substantiating the multiple expansion phase is that heavyweight AAPL is now a services oriented company and rightly so commands a sky-high multiple similar to the cloud and software stocks. While there is some truth to the push into services, the iphone and other hardware still dominates AAPL’s sales and will continue to do so for the foreseeable future especially on the eve of a 5G smartphone rollout. Turning over to the macro backdrop, this still mostly manufacturing-based industry moves with the ebbs and flows of the ISM manufacturing survey. Overall business investment is contracting and so is industry capex. Worrisomely, most of the ISM manufacturing subcomponents remain below the boom/bust line warning that investment will remain soft in the coming months, despite the Sino-American trade détente (middle panel, Chart 8). CEO confidence in capital spending remains downbeat and corroborates that at least a wait and see attitude toward greenfield expansion plans is a high probability outcome (bottom panel, Chart 8). Moreover, global export expectations continue to plumb cyclical lows. Similarly, the Emerging Asian (a key tech manufacturing hub) leading economic indicator broke below the GFC lows warning that industry exports are at risk of a further collapse (second & third panels, Chart 9). Chart 8Something’s Gotta Give Chart 9Weak Operating Metrics Chart 10Soft Pricing Power… Chart 11…Will Continue To Weigh On Margins Beyond soft exports, industry new orders are also contracting (bottom panel, Chart 9). This deficient demand backdrop will continue to weigh on industry sales, owing to the recent drubbing in pricing power (third panel, Chart 10).\ Deflating selling prices are also negative for profit margins. The wide gap between industry and SPX margins is clearly unsustainable (Chart 11). Already there is tentative evidence that S&P tech hardware, storage & peripherals margins have peaked and will remain under downward pressure, especially given our expectation of underwhelming profit growth in the coming months. In sum, lofty valuations, overbought technicals, declining capex and weak operating metrics are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Nevertheless, there is one risk that is worth monitoring: the US consumer. A tight labor market should continue to bid up the price of labor and sustains wage gains which means more money in consumers’ wallets. As a result, brisk consumer outlays on computers & peripherals could reverse the ongoing industry sales deceleration (bottom panel, Chart 12). In sum, lofty valuations, overbought technicals, declining capex and weak operating metrics are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Bottom Line: Downgrade the S&P tech hardware, storage & peripherals index. The ticker symbols for the stocks in this index are: BLBG S5CMPE – AAPL, HPQ, WDC, HPE, STX, NTAP, XRX. Chart 12Risk To Bearish View Hazardous Chemicals The S&P chemicals bear market has entered its third year and we remain underweight this capital intensive basic materials subgroup. Relative share prices have broken below the GFC lows and it would not surprise us if they would retest the 2006 lows (Chart 13). Now that the chemicals M&A activity dust has settled for good, China dominates the direction of chemical equities. Chinese authorities are still easing monetary policy and are injecting liquidity in the banking system by slashing the reserve requirement ratio (RRR). The recent coronavirus epidemic almost guarantees further easing via the RRR channel. Such a monetary setting should eventually stabilize the economy. However, until a turnaround is evident, US chemical stocks will continue to follow down the path of the Chinese RRR (top panel, Chart 13). The Australian currency, which is hyper-sensitive to China’s growth, corroborates that Chinese economic activity remains soft (second panel, Chart 13). Broad-based US dollar strength also confirms that global growth has yet to stage a durable comeback. The implication is that US chemical exports will continue to lose market share, weighing on industry profits (third panel, Chart 13). Chart 13China Leads The Way In fact, sell-side analysts are expecting a relative profit growth acceleration phase, but a decline in relative revenue prospects. This suggests that already uncharacteristically high chemical profit margins will continue to outpace the broad market (bottom panel, Chart 13). Our indicators suggest that it pays to lean against such relative EPS and profit margin euphoria. Importantly, our chemicals profit margin proxy is sinking, warning that a profit margin squeeze looms. Not only are selling prices deflating, but also the industry’s wage bill is gaining steam (bottom panel, Chart 14). Adding it up, China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Moreover, chemical railcar loads are contracting at a time when the ISM manufacturing survey remains squarely below the boom/bust line (middle panel, Chart 14). This deficient chemical demand backdrop is deflationary (second panel, Chart 15) and will eat into industry profit margins. Chart 14Downbeat Demand Backdrop Chart 15Deflation Getting Entrenched On the operating front, our chemicals industry productivity proxy (industrial production/employment) is also in negative territory, underscoring that profits will likely surprise to the downside (third panel, Chart 15). Chemical industrial production is contracting at an accelerating pace and industry shipments are in retreat, warnings that the risk is high of an inventory liquidation phase (bottom panel, Chart 15). While we remain bearish on chemical stocks on a cyclical horizon, there are two key risks we are closely monitoring that would push our view offside. The global reflation handoff to actual growth is the key risk. If the global economy enters a V-shaped recovery, global bond yields will immediately reflect such a growth backdrop and push interest rates higher. This would put downward pressure on the greenback and significantly reflate chemical earnings (middle panel, Chart 16). Finally, chemical stocks are cheap and trade at a steep discount to the broad market. When our relative valuation indicator has plunged to such depressed levels in the past fifteen years, bottom-fishing buyers have come back in the market and added chemical stock exposure to their portfolios (bottom panel, Chart 16). Adding it up, China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Bottom Line: Stay underweight the S&P chemicals index. The ticker symbols for the stocks in this index are: BLBG S5CHEM – LIN, APD, ECL, SHW, DD, DOW, PPG, CTVA, LYB, IFF, CE, FMC, EMN, CF, ALB, MOS. Chart 16Two Risks To Monitor Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “When The Music Stops...” dated January 27, 2020, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of January 31, 2020. The model made a significant change in its allocation this month. The allocation to the US is now overweight from neutral previously. Japan, the UK and France remain the three largest underweight countries, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark in January by 9 bps, driven by the outperformance from the Level 2 mode (21 bps). The Level 1 model also generated two basis points of outperformance. Since going live, the overall model has outperformed by 80 bps, with 297 bps of outperformance by Level 2 model, offset by 55 bps of underperformance from Level 1. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US Model (Level 1) Chart 3GAA Non US Model (Level 2) For more on historical performance, please refer to our website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of January 31, 2019. Chart 4Overall Model Performance The model’s relative tilts between cyclicals and defensives have changed compared to last month. The global growth proxies used in our model continue providing positive signals. This in turn led the model to maintain its overweight on multiple cyclical sectors. The valuation component remains muted across all sectors except Energy. Global central bankers will continue to keep monetary policy accommodative, leading the model to favor a mixed bag of cyclical and defensive sectors. The model is now overweight four sectors in total, three cyclical sectors versus one defensive sector. These are Consumer Discretionary, Information Technology, Communication Services, and Health Care. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates”, dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 3Overall Model Performance Table 4Current Model Allocations Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy Research Associate amrh@bcaresearch.com
Highlights The SARS episode of 2003 suggests that the panic over the coronavirus will only subside when the number of new cases peaks. Although the latest data is somewhat encouraging, it is far from clear that we have reached that point. Provided the outbreak is contained, global equities should move higher over the course of the year. US companies remain net buyers of shares, implying that households and other holders have been net sellers. But against a backdrop of rising incomes, high savings, and improving confidence, households have also wanted to own more equities. How can households be net sellers of stocks while simultaneously increasing their equity exposure? There is only one answer: Share prices need to rise. The process will only stop once households decide they own enough stocks. In the US, while household equity holdings are on the high side as a share of household wealth, this is counterbalanced by the fact that the earnings yield on stocks is well above the yields on competing assets. Outside the US, household ownership of equities is quite low while the equity risk premium is still high. Going Viral We upgraded global equities after markets plunged in late 2018 and have remained overweight stocks on a 12-month horizon to this day. However, we indicated three weeks ago that equities had become technically overbought and would likely need to consolidate their gains. Thus, while we kept our 12-month views unchanged, we downgraded our tactical 3-month view on global stocks from overweight to neutral, while also advising clients with short horizons to boost exposure to cash and government bonds at the expense of riskier credit (our entire set of views can be found in the Global Investment Strategy View Matrix at the back of this report). Since then, the outbreak of the coronavirus has added another headwind to the near-term outlook for stocks. Many commentators have drawn comparisons between today’s outbreak and the SARS epidemic in 2003. The SARS episode imposed a significant but short-lived economic toll on the affected countries. While Chinese GDP growth fell to 3.4% in Q2 of 2003, it surged back to 15.7% in Q3, leaving the overall level of GDP down about 1% for the year as a whole relative to what would have transpired if the virus had never emerged.1 The broader Asia-Pacific region experienced a hit to growth of around 0.5%. In contrast, growth in developed economies was barely affected. Even in Canada, where 44 people died from SARS, the outbreak shaved only around 0.1% from the level of GDP in 2003, according to the Bank of Canada.2 The outbreak of the coronavirus has added another headwind to the near-term outlook for stocks. The obvious problem with the SARS analogy is that it is based on a sample of one. We do not know how this new strain of the virus compares to SARS or, for that matter, the Spanish flu, which killed 50-to-100 million people (3%-to-5% of the world’s population at the time). We do not even know if the full scope of the SARS outbreak was as fleeting as what we remember, since in a cosmic multiverse there will be a tendency to recall life-or-death outcomes more favorably than they actually were (I will have more to say about the financial implications of this in a future special report). Chart 1The Coronavirus Is Spreading Faster Than SARS Did What we do know is that, to date, the coronavirus has spread more quickly than SARS (Chart 1). It is not clear if that is because of faster, more accurate reporting methods or because the virus is more communicable. The Chinese Minister of Health has said that this new virus, unlike SARS, can be transmitted while people are still asymptomatic. While others have cast doubt on this claim, if it turns out to be correct, the coronavirus may be much more difficult to control. Viruses often become less lethal as they mutate because a virus that kills its host is also a virus that kills itself. Unfortunately, in a world of mass travel, a virus can spread across the globe before it has time to lose potency. The typical seasonal flu kills less than 0.1% of those who contract it. Most estimates suggest that SARS killed 10%-15% of infected patients. The Spanish flu killed a similar percentage. The death rate from the coronavirus is currently tracking at 2%-to-3%. However, it is possible that this estimate will rise. The vast majority of the people who have contracted the coronavirus are still sick. In fact, more people have died from it than have fully recovered (Chart 2). Thus, an honest assessment would simply admit that we do not know how bad this potential pandemic will get. Chart 2How Will This End: Outbreak, Epidemic, Or Pandemic? Chart 3Markets Bottomed As The SARS Infection Rate Was Peaking What should investors do? The SARS experience suggests that risk assets will only bottom when the number of new cases peaks (Chart 3). It is not clear that we have reached this point yet. While the number of new cases reported by China’s National Health Commission has stabilized over the past two days, this could just be a temporary respite (Chart 4). Until the rate at which new cases are diagnosed begins a clear downward trend, a somewhat cautious stance towards risk assets is warranted. Global Growth Should Recover Provided the outbreak is contained during the coming weeks, global equities should move higher over the course of the year. This is partly because global growth should pick up thanks to the lagged effects of last year’s decline in bond yields, an improvement in the global manufacturing inventory cycle, and diminished Brexit and trade war risks. Continued fiscal/credit stimulus out of China should also help. China spends less on health care than almost all other countries (Chart 5). It is likely that the past few weeks will prompt the government to increase social spending. Chart 4The Number Of New Cases Has Stagnated Over The Past Two Days Chart 5China: Public Spending On Health Care Has Room To Catch Up Higher Equity Prices: Just A Matter Of Arithmetic? Chart 6There Is A Structural Decline In Listed Companies In The US Chart 7The Supply Of US Stocks Has Been Drying Up In addition to stronger global growth, there is another factor supporting stocks which receives insufficient attention and is worth highlighting in this week’s report: corporate buybacks. US companies have repurchased about 3% of their shares every year for the past decade. On the flipside, only 110 companies went public last year, less than a third of the number of new listings in 1996-99. In fact, the number of publicly traded domestic companies has fallen by over 40% since 1996 (Chart 6). The combination of copious buybacks and dearth of IPOs has caused the S&P divisor – a broad measure of the total number of split-adjusted shares outstanding – to decline by a cumulative 9% since 2011. Between 1990 and 2004, the divisor increased by 40% (Chart 7). If companies are net buyers of stocks, then households and other holders must be net sellers of stock. But this raises an obvious question: What if households also want to be net buyers of stocks? Chart 8Households Are Bullish Chart 9High Equity Ownership By Households Translates Into Poor Long-Term Returns This question is highly relevant in today’s environment, where unemployment is low, wage growth is accelerating, the household savings rate is high, consumer confidence is strong, and a higher-than-average percentage of people expect stocks to increase in the coming months (Chart 8). Arithmetically, there is only one way that households can be net sellers of stocks while simultaneously increasing their equity exposure: Share prices need to rise. At what point will share prices stop rising? That depends on two things: 1) How much stock market wealth households hold relative to other assets; and 2) The risk-adjusted rate of return that households expect from stocks compared to other assets. Stock returns are highest when equity holdings are low, but sentiment towards stocks is improving. Conversely, returns are lowest when equity holdings are high, but stock market sentiment is deteriorating (Chart 9 and Table 1). Table 1Equity Returns Tend To Suffer When Bulls Are Losing Conviction The latter typically occurs during economic downturns when earnings are falling and risk aversion is rising. Thus, it is no surprise that recessions and equity bear markets tend to overlap (Chart 10). Chart 10Recessions And Bear Markets Tend To Overlap Where Things Stand Today In the US, household equity holdings are on the high side. According to Fed data and our own estimates, households currently hold 33% of their financial assets in stocks (Chart 11). This is higher than in 2007, but still below the dotcom peak of 39%. Similarly, the monthly asset allocation survey conducted by the American Association of Individual Investors shows a somewhat elevated allocation to equities, although one that is still broadly on par with the 2003-2007 and post-2014 averages (Chart 12). Chart 11US Household Equity Holdings Are On The High Side (I) Chart 12US Household Equity Holdings Are On The High Side (II) Chart 13Relative Valuations Favor Stocks One major difference with prior occasions when US equity allocations were elevated is that the earnings yield on stocks at present is still quite a bit higher than the yield on competing assets such as cash and bonds (Chart 13). While this is mainly because interest rates are so low, it does suggest that households may seek to further increase their equity allocations provided that the economy continues to perform well. Foreign companies have been less aggressive re-purchasers of their own shares than their US peers. That said, household equity ownership is significantly lower outside the US (Chart 14). The spread between equity earnings yields and bond yields is also higher abroad, reflecting the fact that both PE multiples and interest rates are generally lower outside the US. Given that investors tend to favor companies listed in their home country, efforts by non-US investors to increase their equity allocations will primarily benefit stock markets outside the US. In addition, stronger global growth tends to favor EM and European equities, largely because stock markets in those regions have more of a cyclical bent (Chart 15). Thus, on balance, we recommend that investors overweight non-US stocks this year. Chart 14Equity Ownership By Households Is Lower Outside The US Chart 15Stronger Global Growth Tends To Favor A Cyclical Bias In Equity Allocation Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Jong-Wha Lee and Warwick J. McKibbin, “Globalization and Disease: The Case of SARS,” Brookings Institution, dated February 2004. 2 Please see Monetary Policy Report, Bank of Canada, October 2003. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Highlights Collective market signals suggest a low but non-negligible probability of a dollar spike due to the coronavirus. Stay long the yen as a portfolio hedge. Short CHF/JPY bets also make sense. Our limit sell on the gold/silver ratio was triggered at 90. Place a stop at 95, with an initial target of 80. Feature Chart I-1Watching Market Signals Investors can generally be classified in two camps. There are those who are predisposed to being risk averse. As such, capital preservation trumps the desire for outsized returns. For such investors, defensive equities such as staples and utility stocks, fixed-income assets, or even gold tend to be the favored vehicles over time. At the opposite end of the spectrum are the investors who desire hopping on and riding the next growth unicorn. Their favored investment universe can include technology and biotech concerns, but can also span industries such as automotive and food. The key, however, is that their inherent disposition is to multiply returns rather than preserve capital. There is a crucial difference between this bias and a risk-on/risk-off environment. For example, in a risk-on environment, the more prudent investor might choose high-yielding government bonds, while the high flyer will be in the S&P 500 or private equity. In the currency world, the “preservationist” might choose the euro as an anti-dollar play despite negative yields, while the “high flyer” would rather be in the New Zealand dollar or the Norwegian krone. The oscillation between these two bipolar universes can be measured in various ways, but one that has been prescient in gauging the direction for currency markets is the ratio between the S&P 500 index and gold prices. In general, whenever the S&P 500 has been outperforming gold, the dollar has tended to soar, and vice versa (Chart I-1). As a closed economy, US markets are generally more defensive. So even in a risk-off environment, this ratio can capture the preference for capital preservation versus growth. The collective signals from financial markets suggest there is a low probability of a dollar spike. The SPX/Gold ratio hit a peak of 2.5 in the last quarter of 2018 and has since been exhibiting a bearish pattern of lower highs, with the latest rise peaking a nudge below 2.2. Our belief is that it is less a story of greed versus fear, and more an indication of a powerful underlying preference for investors being revealed in asset prices. Gauging FX Market Signals The coronavirus outbreak has been dominating market headlines in recent weeks. We are not infectious disease specialists, so cannot provide any insight on the potential impact on growth and/or the probability for the virus to become much more widespread. However, the collective signals from financial markets suggest there is a low probability of a dollar spike. The rise in the dollar has been relatively on par with the SARS experience of 2002 (Chart I-2A and Chart I-2B). Back then, the Chinese economy had a much smaller effect on global growth, and so far, the number of reported cases is outpacing the SARS experience. So, it is possible that given the dollar bull market of the last decade or so, there is a dearth of new buyers in the greenback. Chart I-2ARun Of The Mill Virus ? (1) Chart I-2BRun Of The Mill Virus ? (2) The most recent fall in the S&P 500 index versus gold is definitely a sign of risk aversion, but the much broader peak almost two years ago might be signaling an outright shift in the investment universe. In other words, capital preservation might now be best sought outside US bourses. If this is the case, cheap and unloved value stocks will provide better shelter compared to the growth champions of the last decade. It is interesting that emerging market cyclical stocks (where the epicenter of the crisis is) have not underperformed defensives in a meaningful way during the latest riot (Chart I-3). The typical narrative is that the dollar is now a high-yielding currency within the G10. That means it has now become the object of carry trades. Should the investment universe be shifting to one of prudence, it is plausible though not probable that the greenback will provide both functions. Chart I-3Mixed Message From Cyclicals Versus Defensives Chart I-4Correlation Break Down Or Unsustainable Gap? The absolute collapse in the gold-to-bond ratio further confirms that after almost a decade of underperformance, hard money might be coming back into favor versus yield plays (Chart I-4). Gold was a monetary aggregate for centuries, and continues to stand as a viable threat to dollar liabilities. This is not only visible in the rampant accumulation of gold by foreign central banks, notably Russia and China, but also by the breakout in gold in almost every currency, including safe-havens like the Swiss franc and the Japanese yen (Chart I-5). The absolute collapse in the gold-to-bond ratio further confirms that after almost a decade of underperformance, hard money might be coming back into favor. Data from the US Treasury confirms that foreign entities have been fleeing US bond markets at among the fastest pace in recent years. On a rolling 12-month total basis, the US saw an exodus of about US$250 billion in Treasurys from foreigners, one of the largest on record (Chart I-6). Foreign private investors are still net buyers of US Treasurys, but the downtrend in purchases in recent years is evident. In addition, this helps explain why gold has also outperformed Treasurys over this period. Chart I-5Soft Versus Hard ##br##Money Chart I-6Official Data Shows Less Preference For Treasurys The US dollar’s reserve status remains intact for now. But subtle shifts in this exorbitant privilege are worth monitoring. If balance-of-payment dynamics continue to head in the wrong direction, as they are now, this will favor hard money and non-US assets, while accelerating divestment out of US Treasurys. This is irrespective of whether we enter a risk-on versus risk-off environment. A good proxy for whether the US government was prudent or profligate over the past four decades can be measured by the gap between unemployment relative to NAIRU (the so-called unemployment gap) and the corresponding budget deficit. In simple terms, full employment should be accompanied by balanced budgets, while governments can step in during recessions to put a floor under aggregate demand. Not surprisingly, using this simple rule, sound fiscal policies in the US were usually accompanied by a strong dollar, and vice versa. Chart I-7The Risk To Long Dollar Positions Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.6% of GDP. Assuming the current account deficit remains stable, this will pin the twin deficits at 7.2% of GDP. This assumes no recession, which would have the potential to boost the deficit even further. In the last forty years, there has not been any prolonged period where twin deficits in the US have been expanding while the dollar has been in a bull market (Chart I-7). In a nutshell, even though the coronavirus is dominating headlines, the lack of a more pronounced greenback strength can be pinpointed to a rising number of negative market signals. Our bias is that when this eventually rolls over and global growth picks up in earnest, dollar bulls may be forced to capitulate. Bottom Line: We are not downplaying the potential impact of the coronavirus, but are skeptical of its ability to catapult the dollar higher. We are short the DXY index, with a target of 90 and a stop at 100. Stick with it. Bullish Both Gold And Silver, But Go Short The GSR If we are right, then both gold and silver will tend to rise in an environment where the dollar is falling. That said, the gold/silver ratio (GSR) hit a three-decade high of 93.3 last summer, opening up an arbitrage opportunity. The history of these reversals is that they tend to be powerful, quick, and extremely volatile (Chart I-8). This not only paves the way for an excellent entry point to short gold versus silver, but provides important information on the battleground between easing financial conditions and a pick-up in economic (or manufacturing) activity. The ratio of the velocity of money between the US and China has tended to track both the gold/silver ratio and the dollar closely. Just like gold, silver benefits from low interest rates, plentiful liquidity, and the incentive for fiat money debasement. However, the gold/silver ratio is sitting near two standard deviations above its mean. Meanwhile, over the past century, the peak in GSR has been around 100. The gold/silver ratio tends to rally ahead of an economic slowdown, but then peaks when growth is still weak but liquidity conditions are plentiful enough to affect the outlook for future growth. This appears to be the case today. The simple reason is that silver has more industrial uses than gold (Chart I-9). Chart I-8GSR At A Speculative Extreme Chart I-9No Recession = Buy Silver The ratio of the velocity of money between the US and China has tended to track both the gold/silver ratio and the dollar closely (Chart I-10). A falling ratio signifies that the number of times money is changing hands in China is outpacing that number in the US. This also tends to coincide with a preference for US versus non-US assets, since animal spirits (as measured by money velocity) tend to be pronounced in places where returns on capital are higher. Silver is a more volatile metal than gold. Part of the reason is that the silver market is thinner, with future open interest that is about one-third that of gold. As such, silver tends to rise faster than gold during precious metal bull markets (Chart I-11). Chart I-10Falling GSR = Rising Manufacturing Activity Chart I-11Silver Is More Volatile Than Gold This brings us to the sweet spot for silver. Even if global growth remains tepid over the next few months, due to a rise in infections from the coronavirus, a lot of the bad news is already reflected in a high GSR. This means the potential for upside will have to be nothing short of a deep recession. Relative speculative positioning favors gold, which is positive from a contrarian standpoint. Ditto for relative sentiment. More often than not, a positive signal from both these indicators has been a good timing tool for a selloff in the GSR. If global growth bottoms, then the rise in silver prices could be explosive. Silver fabrication demand benefits from new industries such as solar and a flourishing “cloud” industry that are capturing the new manufacturing landscape. Meanwhile, we are also entering a window where any pickup in demand could lead to a sizeable increase in the physical silver deficit. Bottom Line: A falling GSR provides important information about the battleground between easing financial conditions and a pickup in economic activity. We remain bullish on both gold and silver, but a trading opportunity has opened up for a short GSR position. Housekeeping Chart I-12AUD Will Follow Asian Currencies Our limit buy on the Australian dollar was triggered at 68 cents. We discussed the Aussie at length in our report dated January 17.1 Place an initial target at 0.75 cents and a tight stop at 0.66. The near-term risk to this trade is any escalation in virus infections that will collectively send Asian currencies into a tailspin (Chart I-12). Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled "On AUD And CNY," dated January 17, 2020, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The Markit manufacturing PMI fell to 51.7 while the services component increased to 53.2 in January. The Dallas Fed manufacturing index improved from -3.2 to -0.2 in January. Moreover, the Richmond Fed manufacturing index soared to 20 in January. Durable goods orders increased by 2.4% month-on-month in December. The trade deficit widened further to $68.3 billion from $63 billion in December. Annualized GDP growth was unchanged at 2.1% year-on-year in Q4. Initial jobless claims fell to 216K from 223K for the week ended January 24th. The DXY index appreciated by 0.1% this week. While the coronavirus spurred worries about a further slowdown in the global economy, the impact on the US remains to be seen. On Wednesday, the Fed committee voted unanimously to keep interest rates on hold at 1.75% and concluded that the current rate is appropriate to support sustained expansion of the US economy. Report Links: Portfolio Tweaks Before The Chinese New Year - January 24, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mostly positive: The Markit manufacturing PMI jumped to 47.8 in January while the services PMI fell slightly to 52.2. The German IFO current assessment index increased to 99.1 from 98.8 in January, while expectations component fell to 92.9. The economic sentiment indicator increased to 102.8 from 101.3 in January. The unemployment rate fell further to 7.4% in December from 7.5% the prior month. The euro has been flat against the US dollar this week. Though the German IFO expectations component disappointed, the overall assessment has shown tentative signs of recovery. More importantly, changes in the manufacturing PMI indices, especially in Germany, are staging the V-shaped recovery we have been expecting. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: Consumer confidence was unchanged at 39.1 in January. Services PPI increased by 2.1% year-on-year in December. Headline inflation increased to 0.8% year-on-year from 0.5% in December. Both manufacturing and services PMIs increased to 49.3 and 52.1, respectively in January. The Japanese yen appreciated by 0.6% against the US dollar this week. The flare up in risk aversion was a very potent catalyst, given the yen had become unloved and under owned. Persistent global risks, including Mid East tensions, and more recently, the spread of coronavirus, all warrant holding the Japanese yen as a portfolio hedge. Our last weekly report discussed why we prefer the Japanese yen to the Swiss franc as portfolio insurance. Report Links: Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been solid: Both Markit manufacturing and services PMIs soared to 49.8 and 52.9 respectively in January. Nationwide housing prices increased by 1.9% year-on-year in January, compared with 1.4% the previous month. The saucer-shaped bottom in home prices is becoming more and more evident. The British pound has been flat against the US dollar this week. On Thursday, the BoE decided to leave interest rates unchanged at 0.75%. The fact that there were only two dissenters, in line with the previous month, suggests that rising bets for a rate cut were misplaced. The UK is due to leave the EU as of January 31st and enter a transition period that is supposed to last until December 31st 2020. The immediate aftermath of the exit will be business as usual. Trading strategy on the pound should be a buy on dips. We will continue to explore opportunities in GBP in upcoming reports. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The NAB business conditions index fell to 3 from 4 in December. Moreover, the business confidence index decreased to -2 from 0. Headline inflation increased to 1.8% year-on-year from 1.7% in the fourth quarter. Import prices increased by 0.7% quarter-on-quarter, while export prices plunged by 5.2% quarter-on-quarter in Q4. The Australian dollar fell by 2.1% against the US dollar this week, triggering our limit buy position at AUD/USD 0.68. Despite temporary challenges from the bushfires and the coronavirus, we continue to hold our base case view that global growth is likely to rebound in the next 12-to-18 months, which is bullish for the Aussie dollar. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: Headline inflation increased to 1.9% year-on-year in Q4, compared with 1.5% the previous quarter. It also beat expectations of 1.8%. The trade balance shifted to a surplus of NZ$547 million in December. Goods exports rose by 4.8% year-on-year to NZ$5.5 billion, while imports fell by 5.4% year-on-year to NZ$5 billion. Shortly after the rise along with inflation data, the New Zealand dollar fell by more than 2% this week, amid growing risk aversion. New Zealand, as a chief exporter of agricultural products, bore a good brunt of speculative selling. Assuming infections peak in the coming weeks, we remain positive on the kiwi as the Chinese government is likely to inject more stimulus into the economy. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mostly positive: Retail sales increased by 0.9% month-on-month in November. The Bloomberg Nanos confidence index rose to 56.5 from 56.1 for the week ended January 24th. The Canadian dollar fell by 0.6% against the US dollar this week. As a petrocurrency, the risk of much reduced travel hit the loonie. We have written at length in various reports about the loonie, but the bottom line is that Canada benefits less than other petrocurrencies in oil bull markets. Ergo, the underperformance of short CAD/NOK and long AUD/CAD positions this week is expected. In other news, Trump has signed the new USMCA bill into law this week, leaving Canada the only member of the trilateral deal that has yet to ratify the agreement. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mixed: The trade surplus narrowed for a fourth consecutive month in December, falling to CHF 2 billion. Real exports decreased by 3.4% month-on-month while real imports grew by 0.2% month-on-month. The ZEW expectations index fell to 8.3 from 12.5 in January. The KOF leading indicator jumped to 100.1 from 96.2 in January. The Swiss franc has been more or less flat against the US dollar this week. The fall in exports of chemical and pharmaceutical production was the main driver behind the decrease in the Swiss trade balance in December. The SNB is walking a fine line. The improvement in the KOF leading indicator, along with rising inflation and PMI data is definitely a source of comfort, but the surge in EUR/CHF will hurt competitiveness and warrant stealth intervention. Buy EUR/CHF at 1.06. Report Links: Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Retail sales fell by 2% month-on-month in December. The Norwegian krone fell by 1.9% against the US dollar this week. The WTI crude oil price plunged by 20% since the peak earlier this month, due to a combination of falling global travel demand, eased Iran tensions and a bearish EIA inventory report. That being said, our Commodity & Energy strategists continue to be bullish energy prices and expect the WTI crude oil price to reach $63/bbl in 2020, based on recovering global demand and supply constraints. This should eventually lift the Norwegian krone. OPEC is scheduled to meet early March, and plunging prices could be a catalyst for the cartel to cut production. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Producer prices increased by 1.3% year-on-year in December. The trade surplus shrank to SEK 0.3 billion from SEK 2.7 billion in December. Retail sales grew by 3.4% year-on-year in December. Consumer confidence marginally fell to 92.6 from 94.7 in January, while business confidence jumped to 97.4 in January, the highest in seven months. The Swedish krona fell by 1.3% against the US dollar this week. Recent Swedish data has been disappointing given the steep decline during the trade war, but we are beginning to see second-derivative improvements. The trade surplus is rising on a year-on-year basis. Particularly noteworthy was the improvement in business confidence, which has historically led the Swedbank PMI index tick for tick. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights The intense focus on the weakening of global oil demand expected in the wake of another coronavirus outbreak in China – dubbed 2019-nCoV – obscures likely supply-side responses by OPEC 2.0. The producer coalition likely will rebalance markets by extending production cuts from end-March to at least the end of June when it meets in Vienna March 5-6. OPEC 2.0 producers will be exquisitely sensitive to Asian refiner demand. They will use it as a gauge for how severe 2019-nCoV’s impact will be on EM demand, and adjust production and exports accordingly. On the demand side, it is difficult to analogue the 2019-nCoV outbreak to the 2003 SARS outbreak, given all the conflicting fundamentals at play at that time. Forward curves for the principal benchmark crude oils – Brent and WTI – remain backwardated, in spite of the 2019-nCoV-related sell-off. Longer-dated WTI (out to December 2023) traded below $50/bbl earlier in the week, roughly in line with shale-breakeven costs reported by the Dallas Fed earlier this month. This likely will continue to pressure capex in the US shales, keeping future supply growth constrained. Feature Forward curves for the principal benchmark crude oils – Brent and WTI – remain backwardated, in spite of the 2019-nCoV-related sell-off. Chart of the WeekChina's Oil Demand Drives Global Growth Oil markets are rightly focused on the demand implications of the 2019-nCoV outbreak in China.1 Since 2000, China has accounted for 42% of annual oil-demand growth worldwide (Chart of the Week). China is second only to the US in oil demand, accounting for 14% of total global demand of 100.7mm b/d at the end of 2019; its oil imports averaged more than 10mm b/d last year, and are expected to remain strong as it continues to build out its refining sector. Chart 2Asian Air Travel Hit Hard By SARS Historical analogues for 2019-nCoV are difficult. The immediate analogue is the SARS coronavirus outbreak identified in China in February 2003, which lasted six months and hit Asian air travel especially hard (Chart 2). During the height of the SARS outbreak in April 2003, air-travel passenger demand in Asia plunged 45%, according to the International Air Transport Association (IATA). This pushed jet fuel prices lower in Asia and in other key markets, along with distillate prices generally (Chart 3).2 Chart 3Fundamental Supply-Demand Balances Support Higher Crude Oil Prices China now is an extremely large share of global jet fuel consumption. Chart 4BCA Models, Base Metals Prices Suggest SARS Effect Was Short-Lived The industry now is more reliant on Chinese travelers. Since 2003, the number of annual air passengers has more than doubled, with China growing to become the world’s largest outbound travel market. In 2003, close to 7mm passengers from China traveled on international flights. By 2018, that number had grown close to 64mm people, according to China’s aviation authority. As Chart 2 demonstrates, China now is an extremely large share of global jet fuel consumption. Still, oil is a global market – the avoidance of China during the SARS outbreak in 2003 would have impacted global air travel, and, as a result, global jet-fuel prices. Our proprietary EM commodity-demand models and the behavior of base metals prices, which were and remain heavily influenced by China’s economy, suggest China’s GDP growth slowed in 2003 (mainly 1H03) because of the SARS outbreak (Chart 4). The LME’s base metals index fell 9% between February and July 2003, while copper prices fell 11%. By year-end, these markets had fully recovered. Oil-Supply Management Drives Price Evolution In the modern era of the oil market beginning roughly around 2000, there have been numerous demand shocks requiring a supply response from OPEC. During the SARS outbreak in 2003, oil-market fundamentals at the time were complicated by the sudden loss of Venezuelan output in December 2002 to a general strike, which lasted three months and removed more than 2mm b/d from the market, and the US invasion of Iraq on March 2003. Both of these supply-side shocks hit markets just as demand was being hit by SARS. This makes it difficult to extract a pure price response on the demand side to the SARS episode. In the modern era of the oil market beginning roughly around 2000, there have been numerous demand shocks requiring a supply response from OPEC. These including the 9/11 terror attacks in the US in 2001; the SARS outbreak in late 2002-03; the Global Financial Crisis in 2007-08; and the euro debt crisis in 2011-12 (Chart 5).3 Chart 5Demand Shocks Abound In 21st Century Chart 6OPEC Lost Key Members' Output During SARS Outbreak OPEC 2.0’s goal – similar to OPEC’s goal before it – is to avoid an unintended inventory accumulation. Importantly, these demand shocks were accompanied by supply shocks – Venezuela's general strike; the US invasion of Iraq continues to play havoc with global supply; the BP Macondo blowout in the Gulf of Mexico in 2010; the Arab Spring and the loss of Libyan output in 2011 – all of which complicated OPEC’s decision making (Chart 6). Much of OPEC’s adjustment then and now is made by the Kingdom of Saudi Arabia (KSA), which functions as the central bank of the global oil market increasing and decreasing production to balance markets (Chart 7). Chart 7KSA Primarily Balances Markets During Supply, Demand Shocks OPEC 2.0’s goal – similar to OPEC’s goal before it – is to avoid an unintended inventory accumulation, which would push prices lower and severely alter the forward curves for the principal crude oil pricing benchmarks, WTI and Brent (Chart 8). Chart 8OPEC 2.0’s Goal: Avoid Unintended Inventory Accumulation Navigating The 2019-nCoV Outbreak Oil prices – like all commodity prices – are a function of supply and demand, which clear the market instantaneously (here and now), and across time as buyers and sellers contract for forward delivery. The relentless focus on the demand-side consequences of the 2019-nCoV outbreak is not helpful in determining how oil prices will trade going forward. Oil prices – like all commodity prices – are a function of supply and demand, which clear the market instantaneously (here and now), and across time as buyers and sellers contract for forward delivery. The discussion above is meant to highlight this, by recalling OPEC’s production management during various demand shocks, not just the SARS outbreak in 2003. OPEC then, and OPEC 2.0 now, is not forced to produce oil and export regardless of the physical realities it confronts. It can adjust production and exports in response to direct demand indications from its refinery buyers and traders lifting its crude oil. Demand slowdowns, all else equal, typically will show up in falling crack-spread differentials between refined products and crude oil prices (Chart 9).4 Chart 9Crack Spreads Inform Crude Oil Production Decisions It still is too early to gauge the extent of the fall-off in demand arising from 2019-nCoV, but it will become apparent in cracks and in OPEC 2.0 producers’ responses to lower refiner demand. Falling crack spreads inform crude oil producers they need to throttle back on production – refiners are not able to profitably run all the crude being made available to them and crude and product are backing up in inventory. It still is too early to gauge the extent of the fall-off in demand arising from 2019-nCoV, but it will become apparent in cracks and in OPEC 2.0 producers’ responses to lower refiner demand, which will determine how much production they need to cut in order to balance the market. This will be done against a backdrop of supply concerns that are not too dissimilar to those prevailing during the 2003 SARS crisis – e.g., instability in Iraq and Iran that could threaten production, and the loss of Venezuelan exports. Bottom Line: Markets still are in the process of assessing how damaging 2019-nCoV will be for industrial commodity demand – oil, bulks and base metals, in particular. As has been the case in all such demand shocks, OPEC’s supply response (and now OPEC 2.0’s) will determine how deeply and for how long prices are impacted. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Commodities Round-Up Energy: Overweight Brent prices fell 8% since last Monday amid the coronavirus outbreak in China. The number of confirmed cases is rapidly expanding, reaching more than 6,000 as of Wednesday which surpasses the trajectory of SARS in the first month of the outbreak in 2003. Nonetheless, the fatality rate remains below that of SARS, estimated at less than 3% vs. ~ 10% for SARS. Separately, the WCS discount to WTI averaged -$23/bbl this month. This is in line with our view that the discount would drop below -$20/bbl in 1Q20. This level is appropriate to incentivize additional rail transportation to the US. We expect the discount will remain close to current levels and for crude-by-rail volumes to pick up this year (Chart 10). Base Metals: Neutral Base metals have been severely impacted this week by the coronavirus outbreak – copper, aluminum, zinc, and lead are down 9%, 4%, 9%, and 5%. A prolonged slowdown in China’s economic activity – the driver of the global industrial activity recovery we expect – would plunge metals’ prices. China’s base metal consumption more than doubled since 2003. Thus, the potential impact of 2019-nCoV is much larger compared to SARS and market participants are pricing in the probability of damaging scenarios to global growth. This explains the pronounced decline in metals’ prices this year vs. 2003. Precious Metals: Neutral Gold was one of the few commodities in the green since last week. The yellow metal rose 1% since last Monday, supported by renewed safe-haven demand flows. Gold and the USD have been rising simultaneously amid the virus outbreak, which is typical of uncertain periods. The spectrum of possible outcomes is wide and negatively skewed. This warrants protection through safe-haven assets. We remain strategically long gold as a portfolio hedge. Our recommendation is up 28% since inception. Ags/Softs: Underweight Corn markets focused on USDA reports of rising exports, highlighted by the sale of 124,355 MT to Mexico. CBOT March corn futures were up 6% Tuesday, reversing earlier losses Monday. Beans remain under pressure, as traders await tangible evidence that China will go ahead with purchases announced in the so-called phase-one deal negotiated between the US and China (Chart 11). Chart 10WCS Discount Under Pressure Chart 11Markets Waiting For China Demand Footnotes 1 The US Centers for Disease Control and Prevention’s 2019-nCoV website highlights the marked differences between China’s response to the current coronavirus outbreak vs the 2003 SARS outbreak. One notable response by the Chinese government this time around – besides the rapid lockdown on travel – has been the alacrity with which officials posted the genome for the virus to a global research database, which allowed US researchers to quickly compare it to the strain they isolated. Separately, Reuters reported Australian researchers were able to grow the virus in a lab, which could accelerate development of a vaccine. 2 Distillates comprise the so-called middle of the refined barrel, and include jet fuel, diesel fuel and heating oil (also known as gasoil). These are primarily associated with industrial markets – mining and transportation, e.g. – and are key barometers of economic activity generally. 3 The "modern" era for oil began roughly in 2000, when oil prices became a random walk. WTI prices were mean-reverting from 1986 to roughly 2000, then became a random walk. Please see Helyette Geman, (2007), "Mean Reversion versus Random Walk in Oil and Natural Gas Prices," in Advances in Mathematical Finance, Birkhäuser, Boston; and Haidar, I. and C.R. Wolff, "Forecasting crude oil price (revisited)," The proceeding of the 30th USAEE Conference, Washington , D.C. USA. 9-12 October, 2011. 4 The “crack spread” is the USD/bbl difference between refined-product prices and crude-oil prices. It represents the gross margin of refiners. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
An analysis on Hong Kong is available below. Highlights The correction in EM risk assets and currencies will be larger than during the SARS outbreak. A number of market indicators that are pertinent for EM assets are sending a disconcerting message. The trouble is that they have relapsed from already low levels. We are closing our long position in EM stocks to manage risk and continue recommending underweighting EM equities and credit versus their DM counterparts. Stay short EM currencies versus the US dollar. A new trade: Go short Hong Kong banks / long Taiwanese banks. Feature Chart I-1Global Equity Correction: SARS- And Coronavirus-Episodes It is tempting to compare the potential impact of the current coronavirus outbreak on the global economy and financial markets with that of SARS in the spring of 2003. The correction in global equities due to the SARS outbreak lasted only a couple of days during April 2003, and global share prices sold off by only 2.5% (Chart I-1). During that period, the EM equity index dropped by 4% and emerging Asian bourses by 8% in US dollar terms (Chart I-2). Presently, the drawdowns in global stocks and EM share prices have been 2.5% and 4%, respectively. Thus, the magnitude of the current correction is on a par with what occurred during the 2003 SARS outbreak (Charts I-1 and I-2). Further, in 2003, share prices bottomed when the number of registered new SARS infections – on a rolling fortnight basis – declined (Chart I-3). This was true both worldwide and in the case of Hong Kong. Chart I-2EM And Asian Stock Corrections: SARS- And Coronavirus-Episodes Chart I-3Number Of New Cases And Share Prices: Global And Hong Kong However, such simplistic comparisons between SARS in 2003 and the current coronavirus outbreak are uninformative. There are striking economic differences between these two episodes. The impact on both the Chinese and global economies will be larger today compared with the effects of SARS. This is true even if the spread of the coronavirus is contained soon and the number of infections and deaths peaks earlier and at much lower levels compared to the SARS outbreak. The rationale behind the meaningful impact on Chinese and global growth is two-fold: The safety measures undertaken by the Chinese authorities, including the extension of the Lunar New Year holiday period and imposition of limits on travel – are much greater than their response in 2003. These efforts might contain the spread of the virus and save human lives, but they will likely dampen economic activity in the near term. The importance of the Chinese economy in the world and hence its impact have grown immensely since early 2003. Overall, the current correction in EM risk assets and currencies will be larger than the one during the SARS outbreak. China’s Share Of The Global Economy: Today Versus 2003 Table I-1China’s Importance Now And In 2003 China’s economy is much more important to global aggregate demand and growth today than it was in 2003 (Table I-1). Specifically: China’s GDP at purchasing power parity accounts for 19.3% of world GDP compared to 8.3% in 2002 before the SARS outbreak occurred. In nominal US dollar terms, the mainland currently accounts for 17% of global GDP versus 4.3% in 2002. We use 2002 because the SARS outbreak occurred in early 2003, so China’s share of world GDP in 2002 is the more accurate measure of the country’s importance in early 2003. Chinese imports of goods and services make up 13.5% of global trade at present, significantly greater than their 4.5% share in 2002. The mainland’s share of consumption of various industrial metals has surged, from between 10-20% in 2002 to 50-60% presently (Table I-1). For copper, it has soared from 18% in 2002 to its current share of 53%. China’s iron ore imports have risen from 21% of the global total in 2002 to 64% presently. The nation’s oil consumption presently accounts for 13.5% compared with 6.6% in 2002. Total semiconductor sales in China currently constitute 34.6% of global semiconductor sales versus 5% in 2002. Personal computer sales in China make up 20% of worldwide sales compared with 2.4% in 2002. Mobile phones sales in China constituted 11% of worldwide sales in 2002. Today, smartphone sales account for 29% of global sales. Finally, in the past 12 months, passenger car sales in China were 21.5 million units, or 34.5% of the global total. In 2002, China’s share in global passenger auto demand was only 7.3%. Other relevant differences between China’s economy then and now include: Chart I-4China's Leverage In 2003 And Now First, leverage among companies and households was low in 2002 compared with the current debt bubble. Aggregate local currency indebtedness of companies, households and the various levels of government stood at 120% of GDP in 2002, compared with 260% currently (Chart I-4). Even a temporary reduction in cash flows of enterprises due to shutdowns and a plunge in demand will weigh on their ability to service debt. This could in turn temporarily curtail their appetite for new investments and hiring. Second, by 2003 China had just completed a major overhaul of its state-owned enterprises (SOEs) and banks. As a result, the nation was in the early stages of a structural economic boom driven by higher productivity growth. Presently, neither SOE reforms nor deleveraging are meaningfully advanced (Chart I-4, bottom panel). Consequently, China is still in a structural decline in terms of productivity growth. Third, China entered the World Trade Organization in late 2001, and by early 2003 it was enjoying an FDI inflow boom and was on the verge of rapidly increasing its market share in global trade (Chart I-5). Presently, both multinational and Chinese producers are moving their production and supply chains out of China in response to US trade protectionism. Chart I-5China's Global Export Market Share In 2003 And Now Finally, enterprises and organizations were not forced to shut down because of the SARS virus in the spring of 2003. Consequently, the hit to economic activity in the spring of 2003 was mild, as shown in Chart I-6A and I-6B. In contrast, the government today has extended the Chinese New Year holidays by a few days, and some companies will be operating on a part-time basis for a couple of weeks. It is impossible to forecast the evolution of the outbreak, but the odds are that a hit to economic activity in China due to the coronavirus outbreak is likely to be worse than during the SARS episode. Chart I-6AChina: Cyclical Variables During SARS Outbreak Chart I-6BChina: Cyclical Variables During SARS Outbreak On a positive note, the Chinese authorities will certainly augment their stimulus, especially fiscal spending, to counteract the negative impact of the shutdowns on the economy. However, it remains to be seen how long it will take for these stimulus efforts to filter through the economy and offset the drag from poor sentiment. Market Signals Are Disconcerting There are several financial market signals that are often important in terms of gauging primary trends in EM risk assets and currencies: Chart I-7Industrial Metal Prices Are Back To Their Cyclical Lows Base metal prices in general and copper prices in particular have relapsed to their cyclical lows (Chart I-7). In short, industrial metal prices are not confirming a durable recovery in global manufacturing and China/EM domestic demand. Industrial metal prices are leveraged to China’s growth as well as closely correlated with EM ex-China currencies (Chart I-8). This is a bearish signpost for EM exchange rates. Notably, Korea’s bond yields are drifting lower, casting doubt on the sustainability of the nation’s export growth (Chart I-9). The latter is a good barometer of global trade. EM assets are very sensitive to global trade and as such remain at risk. EM small-cap stocks have failed to enter a cyclical bull market, despite investor enthusiasm for EM financial markets following the US-China Phase One trade agreement. Their much-muted rebound is not confirming a broad-based recovery in EM/China growth and improvement in EM domestic fundamentals. Chart I-8EM Currencies: Rebound Has Faded Chart I-9Korean Bond Yields And Global Manufacturing Chart I-10EM Risks Are Tilted To The Downside Similarly, the rebound in our Risk-On/Safe-Haven currency ratio has faded and this indicator has rolled over (Chart I-10). It correlates well with EM share prices, and presently heralds further downside in the latter. The disconcerting message from these market indicators is that they – unlike the S&P 500 - are not correcting from very overbought levels, but have relapsed and are gapping down from already low levels. Economic data from China and Asia in the coming months will be weak due to coronavirus-related disruptions. Therefore, investors cannot rely on economic data to gauge the direction of the business cycle, Instead, market signals and market-based indicators might become the predominant tools for gauging financial markets directions. Investment Strategy Last week we recommended investors consider going long EM volatility. The levels of EM and DM currencies’ implied volatility were at all-time lows (Chart I-11). We are reiterating this recommendation. Notably, the previous historical lows in EM and DM currencies’ implied volatility occurred just before major bear markets in EM share prices (Chart I-11). Hence, the odds of a major drawdown in EM share prices are considerable. We gave the benefit of the doubt to the market action and went long EM stocks on December 19, 2019. Given the latest market action, indicators and uncertainty over the Chinese/Asian business cycle, we are closing the open position in EM equities. This trade has been flat since its initiation. The EM equity index in US dollar terms is hovering above major technical support lines (Chart I-12). If this level is decisively broken, the downside could be substantial. Alternatively, if EM share prices find support around these levels, it would signal a budding major bull market. We will monitor market action and indicators and adjust our strategy accordingly. Chart I-11A Record Low Vol = A Major Top In Risk Assets Chart I-12EM Stocks: Will Long-Term Technical Support Hold? Although we upgraded our view on the absolute performance of EM stocks in December, we have continued recommending underweighting EM versus DM. In recent weeks, we have been arguing that we will upgrade EM stocks and credit from underweight to overweight relative to their DM peers if EM share prices and currencies demonstrate resilience amid a correction in global risk assets. So far, they have not been resilient – EM equities have sold off more than their DM peers (Chart I-13) and the weakness in EM currencies has been broad-based. For now, investors should continue underweighting EM equities and credit versus their DM counterparts. The odds of a breakdown in EM currencies are rising. Investors should continue shorting a basket of EM currencies versus the US dollar. Our favored shorts are BRL, CLP, COP, IDR, MYR, PHP, KRW and ZAR. Finally, EM local currency bond yields as well as sovereign and corporate credit spreads are either at record lows or at extremely low levels (Chart I-14). EM sovereign credit spreads appear elevated because the index includes de-facto defaulted sovereigns like Argentina, Venezuela, and others. EM currency trends hold the key for these asset classes. If EM currencies break down, as we expect, EM domestic bond yields will rise, and sovereign and credit spreads will widen. Chart I-13EM Equities Versus DM: New Lows Ahead? Chart I-14Too Much Complacency In EM Local Bonds And Credit Markets Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Hong Kong: Into Uncharted Waters The Hong Kong economy is in recession and its equity prices – stocks domiciled in Hong Kong and included in the MSCI Hong Kong equity index – have underperformed considerably. Is it time to turn positive on Hong Kong equities? We continue to recommend underweighting Hong Kong-domiciled stocks, because the heavyweight sectors – financials and property – remain at risk. The basis is that Hong Kong’s interest rates will likely creep higher as capital outflows persist. Higher borrowing costs will weigh on this highly leveraged economy. Capital Flows And Interest Rates The currency board system mandates the Hong Kong Monetary Authority (HKMA) to maintain a pegged exchange rate with the US dollar. With an open capital account and a fixed exchange rate, the HKMA has little control over interest rates. Chart II-1Banks Excess Reserves AT HKMA And Interest Rates Capital outflows exert depreciation pressure on the currency, forcing the monetary authorities to sell their foreign currency reserves to defend the exchange rate peg. This drains commercial banks’ excess reserves at the central bank, thereby tightening interbank liquidity and lifting interest rates (Chart II-1). In brief, interbank rates need to rise to inhibit capital flight. For now, we expect the heightened socio-political uncertainty in Hong Kong to linger. This will hurt economic growth, thereby depressing economic sentiment and return on capital. In turn, this will continue to spur capital outflows. The latter will exert upward pressure on interest rates. Overall, this could unleash a feedback loop of deteriorating growth conditions, capital outflows and higher interest rates. While it is doubtful that Hong Kong will experience a full-blown crisis, the most likely scenario is a slow leakage of capital out of the city and gradually rising interest rates. A mirror image of capital outflows from Hong Kong is foreign capital inflows in Singapore. In particular, foreigners’ Singapore dollar deposits rose by S$6.8 billion from May to November 2019, and foreign currency deposits in Singaporean banks increased by S$9 billion during the same period (Chart II-2). Chart II-2Non-Residents Deposits In Singapore Confirm Capital Flight Out Of HK Real Estate Blues Hong Kong’s property market is under stress from both falling income/cash flow and slowly rising interest rates. Odds are that various segments of the Hong Kong property market – especially the retail, commercial and high-end residential – have entered an extended downturn. The protests and the coronavirus outbreak have all but halted tourism, especially from the mainland. Mainland Chinese visitors accounted for 75% of total arrivals a year ago, and their spending accounted for over 10% of personal consumption expenditures in Hong Kong. Tourists from the mainland are not expected to return soon due to both Hong Kong’s protests and the travel limitations due to the coronavirus outbreak. Hong Kong’s domestic demand is also anemic, and will stay so given poor business sentiment and a weakening labor market. In a nutshell, the value of retail sales in November plunged by a record 23.6% from a year earlier (Chart II-3). Contracting consumption has resulted in sharply rising vacancies and pushed retail property rents and prices off the cliff for the first time since 2008 (Chart II-4). Retail sector rents and prices have on average deflated by 10% from last year. Consistently, high-street rents have also fallen by about 18% in 2019. In short, rising vacancy rates of retail properties herald further rent decline. Chart II-3HK: Retail Sales Have Collapsed Chart II-4HK Retail Properties: Vacancy, Rents And Prices Hong Kong’s office market is also at risk, with vacancy rates climbing (Chart II-5). Office property prices have dropped by 8%, and prime grade A property prices have plunged a whopping 20% from a year earlier (Chart II-5, bottom panel). Multinational companies and financial firms have been relocating to reduce their rental costs. In the third quarter of this year, office vacancies in the center of Hong Kong reached 7.4%, their highest in 14 years. With respect to Hong Kong‘s residential market, it is a mixed bag. On average, home prices have so far declined by only 3% from their peak in 2019. (Chart II-6, top panel). That said, luxury residential prices have already plunged by 27% from a year ago (Chart II-6, second panel). The residential sector’s resilience in the middle- and low-ends can be explained by strong end-user demand and lack of speculative purchases over the past three years due to the government’s anti-speculative measures. For example, the number of residential transactions involving stamp duties – a proxy for foreign purchases – has fallen sharply since Q4 2016 due to tougher regulations. Chart II-5HK Offices: Vacancy, Rents And Prices Chart II-6HK Residential Vacancy, Rents And Prices Chart II-7HK: Retail Yields And Interest Rates Even only marginally higher interest rates will be sufficient to hurt real estate. Rental yields on all types of properties are very low and close to borrowing costs (Chart II-7). There is not much of a valuation buffer if borrowing costs rise or rents deflate. In a nutshell, the high-end property market as well as commercial real estate are vulnerable. Importantly, the Hong Kong authorities cannot use lower interest rates to help the economy, leaving fiscal policy as the sole tool. The government has accumulated enormous fiscal surpluses, and it will ramp up spending to stimulate the economy. The authorities have so far announced three tiny fiscal stimulus packages amounting to only 0.8% of GDP in aggregate. This is clearly insufficient to jump start the business cycle amid lingering headwinds. Nevertheless, government expenditures account for only 10% of GDP, and any reasonable jump in spending in the coming months will not be sufficient to preclude a downtrend in the broader economy. Banks Holds The Key Chart II-8HK-Domiciled Banks: Profit Outlook Is Downbeat Hong Kong-domiciled bank share prices are at risk from a deceleration in loan growth, rising non-performing loans (NPLs) and a drop in their net interest rate margins (Chart II-8). Banks’ domestic loans are concentrated in real estate: About 55% of domestic loans consist of lending to property developers and mortgages. Such a high concentration of real estate lending makes Hong Kong banks vulnerable to a property market correction. If banks begin tightening lending standards, the game will be over. At the moment, bankers might be relaxed as they are comparing the current episode with short-lived corrections in the property market and the economy in 2008, 2013 and 2015. However, odds are that this downturn will be more severe. As the economic stress heightens, banks might begin tightening lending standards. In such a case, property prices and construction activity will sink, feeding back into the economy. Notably, this process seems to have started, as evidenced by bank tightening of credit standards for small businesses (Chart II-9). Importantly, the debt service ratio for Hong Kong’s nonfinancial sectors is among the highest in the world (Chart II-10). Provided all outstanding mortgages are floating-rate, any rise in interest rates will increase borrowing costs. Coupled with shrinking nominal incomes, debtors – both households and companies – will struggle to service their debt. Chart II-9HK Banks Have Been Tightening Credit For Small Businesses Chart II-10HK Private Sector: Debt-Service Ratio Is the Highest Investment conclusions We continue to reiterate our underweight position in Hong Kong equities within emerging markets, global and Asian equity portfolios (Chart II-11). The Hong Kong currency peg will be maintained for now, even at the cost of rising interest rates and debt deflation in the real economy. We discussed the Hong Kong exchange rate outlook in a special report last June, and the main points of that analysis remain valid. The HKMA has an enormous amount of foreign exchange reserves to defend the currency peg. However, the cost of defending the exchange rate will be higher interest rates. The latter will hurt Hong Kong’s highly leveraged economy in general and its property market in particular. As a bet on property market travails, we continue to recommend being short Hong Kong property stocks and long Singapore real estate equities (Chart II-12). The macro justification for this trade is the ability of Singapore to drop interest rates and tolerate currency depreciation, and Hong Kong’s inability to do so. Finally, as a new trade, we recommend shorting Hong Kong-domiciled banks relative to Taiwanese banks. As discussed, Hong Kong banks are exposed to rising borrowing costs, weakening real estate and rising NPLs. Chart II-11Continue Underweighting HK Stocks Chart II-12Stay Short HK Property / Long Singapore Property Stocks We chose Taiwanese banks because they are defensive in nature – i.e., they will likely be a low-beta play within the Asia equity universe. Lin Xiang, CFA Research Analyst linx@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights The coronavirus scare is the catalyst for the recent correction, not the cause. The true cause is that the stock market had reached a point of groupthink-triggered instability and therefore needed the slightest catalyst to correct. Bond yields will stay depressed for (at least) the first half of 2020. Long-term investors should use corrections to overweight equities versus bonds, provided bond yields stay near or below current levels. The pound and UK-exposed investments will come under near-term pressure as UK/EU trade deal tensions ratchet up. But ultimately, UK-exposed investments will enjoy a major leg up later this year if both the UK and EU blink. Feature Chart of the WeekThe Next Up-Leg In The Pound And UK-Exposed Investments Will Occur Later In 2020 Corrections, Catalysts, And Coronavirus Markets have suffered a correction, begging the question: what caused it? The question is a good one, because identifying the cause can help to inform our response. Yet the danger is that the knee-jerk narrative pinpoints the catalyst rather than the true cause. In which case our response will be wrong too. For example, consider the following two narratives: Tree foliage collapses because of 40 mph winds. Tree foliage collapses because it is autumn. The first narrative is exciting, satisfying, and headline grabbing, but it only pinpoints the catalyst for the foliage collapse: the puff of wind. The second explanation is dull and less newsworthy, but it pinpoints the true cause: in autumn, tree foliage is unstable. Likewise, the coronavirus scare is the catalyst for the recent correction. The true cause is that the stock market had reached a point of groupthink-triggered instability and therefore needed the slightest catalyst to correct. The catalyst could have come from anywhere at any time. If it hadn’t been the coronavirus scare, it would have been the next worry… or the one after that. On January 9 in Markets Are Fractally Fragile we warned that usually cautious value investors had become momentum traders – undermining market liquidity and stability. When this happens, there is a two in three chance of a tactical reversal (Chart I-2). Chart I-2When Markets Are Fractally Fragile, There Is A 2 In 3 Chance Of A Tactical Reversal We also warned that the bond yield 6-month impulse – the change in the change – had recently become a severe 100 bps headwind to growth. At this severity of headwind, there is a nine in ten chance that bond yields have reached a near-term peak (Chart I-3). Chart I-3When The Bond Yield 6-Month Impulse Becomes A Severe Headwind, There Is A 9 In 10 Chance Of A Near-Term Peak In Yields In combination, we warned that equities would underperform bonds by about 4 percent on a tactical horizon. Now that this anticipated correction has happened, what next? Long-term investors should use corrections to overweight equities versus bonds. First, irrespective of coronavirus – or any other catalyst – the recent severe headwind to growth from the bond yield impulse suggests that bond yields will stay depressed for (at least) the first half of 2020. Second, the good news is that the ultra-low bond yields justify and underpin the valuation of equities. Hence, at the current level of bond yields, long-term investors should use corrections to overweight equities versus bonds. Brexit Is “Done”. Or Is It? Rumour has it that Boris Johnson will banish the word Brexit from the UK government lexicon after January 31, because Brexit is now “done”. Good luck with that. When Britain wakes up bleary-eyed on Saturday February 1, what will have changed? Not a lot. The UK will have lost its voice and votes in the EU decision making institutions. Yet in practical terms nothing will have changed, because the UK and EU will enter an 11-month ‘standstill’ transition period in which existing arrangements will continue: the free movement of people, financial contributions, and full access to the single market without tariffs or customs checks. The Conservative government made a manifesto pledge not to extend the 11-month transition, so the more important question is: what will change when the standstill period ends on December 31? The answer depends on what sort of trade deal the UK and EU can negotiate in the limited space of 11 months. Or indeed whether they can negotiate a trade deal at all. Therein lies the problem. A free trade deal with the EU will require a mutual commitment to a ‘level playing field’. If the UK wants to diverge on food standards, environmental protection, labour rights, and state aid – as the Brexit purists yearn – then there is zero chance that the EU will agree to a free trade deal. This leaves two options, neither of which is appealing. The first is for the UK to end the 11-month standstill period without a trade deal. Technically, this would not be ‘no deal’ because the withdrawal agreement would still bind both sides on citizens’ rights, financial contributions, and arrangements for Northern Ireland. A free trade deal with the EU will require a mutual commitment to a ‘level playing field’. However, for UK companies, the option of ending the standstill period without a trade deal would constitute a painful dislocation from the single market involving tariffs and customs checks. It would also hurt the EU economies most exposed to the UK, notably Ireland and the Netherlands. Moreover, a full customs and tariff border in the Irish Sea would endanger the very existence of a ‘United’ Kingdom which included Northern Ireland. The second option is for the UK to accept a trade deal on EU terms, recognising that the EU is the larger and more economically powerful party in the negotiation. The EU will offer the UK a tariff-free and quota-free trade deal conditional on strict level playing field conditions where the UK chooses to diverge from EU standards, combined with a mechanism to adjudicate on any level playing field disputes. Though economically better than no trade deal at all, the Brexit purists would claim it isn’t Brexit. Meanwhile, even without tariffs and quotas, UK companies whose just-in-time supply chains depended on the EU would still suffer disruption, as the level playing field was policed at every border crossing. So this option would satisfy nobody in the UK. The bigger practical problem is a lack of time to leave the EU regulatory orbit smoothly. Nobody believes that eleven months is enough time to implement a system in Northern Ireland that prevent a hard border in the Irish Sea; or indeed to implement a new UK immigration system if free movement were to end at the end of 2020. So what’s the resolution? The answer is the same as it has always been for Brexit – a gradual ratcheting up of tension ahead of a hard deadline to focus minds and force progress. Followed by a ‘fudged resolution’ at the eleventh hour in which both sides blink – because neither side is prepared to go over the cliff-edge. Recall that to get the withdrawal agreement over the line, the UK blinked by allowing Northern Ireland to be treated differently; but the EU also blinked by allowing the withdrawal agreement to be reopened. And once this happened, the pound and UK-exposed investments enjoyed a major leg up (Chart I-1 and Chart I-4-Chart I-7). Chart I-4The FTSE 250 Is A UK-Exposed ##br##Investment Chart I-5The FTSE 100 Is Not A UK-Exposed Investment Chart I-6UK General Retail Is A UK-Exposed Investment Chart I-7UK Clothing And Accessories Is Not A ##br##UK-Exposed Investment In the next fudged resolution, the UK could blink by retaining full regulatory alignment with the EU in most areas for a little while longer, and where it doesn’t the EU could blink by becoming flexible in its interpretation of ‘level playing field’. Obviously, nobody would call this an extension to the transition, but the UK would, in most practical terms, still be in the single market on January 1 2021. UK-exposed investments will enjoy their next major leg up later this year In this playbook, the pound and UK-exposed investments will come under near-term pressure, as UK/EU trade deal tensions ratchet up. But ultimately, UK-exposed investments will enjoy their next major leg up later this year if both the UK and the EU blink (Chart I-8). Chart I-8The Pound Still Has A Brexit Discount Fractal Trading System* There are no new trades this week. The rolling 1-year win ratio now stands at 62 percent. Chart I-9EUR/GBP When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations