Secession/Breakup
Highlights Buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit. For equity investors the best play is a FTSE Small Company Index ETF and/or U.K. REITS. Beaten-down banks, industrials and materials can continue their recent countertrend outperformances. This necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Go overweight industrials versus utilities as a tactical trade. Feature Chart of the WeekWere It Not For Brexit, U.K. Interest Rates Would be 1 Percent Higher Please join me for a webcast today at 10.00 AM EST (3.00 PM GMT, 4.00 PM CET, 11.00 PM HKT) when I will be elaborating on some of the ideas in this report as well as other major investment themes. For those of you who cannot participate live, the webcast will also be available as a playback. Were it not for the psychodrama called Brexit, the pound would be trading at $1.50 rather than at $1.28. We can say this with utmost confidence because ‘cable’ is very closely tracking the difference in 2-year interest rates in the U.K. versus the U.S. Absent the Brexit shenanigans, U.K. interest rates would be around 1 percent closer to those in the U.S., implying that pound/dollar would be around 15 percent higher ( Chart I-2 and Chart I-3 ). Chart I-2Absent The Brexit Discount On U.K. Interest Rates... Chart I-3...The Pound Would Be At $1.50 Explaining Brexit’s Impact On U.K. Interest Rates And The Pound The difference in U.K. versus U.S. interest rates usually tracks the difference in their inflation rates, in effect equalizing real interest rates in the two economies. But the Brexit referendum in 2016 forced the Bank of England into an ‘emergency monetary policy’ mode, whereby interest rates were left depressed relative to the inflation fundamentals, and U.K. real interest rates collapsed. Applying the BoE’s pre-Brexit reaction function to the current inflation dynamics, U.K. interest rates – and therefore the pound – would be in a completely different ballpark. After all, U.K. and U.S. core inflation rates and unemployment rates are virtually identical ( Chart of the Week ). It follows that the pound’s trajectory will be higher in any negotiated Brexit – or indeed ‘no Brexit’ – which avoids a complete and overnight no-deal divorce. The simple reason is that a transition period lasting several years that continues to give the U.K. access to the EU single market will allow the BoE to revert to its pre-Brexit monetary policy reaction function. But any workable alternative to a no-deal Brexit must satisfy two conditions: the way forward must be acceptable to the EU27; and it must command a majority in the U.K. parliament. From the perspective of investors, what this way forward turns out to be – Common Market 2.0, permanent customs union, second referendum, or general election – does not really matter. What matters is that a parliamentary majority exists for a course of action that avoids no-deal. The investment strategy is to buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit . In this event, do not buy the FTSE100. Whenever the pound strengthens, the weaker translation of the FTSE100 companies’ dollar-denominated earnings tends to weigh down this large-cap index. A better play is the FTSE250 mid-cap index ( Chart I-4 ), but for equity investors t he best play is a FTSE Small Company Index ETF and/or U.K. REITS ( Chart I-5 ). Chart I-4A Negotiated Brexit Would Favour The FTSE250... Chart I-5...And U.K. Small Companies Europeans Are Celebrating Lower Oil Europeans will be celebrating the near halving of the crude oil price from its $86 high just three months ago. The simple reason is that Europeans are net importers of energy, and the amount of energy they consume tends to be price inelastic. After all, Europeans have to do the school run and stay warm in winter, irrespective of the oil price. Hence, when energy prices soar as they did for most of 2018, it squeezes European real spending. Conversely, when energy prices plunge as they have more recently, it boosts real spending ( Chart I-6 ). A second transmission mechanism is via credit creation: higher inflation, through its implication for tighter monetary policy, lifts bond yields and depresses credit impulses; lower inflation does the opposite, it depresses bond yields and lifts credit impulses. The upshot is that higher oil weighed on European growth in 2018 while lower oil should boost growth in early 2019. Chart I-6Inflation Is Likely To Plunge, Boosting Real Incomes Compelling proof comes from the oscillations in the euro area economy. For several years, these growth oscillations have perfectly and inversely tracked oscillations in the oil price ( Chart I-7 ). The economic implication is that the recent collapse in energy prices should engineer some sort of growth rebound in the euro area. The investment implication is that such a growth rebound will support the classically cyclical equity sectors – banks, industrials and materials – because of their very high operational leverage to economic growth. Chart I-7Euro Area Growth Oscillations Inversely Track Oil Price Oscillations Profit is a small number created from the difference between two large numbers: sales minus the cost of generating those sales. But the dominant cost – the wage bill – tends to be quite sticky. Hence, if a company’s sales are highly sensitive to the economy, the power of operational leverage means that a small change in GDP can have a dramatically large proportional impact on profit. This is a simple principle, but it turns out to be an excellent explanation for the Eurostoxx50 earnings per share (eps) cycle. Because the index is dominated by the classically economic-sensitive sectors, Eurostoxx50 eps growth has a very high operational leverage to changes in euro area GDP growth, potentially as high as 50 times over short periods such as six months ( Chart I-8 ). In contrast the less cyclical S&P500 has an operational leverage to economic growth of less than 10 ( Chart I-9 ). Chart I-8Eurostoxx50 Profits Growth Is Highly Geared To Economic Growth Chart I-9S&P500 Profits Growth Is Less Geared To Economic Growth On the expectation that euro area growth will rebound modestly in early 2019, the beaten-down banks, industrials and materials can continue their recent countertrend outperformances. And this necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Explaining The ‘Unexplainable’ Moves In Markets During the recent Christmas holiday period, financial markets experienced sharp moves with no explainable catalyst. Such reversals leave many strategists and analysts scratching their heads in bewilderment, wondering: what was the catalyst for that reversal? The answer is there was no fundamental catalyst; the market reversed because liquidity dried up . But to explain why liquidity dried up and markets ‘unexplainably’ reversed, we first need to understand what creates market liquidity in the first place. Market liquidity is the ability to convert cash into an investment quickly and in volume without affecting its price. But for an investor to convert a large amount of cash into an investment without affecting its price, another investor must be willing to do the exact opposite – convert a large amount of the investment into cash at the given price. Therefore, market liquidity comes from a disagreement about the attractiveness of an investment at that given price. Investors disagree about the attractiveness of an investment at a given price because investors with different time horizons interpret the same facts and information very differently. Hence, a market remains stable when it possesses investors with many different time horizons. The reason is that when a day-trader experiences a ‘six-sigma’ price move, an investor with a longer investment horizon, for example 65 days, will step in and stabilize the market. The longer-term investor will do so because, within his investment horizon, the day-trader’s six-sigma price move is not unusual. As long as another investor has a longer trading horizon than the investor experiencing an extreme event, the market will stabilize itself. Therefore, the market’s liquidity and stability are maximized when its participants possess a variation of investment horizons, say, both the 1 day horizon and the 65 day horizon. The corollary is that the market’s liquidity and stability disappear when its participants no longer possesses this healthy variation in horizons. In technical terms, this occurs when the market’s 65-day fractal dimension collapses to its lower bound. Without a shadow of a doubt, this is what happened to the S&P500 on Christmas Eve and triggered a 5 percent market rebound on Boxing Day ( Chart I-10 ). And this is now what is happening to the relative performance of industrials versus utilities, which is also in the process of a similar liquidity-triggered rebound ( Chart I-11 ). Chart I-10A Liquidity Shortage Triggered A Sharp Rebound In The S&P500 Chart I-11Expect A Liquidity-Triggered Rebound In Industrials Versus Utilities Fractal Trading System* This week we note that the strong rally in the Indian rupee versus the Pakistan rupee has reached a point where an imminent liquidity shortage could trigger a countertrend move. Go short the Indian rupee versus the Pakistan rupee with a profit target of 3 percent, and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 The post-June 9, 2016 fractal trading model rules are: 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. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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 , Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades 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
Highlights So What? Our best and worst calls of 2018 cast light on our methodology and 2019 forecasts. Why? Our clients took us to task for violating our own methodology on the Iranian oil sanctions. Sticking to our guns would have paid off with long Russian equities versus EM. We correctly called China’s domestic policy, the U.S.-China trade war, Europe, the U.S. midterms, and relative winners in emerging markets. Feature It has been a tradition for BCA’s Geopolitical Strategy, since our launch in 2012, to highlight our best and worst forecasts of the year.1 This will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 9, when we return to our regular publication schedule. We wish all of our clients a great Holiday Season. And especially all the very best in 2019: lots of happiness, health, and hefty returns. Good luck and good hunting. The Worst Calls Of 2018 A forecasting mistake is wasted if one learns nothing from the error. This is why we take our mistakes seriously and why we always begin the report card with our zingers. Our overall performance in 2018 was … one of our best. The successes below will testify to this. However, we made three notable errors. A Schizophrenic Russia View Our worst call of the year was to panic and close our long Russian equities relative to emerging markets trade in the face of headline geopolitical risks. In early March, we posited that Russia was a “buy” relative to the broad EM equity index due to a combination of cheap valuations, strong macro fundamentals, orthodox policy, and an end to large-scale geopolitical adventurism. This call ultimately proved to be correct (Chart 1). Chart 1Russian Stocks Outperformed In The End What went wrong? The main risk to our view, that the U.S. Congress would pursue an anti-Russia agenda regardless of any Russian sympathies in the Trump White House, materialized in the wake of the poisoning of former Russian military intelligence officer Sergei Skripal with a Novichok nerve agent in the United Kingdom. As fate would have it, the incident occurred just before our bullish report went to clients! The ensuing international uproar and sanctions caused a selloff. Our bullish thesis did not rest exclusively on geopolitics, but a thaw in West-Russia relations did form the main pillar of the view. Our Russia Geopolitical Risk Index, which had served us well in the past, was pricing as low of a level of geopolitical risk as one could hope for in the post-Crimea environment (Chart 2). Naturally the measure jumped into action following the Skripal incident. Chart 2Geopolitical Risk Was Low Prior To Skripal The timing of our call was therefore off, but we should have stuck with the overall view. The U.S. imposed preliminary sanctions that lacked teeth. While Washington accepted the U.K.’s assessment that Moscow was behind the poisoning, the weakness of the sanctions also signaled that the U.S. did not consider the incident worthy of a tougher position. There are now two parallel sanction processes under way. The first round of sanctions announced in August gave Russia 90 days to comply and adopt “remedial measures” regarding the use of chemical and biological weapons. On November 9, the U.S. State Department noted that Russia had not complied with the deadline. The U.S. is now expected to impose a second round of sanctions that will include at least three of six punitive actions: Opposition to development aid and assistance by international financial institutions (think the IMF and the World Bank); Downgrading diplomatic relations; Additional restrictions on exports to Russia (high-tech exports have already been barred by the first round of sanctions); Restrictions on imports from Russia; A ban on landing rights in the U.S. for Russian state-owned airlines; Prohibiting U.S. banks from purchasing Russian government debt. While the White House was expected to have such sanctions ready to go on the November 9 deadline, it has dragged its feet for almost two months now. This suggests that President Trump continues to hold out for improved relations with President Putin. A visit by President Putin to Washington remains possible in Q1 2019. As such, we would expect the White House to adopt some mix of the first five items on the above list, hardly a crushing response from Moscow’s perspective. The U.S. Congress, however, has a parallel process in the form of the Defending American Security from Kremlin Aggression Act of 2018 (DASKAA). Introduced in August by Senator Lindsey Graham, a Russia hawk, the legislation would put restrictions on Americans buying Russian sovereign debt and curb investments in Russian energy projects. The bill also includes secondary sanctions on investing in the Russian oil sector, which would potentially ensnare European energy companies collaborating with Russia in the energy sector. There was some expectation that Congress would take up the bill ahead of the midterm election, but nothing came of it. Even with the latest incident – the seizing of two Ukrainian naval vessels in the Kerch Strait – we have yet to see action. While we expect the U.S. to do something eventually, the White House approach is likely to be tepid while the congressional approach may be too draconian to pass into law. And with Democrats about to take over the House, and likely demand even tougher sanctions against Russia, the ultimate legislation may be too bold for President Trump to sign into legislation. The point is that Russia has acted antagonistically towards the West in 2018, but in small enough increments that the response has been tepid. Given the paucity of Russian financial and trade links with the U.S., Washington’s sanctions would only bite if they included the dreaded “secondary sanction” implications for third party sovereigns and firms – particularly European, which do have a lot of business in Russia. This is highly unlikely without major Russian aggression. We cannot completely ignore the potential for such aggression in 2019, especially with President Putin’s popularity in the doldrums (Chart 3) and a contentious Ukrainian election due for March 31. However, we outlined the constraints against Russia in 2014, amidst the Ukrainian crisis, and we do not think that these constraints have been reduced (they may have only grown since then). Chart 3Non-Negligible Risk Of Russian Aggression Regardless of the big picture for 2019, we could have faded the risks in 2018 and stuck to the fundamentals. Russia is up 17.2% against EM year-to-date. The lesson here, therefore, is to find re-entry points into a well-founded view despite market volatility. Chart 1 shows that Russian equities climbed the proverbial “wall of worry” relative to EM in 2018. Doubting Jair Bolsonaro Our list of mistakes keeps us in the EM universe where we underestimated Jair Bolsonaro’s chances of winning the presidency in Brazil. The answer to the question we posed in the title of our September report – “Brazil: Can The Election Change Anything?” – was a definitive “yes.” Since the publication of that report, BRL/USD is up 2.9% and Brazilian equities are up 18.5% relative to EM (Chart 4). Chart 4Bolsonaro Rally Losing Its Luster Already To our credit, the question of Bolsonaro’s electoral chances elicited passionate and pointed internal debate. But our clients did not see the internal struggle, just the incorrect external output! A bad call is a bad call, no matter how it is assembled on the intellectual assembly line. That said, we still think that our report is valuable. It sets out the constraints facing Bolsonaro in 2019. He has to convince the left-leaning median voter that meaningful pension reform is needed; bully a fractured Congress into painful structural reforms; and overcome an unforgiving macro context of tepid Chinese stimulus and a strong USD. If the Bolsonaro administration wastes the good will of the investment community over the next six months, we expect the market’s punishment to be swift and painful. In fact, Chart 4 notes that the initial Bolsonaro rally has already lost most of its shine. Brazilian assets are still up since the election, but the gentle slope could become a steep fall if Bolsonaro stumbles. The market is priced for political perfection. To be clear, we are not bearish on Bolsonaro. We believe that, relative to EM, he will be a positive for Brazil. However, the market is currently betting that he will win by two touchdowns, whereas we think he will squeak by with a last-second field goal. The difference between the two forecasts is compelling and we have expressed it by being long MXN/BRL.2 Not Sticking To Our Method In The Case Of Iran Throughout late-2017 and 2018 we pointed out that President Trump’s successful application of “maximum pressure” against North Korea could become a market-relevant risk if he were emboldened to try the same strategy against Iran. For much of the year, this view was prescient. As investors realized the seriousness of President Trump’s strategy, a geopolitical risk premium began to seep into oil prices, as illustrated in Chart 5 by the red bar. Every time we spoke to clients or published reports on this topic, we highlighted just how dangerous a “maximum pressure” strategy would be in the case of Iran. We stressed that Iran could wreak havoc across Iraq and other parts of the Middle East and even drive up oil prices to the point of causing a “geopolitical recession in 2019.” In other words, we stressed the extraordinary constraints that President Trump would face. To their credit many of our clients called us out on the inconsistency: our market call was über bullish oil prices, while our methodology emphasized constraints over preferences. We were constantly fielding questions such as: Why would President Trump face down such overwhelming constraints? We did not have a very good answer to this question other than that he was ideologically committed to overturning the Iranian nuclear deal. In essence, we doubted President Trump’s own ideological flexibility and realism. That was a mistake and we tip our hat to the White House for recognizing the complex constraints arrayed against it. President Trump realized by October how dangerous those constraints were and began floating the idea of sanction waivers, causing the geopolitical risk premium to drain from the market (Chart 6). To our credit, we highlighted sanction waivers as a key risk to our view and thus took profit on our bullish energy call early. Chart 6Sanction Waivers Caused A Collapse In Oil Prices That said, our clients have taken the argument further, pointing out that if we were wrong on Trump’s ideological flexibility with Iran, we may be making the same mistake when it comes to China. However, there is a critical difference. Americans are more concerned about conflict with North Korea than with Iran (Chart 7), while China is the major concern about trade (Chart 8). Second, railing against the Iran deal did not get President Trump elected, whereas his protectionist rhetoric – specifically regarding China – did (Chart 9). Getting anything less than the mother-of-all-deals with Beijing will draw down Trump’s political capital ahead of 2020 and open him to accusations of being “weak” and “surrendering to China.” These are accusations that the country’s other set of protectionists – the Democrats – will wantonly employ against him in the next general election. Chart 9Protectionism, Not Iran, Helped Trump Get Elected Ultimately, if we have to be wrong, we are at least satisfied that our method stood firm in the face of our own fallibility. We are doubly glad to see our clients using our own method against our views. This is precisely what we wanted to accomplish when we began BCA’s Geopolitical Strategy in March 2012: to revolutionize finance by raising the sophistication with which it approaches geopolitics. That was a lofty goal, but we do not pretend to hold the monopoly on our constraint-based methodology. In the end, our market calls did not suffer due to our error. We closed our long EM energy-producer equities / EM equities for a gain of 4.67% and our long Brent / short S&P 500 for a gain of 6.01%. However, our latter call, shorting the S&P 500 in September, was based on several reasons, including concerns regarding FAANG stocks, overstretched valuations, and an escalation of the trade war. Had we paired our S&P 500 short with a better long, we would have added far more value to our clients. It is that lost opportunity that has kept us up at night throughout this quarter. We essentially timed the S&P 500 correction, but paired it with a wayward long. The Best Calls Of 2018 BCA’s Geopolitical Strategy had a strong year. We are not going to list all of our calls here, but only those most relevant to our clients. Our best 2018 forecast originally appeared in 2017, when in April of that year we predicted that “Political Risks Are Understated In 2018.” Our reasoning was bang on: U.S. fiscal policy would turn strongly stimulative (the tax cuts would pass and Trump would be a big spender) and thus cause the Fed to turn hawkish and the USD to rally, tightening global monetary policy; Trump’s trade war would re-emerge in 2018; China would reboot its structural reform efforts by focusing on containing leverage, thus tightening global “fiscal” policy. In the same report we also predicted that Italian elections in 2018 would reignite Euro Area breakup risks, but that Italian policymakers would ultimately be found to be bluffing, as has been our long-running assertion. Throughout 2018, our team largely maintained and curated the forecasts expressed in that early 2017 report. We start the list of the best calls with the one call that was by far the most important for global assets in 2018: economic policy in China. The Chinese Would Over-Tighten, Then Under-Stimulate Getting Chinese policy right required us, first, to predict that policy would bring negative economic surprises this year, and second, once policy began to ease, to convince clients and colleagues that “this time would be different” and the stimulus would not be very stimulating. In other words, this time, China would not panic and reach for the credit lever of the post-2008 years (Chart 10), but would maintain its relatively tight economic, financial, environmental, and macro-prudential oversight, while easing only on the margin. Chart 10No Massive Credit Stimulus In 2018 This is precisely what occurred. BCA Foreign Exchange Strategy’s “China Play Index,” which is designed to capture any reflation out of Beijing, collapsed in 2018 and has hardly ticked up since the policy easing announced in July (Chart 11). Chart 11Weak Reflation Signal From China Our view was based on an understanding of Chinese politics that we can confidently say has been unique: From March 2017, we highlighted the importance of the 2017 October Party Congress, arguing that President Xi Jinping would consolidate his power and redouble his attempts to “reform” the economy by reining in dangerous imbalances. We explicitly characterized the containment of leverage as the most market-relevant reform to focus on. We stringently ignored the ideological debate about the nature of reform in China, focusing instead on the major policy changes afoot. We identified very early on how the rising odds of a U.S.-China conflict would embolden Chinese leadership to double-down on painful structural reforms. Will China maintain this disciplined approach in 2019? That is yet to be seen. But we are arming ourselves and clients with critical ways to identify when and whether Beijing’s policy easing transforms into a full-blown “stimulus overshoot”: First, we need to see a clear upturn in shadow financing to believe that the Xi administration has given up on preventing excess debt. Assuming that such a shift occurs, and that overall credit improves, it will enable us to turn bullish on global growth and global risk assets on a cyclical, i.e., not merely tactical, horizon (Chart 12). Chart 12A Shadow Lending Surge Would Mean A Big Policy Shift Second, our qualitative checklist will need to see a lot more “checks” in order to change our mind. Short of an extraordinary surge in bank and shadow bank credit, there needs to be a splurge in central and especially local government spending (Table 1). The mid-year spike in local governments’ new bond issuance in 2018 was fleeting and fell far short of the surge that initiated the large-scale stimulus of 2015. Frontloading these bonds in 2019 will depend on timing and magnitude. Table 1A Credit Splurge, Or Government Spending Splurge, Is Necessary For Stimulus To Overshoot Third, we would need to see President Xi Jinping make a shift in rhetoric away from the “Three Battles” of financial risk, pollution, and poverty. Having identified systemic financial risk as the first of the three ills, Xi needs to make a dramatic reversal of this three-year action plan if he is to clear the way for another credit blowout. Trade War Would Reignite In 2018 It paid off to stick with our trade war alarmism in 2018. We correctly forecast that the U.S. and China would collide over trade and that their initial trade agreement – on May 20 – was insubstantial and would not last. In the event it lasted three days. Our one setback on the trade front was to doubt the two sides would agree to a trade truce at the G20. However, by assigning a subjective 40% probability, we correctly noted the fair odds of a truce. We also insisted that any truce would be temporary, which ended up being the case. We may yet be vindicated if the March 1 deadline produces no sustainable deal, as we forecast in last week’s Strategic Outlook. That said, correct geopolitical calls do not butter our bread at BCA. Rather, we are paid to make market calls. To that end, we would point out that we correctly assessed the market-relevance of the trade conflict, fading S&P 500 risks and focusing on the effect on global risk assets. Will this continue into 2019? We think so. We do not see trade conflict as the originator of ongoing market turbulence (Chart 13) and would expect the U.S. to outperform global equities again over the course of 2019 (Chart 14). This view may appear wrong in Q1, as the market digests the Fed backing off from hawkish rhetoric, the ongoing trade negotiations, and the likely seasonal uptick in Chinese credit data in the beginning of the calendar year. Chart 13Yields, Not Trade War, Drove Stocks Chart 14U.S. Stocks Will Resume Outperformance However, any stabilization in equity markets would likely serve to ease financial conditions in the U.S., where economic and inflation conditions remain firmly in tightening territory (Chart 15). As such, the Fed pause is likely to last no more than a quarter, maybe two at best, leading to renewed carnage in global risk assets if our view on Chinese policy stimulus – tepid – remains valid through the course of 2019. Chart 15If Financial Conditions Ease, Tightening Will Be Back On Europe (All Of It… Again) In 2017, our forecasting track record for Europe was stellar. This continued in 2018, with no major setbacks: Populism in Italy: Our long-held view has been that Europe’s chief remaining risks lay in Italian populists coming to power. We predicted in 2016 that this would eventually happen and that they would then be proven to be bluffing. This is essentially what happened in 2018. Matteo Salvini’s Lega is surging in the polls because its leader has realized that a combination of hard anti-immigrant policy and the softest-of-soft Euroskepticism is a winning combination. We believe that investors can live with this combination. Our only major fault in forecasting European politics and assets this year was to close our bearish Italy call too early: we booked our long Spanish / short Italian 10-year government bond trade for a small loss in August, before the spread between the two Mediterranean countries blew out to record levels. That missed opportunity could have also made it on our “worst calls” list as well. Pluralism in Europe: To get the call on Italy right, we had to dabble in some theoretical work. In a somewhat academic report, we showed that political concentration was on the decline in the developed world (Chart 16), but especially in Europe (Chart 17). Put simply, lower political concentration suggests that a duopoly between the traditional center-left and center-right parties is breaking down. Contrary to the conventional wisdom, we argued that Europe’s parliamentary systems would enable centrist parties to adopt elements of the populist agenda, particularly on immigration, without compromising the overall stability of European institutions. As such, political pluralism, or low political concentration, is positive for markets. Immigration crisis is over: For centrist parties to be able to successfully adopt populist immigration policy, they needed a pause in the immigration crisis. This was empirically verifiable in 2018 (Chart 18). Chart 18European Migration Crisis Is Over Merkel’s time has run out: Since early 2017, we had cautioned clients that Angela Merkel’s demise was afoot, but that it would be an opportunity, rather than a risk, when it came. It finally happened in 2018 and it was not a market moving event. The main question for 2019 is whether German policymakers, and Europe as a whole, will use the infusion of fresh blood in Berlin to reaccelerate crucial reforms ahead of the next global recession. Brexit: Since early 2016, we have been right on Brexit. More specifically, we were corrent in cautioning investors that, were Brexit to occur, “the biggest loser would be the Conservative Party, not the EU.” As with the previous two Conservative Party prime ministers, it appears that the question of the U.K.’s relationship with the EU has completely drained any political capital out of Prime Minister Theresa May’s reign. We suspect that the only factor propping up the Tories in the polls is that Jeremy Corbyn is the leader of Her Majesty’s Most Loyal Opposition. We have also argued that soft Brexit would ultimately prove to be “illogical” and that “Bregret” would begin to seep in, as it now most clearly has. We parlayed these rising geopolitical risks and uncertainties by shorting cable in the first half of the year for a 6.21% gain. Malaysia Over Turkey And India Over Brazil Not all was lost for our EM calls this year. We played Malaysia against Turkey in the currency markets for a 17.44% gain, largely thanks to massively divergent governance and structural reform trajectories after Malaysia’s opposition won power for the first time in the country’s history. Second, we initiated a long Indian / short Brazilian equity view in March that returned 27.54% by August. This was a similar play on divergent structural reforms, but it was also a way to hedge our alarmist view on trade. Given India’s isolation from global trade and insular financial markets, we identified India as one of the EM markets that would remain aloof of protectionist risks. We could have closed the trade earlier for greater gain, but did not time the exit properly. Midterm Election: A Major Democratic Victory Our midterm election forecast was correct: Democrats won a substantial victory. Even our initial call on the Senate, that Democrats had a surprisingly large probability of picking up seats, proved to be correct, with Republicans eking out just two gains in a year when Democrats were defending 10 seats in states that Trump carried in 2016. What about our all-important call that the election would have no impact on the markets? That is more difficult to assess, given that the S&P 500 has in fact collapsed in the lead-up to and aftermath of the election. However, we see little connection between the election outcome and the stock market’s performance. Neither do our colleagues or clients, who have largely stopped asking about the Democrats’ policy designs. In 2019, domestic politics may play a role in the markets. Impeachment risk is low, but, if it rears its head, it could prompt President Trump to seek relevance abroad, as his predecessors have done when they lost control of domestic policy. In addition, the Democratic Party’s sweeping House victory may suggest a political pendulum swing to the left in the 2020 presidential election. We will discuss both risks as part of our annual Five Black Swans report in early 2019. U.S. domestic politics was a collection of Red Herrings during much of President Obama’s presidency, and has produced strong tailwinds under President Trump (tax cuts in particular). This may change in 2019, with considerable risk to investors, and asset prices, ahead. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 For our 2019 Outlook, please see BCA Geopolitical Strategy Strategic Outlook, “2019 Key Views: Balanced On A Knife’s Edge,” dated December 14, 2018, available at gps.bcaresearch.com. For our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 In part we like this cross because we also think that Mexico’s newly elected president, Andrés Manuel López Obrador, is priced to lose by two touchdowns, whereas he may merely lose by a last-second field goal.
Highlights So What? Global divergence will persist beyond the near term. Why? China’s stimulus will be disappointing unless things get much worse. U.S.-China trade war will reignite and strategic tensions will continue. European risks are limited short-term, but will surge without reform. U.S. assets will outperform; oil and the yen will rise; the pound is a long-term play; EM pain will continue. Feature The year 2019 will be one of considerable geopolitical uncertainty. Three issues dominate our Outlook, with low-conviction views on all three questions: Question 1: How much will China stimulate? Question 2: Will the trade war abate? Question 3: Is Europe a Black Swan or a Red Herring? The main story in 2018 was policy divergence. American policymakers ramped up stimulus – both through the profligate tax cuts and fiscal spending – at the same time that Chinese policymakers stuck to their guns on de-levering the economy. The consequence of this policy mix was that the synchronized global recovery of late 2016 and 2017 evolved into a massive outperformance by the U.S. economy (Chart 1). The Fed responded to the bullish domestic conditions with little regard for the global economy, causing the DXY to rally from a 2018 low of 88.59 in February to 97.04 today. While the policy divergence narrative appears to be macroeconomic in nature, it is purely political. There is nothing cyclical about the ‘U.S.’ economic outperformance in 2018. President Donald Trump campaigned on an economic populist agenda and then proceeded to deliver on it throughout 2017 and 2018. He faced little opposition from fiscal conservatives, mainly because fiscal conservativism melts away from the public discourse when budget deficits are low (Chart 2) and when the president is a Republican (Chart 3). Meanwhile, Chinese policymakers have decided to tolerate greater economic pain in an effort to escape the Middle Income Trap (Chart 4). They believe this trap will envelop them if they cannot grow the economy without expanding the already-massive build-up of leverage (Chart 5). Geopolitics is not just about “things blowing up somewhere in the desert.” In today’s world, emblematized by paradigm shifts, politicians are more than ever in the driver’s seat. While technocrats respond to macroeconomic factors, politicians respond to political and geopolitical constraints. Few investment narratives last much longer than a year and policy divergence is coming to a close. Will the Fed pause given the turn in global growth? Will China respond with effective stimulus in 2019? If the answer to both questions is yes, global risk assets could light up in the next quarter and potentially beyond. Already EM has outperformed DM assets for a month and some canaries in the coal mine for global growth – like the performance of Swedish economic indicators – signal that the outperformance is real. We are skeptical that the move is sustainable beyond a quarter or two (Chart 6). As our colleague Peter Berezin has highlighted, the market is pricing less than one hike in 2019 (Chart 7). Regardless, the impact on the U.S. dollar, remains muted, with the DXY at 97.04. This suggests that the backing off that the Fed may or may not have already done is still not enough from the perspective of weakening global growth (Chart 8). Global risk assets need more from the Fed than what the market is already pricing. And with U.S. inflationary pressures building (Chart 9), the BCA House View expects to see multiple Fed hikes in 2019, disappointing investors bullish on EM and global risk assets. With our Fed view set by the House View, we therefore turn to where we can add value. To this end, the most important question of 2018 largely remains the same in 2019: How much will China stimulate? Question 1: How Much Will China Stimulate In 2019? China is undoubtedly already stimulating, with a surge in local government bond issuance earlier this year and a bottoming in the broad money impulse (Chart 10). M2 is in positive territory. However, the effort can best be characterized as tepid, with a late-year collapse in bond issuance (Chart 11) and a still-negative total social financing (TSF) impulse (Chart 12). TSF is the broadest measure of private credit in China’s economy. We expect a surge in TSF in Q1, but this is a normal seasonal effect. A typical Q1 credit surge will not be enough to set global risk assets alight for very long, particularly if the market has already priced in as much of a “pause” from the Fed as we are going to get. Investors should specifically focus on new local government bond issuance and whether the “shadow financing” component of TSF gets a bid, since the primary reason for the weakness in TSF over the past year is the government’s crackdown on shadow lending. As Chart 13A & B shows, it was new local government bonds that led the way for stimulus efforts in 2015, followed by a surge in both bank lending and shadow lending in 2016. We would also expect further monetary policy easing, with extra RRR cuts or even a benchmark policy rate cut. However, monetary policy has been easy all year and yet the impact on credit growth has remained muted. This begs two important questions: Is the credit channel impaired? A slew of macroprudential reforms – which we have dubbed China’s “Preemptive Dodd-Frank” – may have impaired the flow of credit in the system. The official policy of “opening the front door, closing the back door” has seen bank loans pick up modestly but shadow lending has been curtailed (Chart 14A & B). This way of controlling the rise of leverage has its costs. For private enterprises – with poor access to the official banking sector – the shadow financial system was an important source of funding over the past several years. Is policy pushing on a string? An even more dire scenario would be if China’s credit channel is not technically, but rather psychologically, impaired. Multiple reasons may be to blame: a negative net return on the assets of state-owned enterprises (Chart 15); widespread trade war worries; mixed signals from policymakers; or a general lack of confidence in the political direction of the country. The rising M2/M1 ratio suggests that the overall economy’s “propensity to save” is rising (Chart 16). Why would Chinese policymakers keep their cool despite a slow pickup in credit growth? Are they not concerned about unemployment, social unrest, and instability? Of course, they are. But Chinese policymakers are not myopic. They also want to improve potential GDP over the long run. Table 1China: The Trend In Domestic Demand, And The Outlook For Trade, Is Negative So far, the economy has weathered the storm relatively well. First, eight out of ten of our China Investment Strategy’s housing price indicators (Table 1) are flat-to-up – although it is true that the October deterioration in floor space started and especially floor space sold (Chart 17) is cause for concern. If and when the housing market weakens further, stimulus will be used to offset it, despite the fact that the government is attempting to prevent a sharp increase in prices at the same time. With so much of China’s middle-class savings invested in the housing market, the key pillar of socio-economic stability is therefore real estate. Second, credit has fueled China’s “old economy,” but policymakers want to buoy “new China” (Chart 18). This means that measures to boost consumption and the service sector economy will be emphasized in new rounds of stimulus, as has occurred thus far (tax cuts, tariff cuts, deregulation, etc). This kind of stimulus is not great news for global risk assets leveraged to “old China,” such as EM and industrial metals. Third, policymakers are not exclusively focused on day-to-day stability but are also focused on the decades-long perseverance of China’s political model. And that means moving away from leverage and credit as the sole fuel for the economy. This is not just about the Middle Income Trap, it is also about national security and ultimately sovereignty. Relying on corporate re-levering for stimulus simply doubles-down on the current economic model, which is still export-oriented given that most investment is geared toward the export sector. But this also means that China will be held hostage to foreign demand and thus geopolitical pressures, a fact that has been revealed this year through the protectionism of the White House. As such, moving away from the investment-led growth model and towards a more endogenous, consumer-led model is not just good macro policy, it makes sense geopolitically as well. Will the trade war – or the current period of trade truce – change Chinese policymakers’ decision-making? We do not see why it would. First, if the trade truce evolves into a trade deal, the expected export shock will not happen (Chart 19) and thus major stimulative measures would be less necessary. Second, if we understand correctly why policymakers have cited leverage as an “ill” in the first place, then we would assume that they would use the trade war as an excuse for the pain that they themselves have instigated. In other words, the trade war with the U.S. gives President Xi Jinping the perfect excuse for the slowdown, one that draws attention from the real culprit: domestic rebalancing. Bottom Line: Since mid-2018, we have been asking clients to focus on our “Stimulus Overshoot” checklist (Table 2). We give the first item – “broad money and/or total credit growth spike” – a premier spot on the list. If a surge in total credit occurs, we will know that policymakers are throwing in the towel and stimulating in a major way. It will be time to turn super-positive on global risk assets, beyond a mere tactical trade, as a cyclical view at that point. Note that if one had gone long EM in early February 2016, when January data revealed a truly epic TSF splurge, one would not have been late to the rally. Table 2Will China’s Stimulus Overshoot In 2019? Our low-conviction view, at the moment, is that the increase in credit growth that we will see in Q1 will be seasonal – the usual frontloading of lending at the beginning of the year – rather than an extraordinary surge that would signal a policy change. A modest increase in credit growth will not be enough to spark a sustainable – year-long – rally in global risk assets. The Fed has already backed off as far as the market is concerned. As such, a pickup in Chinese credit could temporarily excite investors. But global stabilization may only embolden the Fed to refocus on tightening after a Q1 pause. Question 2: Will The Trade War Abate? The first question for investors when it comes to the trade war is “Why should we care?” Sure, trade policy uncertainty appears to have correlated with the underperformance of global equity indices relative to the U.S. (Chart 20). However, such market action was as much caused by our policy divergence story – being as it is deeply negative for EM assets – as by a trade war whose impact on the real economy has not yet been felt. Nonetheless, we do believe that getting the trade war “right” is a big call for 2019. First, while the impact of the U.S.-China trade war has been minimal thus far, it is only because China front-loaded its exports ahead of the expected tariffs, cut interbank rates and RRRs, accelerated local government spending, and allowed CNY/USD to depreciate by 10%. A restart of trade tensions that leads to further tariffs will make frontloading untenable over time, whereas further currency depreciation would be severely debilitating for EMs. We doubt the sustainability of the trade truce for three reasons: U.S. domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues, but not on his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair (Chart 21). In addition, President Trump will walk into the 2020 election with a wider trade deficit, due to his own stimulative economic policy (Chart 22). He will need to explain why he is “losing” on the one measure of national power that he campaigned on in 2016. Structural trade tensions: Ahead of the G20 truce, the U.S. Trade Representative Robert Lighthizer issued a hawkish report that concluded that China has not substantively changed any of the trade practices that initiated U.S. tariffs. Lighthizer has been put in charge of the current trade negotiations, which is a step-up in intensity from Treasury Secretary Steven Mnuchin, who was in charge of the failed May 2018 round. Geopolitical tensions: The G20 truce did not contain any substantive resolution to the ongoing strategic tensions between the U.S. and China, such as in the South China Sea. Beyond traditional geopolitics, tensions are increasingly involving high-tech trade and investment between the two countries and American allegations of cyber theft and spying by China. The recent arrest of Huawei’s CFO in Canada, on an American warrant, will likely deepen this high-tech conflict in the short term. Since the G20 truce with Xi, President Trump has seen no significant pickup in approval ratings (Chart 23). Given that the median American voter has embraced protectionism – against China at least – we would not expect any. Meanwhile, U.S. equities have sold off, contrary to what President Trump, or his pro-trade advisors, likely expected in making the G20 decision to delay tariffs. At some point, President Trump will realize that he risks considerable political capital on a trade deal with China that very few voters actually want or that the U.S. intelligence and defense community supports. Democrats did not oppose his aggressive China policy in the midterm election because they know that the median voter does not want it. As such, it is guaranteed that Trump’s 2020 Democratic Party opponent will accuse him of “surrender,” or at least “weakness.” If, over the next quarter, the economic and market returns on his gambit are paltry, we would expect President Trump to end the truce. Furthermore, we believe that a substantive, and long-lasting, trade deal is unlikely given the mounting tensions between China and the U.S. These tensions are not a product of President Trump, but are rather a long-run, structural feature of the twenty-first century that we have been tracking since 2012.1 Tensions are likely to rise in parallel to the trade talks on the technology front. We expect 2019 to be the year when investors price in what we have called Bifurcated Capitalism: the segmentation of capital, labor, and trade flows into geopolitically adversarial – and yet capitalist in nature – economic blocs. Entire countries and sectors may become off-limits to Western investors and vice-versa for their Chinese counterparts. Countries will fall into either the Tencent and Huawei bloc or the Apple and Ericsson bloc. This development is different from the Cold War. Note our emphasis on capitalism in the term Bifurcated Capitalism. The Soviet Union was obviously not capitalist, and clients of BCA did not have interests in its assets in the 1970s and 1980s. Trade between Cold War economic blocs was also limited, particularly outside of commodities. The closest comparison to the world we now inhabit is that of the nineteenth century. Almost all global powers were quite capitalist at the time, but they engaged in imperialism in order to expand their economic spheres of influence and thus economies of scale. In the twenty-first century, Africa and Asia – the targets of nineteenth century imperialism – may be replaced with market share wars in novel technologies and the Internet. This will put a ceiling on how much expansion tech and telecommunication companies can expect in the competing parts of Bifurcated Capitalism. The investment consequences of this concept are still unclear. But what is clear is that American policymakers are already planning for some version of the world we are describing. The orchestrated effort by the U.S. intelligence community to encourage its geopolitical allies to ban the use of Huawei equipment in their 5G mobile networks suggests that there are limits to the current truce ever becoming a sustainable deal. So does the repeated use of economic sanctions originally designed for Iran and Russia against Chinese companies. President Trump sets short- and medium-term policies given that he is the president. However, the intelligence and defense communities have “pivoted to Asia” gradually since 2012. This shift has occurred because the U.S. increasingly sees China as a peer competitor, for the time being confined in East Asia but with intentions of projecting power globally. To what extent could President Trump produce a trade deal with Xi that also encompasses a change in the U.S. perception of China as an adversary? We assign a low probability to it. As such, President Xi has little reason to give in to U.S. pressure on trade, as he knows that the geopolitical and technology pressure will continue. In fact, President Xi may have all the reason to double-down on his transformative reforms, which would mean more pain for high-beta global plays. Bottom Line: What may have appeared as merely a trade conflict has evolved into a broad geopolitical confrontation. President Trump has little reason to conclude a deal with China by March. Domestic political pressures are not pushing in the direction of the deal, while America’s “Deep State” is eager for a confrontation with China. Furthermore, with President Trump “blinking” on Iranian sanctions, his administration has implicitly acknowledged the constraints discouraging a deeper involvement in the Middle East. This puts the geopolitical focus squarely on China. Question 3: Is Europe a Black Swan or a Red Herring? The last two years have been a dud in Europe. Since the Brexit referendum in mid-2016, European politics have not been a catalyst for global markets, save for an Italy-induced sell-off or two. This could substantively change in 2019. And, as with the first two questions, the results could be binary. On one hand, there is the positive scenario where the stalled and scaled-back reforms on the banking union and Euro Area budget get a shot in the arm in the middle of the year. On the other hand, the negative scenario would see European-wide reforms stall, leaving the continent particularly vulnerable as the next global recession inevitably nears. At the heart of the binary distribution is the broader question of whether populism in Europe is trending higher. Most commentators and our clients would say yes, especially after the protests and rioting in Paris over the course of November. But the answer is more complicated than that. While populists have found considerable success in the ballot box (Chart 24), they have not managed to turn sentiment in Europe against the currency union (Chart 25). Even in Italy, which has a populist coalition government in power, the support for currency union is at 61%, the highest since 2012. This number has apparently risen since populists took over. What explains this divergence? Effectively, Europe’s establishment parties are being blamed for a lot of alleged ills, liberal immigration policy first amongst them. However, European integration remains favored across the ideological spectrum. Few parties that solely focus on Euroskepticism have any chance of winning power, something that both Lega and Five Star Movement found out in Italy. Italy’s Deputy Prime Minister Matteo Salvini confirmed his conversion away from Euroskepticism by stating that he wants to “reform the EU from the inside” and that it was time to give the “Rome-Berlin axis” another go.2 Salvini is making a bet – correct in our view – that by moderating Lega’s populism on Europe, he can capture the center ground and win the majority in the next Italian election, which could happen as soon as 2019. As such, we don’t think that the “rise of populism” in Europe is either dramatic or market-relevant. In fact, mainstream parties are quickly adopting parts of the anti-establishment agenda, particularly on immigration, in a bid to recoup lost voters. A much bigger risk for Europe than populism is stagnation on the reform front, a perpetual Eurosclerosis that leaves the bloc vulnerable in the next recession. What Europe needs is the completion of a backstop to prevent contagion. Such a backstop necessitates greatly enhancing the just-passed banking union reforms. The watered-down reforms did not include a common backstop to the EU’s single resolution fund nor a deposit union. A working group will report on both by June 2019, with a potential legislative act set for some time in 2024. What could be a sign that the EU is close to a grand package of reforms in 2019? We see three main avenues. First, a political shift in Germany. Investors almost had one, with conservative Friedrich Merz coming close to defeating Merkel’s hand-picked successor Annegret Kramp-Karrenbauer (also known as AKK) for the leadership of the ruling Christian Democratic Union (CDU). Merz combined a right-leaning anti-immigrant stance with staunch pro-European integration outlook. It is unclear whether AKK will be willing to make the same type of “grand bargain” with the more conservative factions of the CDU electorate. However, AKK may not have a choice, with both Alternative for Germany (AfD) and the Green Party nibbling at the heels of the right-of-center CDU and left-of-center Social-Democratic Party (SPD) (Chart 26). The rise of the Green party is particularly extraordinary, suggesting that a larger portion of the German electorate is radically Europhile rather than Euroskeptic. AKK may have to adopt Merz’s platform and then push for EU reforms. Second, French President Emmanuel Macron may have to look abroad for relevance. With his reform agenda stalled and political capital drained, it would make sense for Macron to spend 2019 and beyond on European reforms. Third, a resolution of the Brexit debacle. The longer the saga with the U.K. drags on, the less focus there will be in Europe on integration of the Euro Area. If the U.K. decides to extend the current negotiating period, it may even have to hold elections for the European Parliament. As such, we are not focusing on the budget crisis in Italy – our view that Rome is “bluffing” is coming to fruition –or a potential early election in Spain. And we are definitely not focusing on the EU Parliamentary election in May. These will largely be red herrings. The real question is whether European policymakers will finally have a window of opportunity for strategic reforms. And that will require Merkel, AKK, and Macron to expend whatever little political capital they have left and invest it in restructuring European institutions. Finally, a word on Europe’s role in the global trade war. While Europe is a natural ally for the U.S. against China – given its institutional connections, existing alliance, and trade surplus with the latter and deficit with the former (Chart 27) – we believe that the odds are rising of a unilateral tariff action by the U.S. on car imports. This is because the just-concluded NAFTA deal likely raised the cost of vehicle production in the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. The Trump administration may not have the stomach for a long-term trade war with Europe, but it can shake up the markets with actions in that direction. Bottom Line: In the near term, there are no existential political risks in Europe in 2019. As such, investors who are bullish on European assets should not let geopolitics stand in the way of executing on their sentiment. We remain cautious for macroeconomic reasons, namely that Europe is a high-beta DM play that needs global growth to outperform in order to catch a bid. However, 2019 is a make-or-break year on key structural reforms in Europe. Without more work on the banking union – and without greater burden sharing, broadly defined – the Euro Area will remain woefully unprepared for the next global recession. Question 4: Will Brexit Happen? Given the volume of market-relevant geopolitical issues, we have decided to pose (and attempt to answer) five additional questions for 2019. We start with Brexit. Prime Minister Theresa May has asked for a delay to the vote in the House of Commons on the Withdrawal Treaty, which she would have inevitably lost. The defeat of the subsequent leadership challenge is not confidence-inspiring as the vote was close and a third of Tory MPs voted against her. May likely has until sometime in January to pass the EU Withdrawal Agreement setting out the terms of Brexit, given that all other EU member states have to get it through their parliaments before the Brexit date on March 29. The real question is whether any deal can get through Westminster. The numbers are there for the softest of soft Brexits, the so-called Norway+ option where the U.K. effectively gets the same deal as Norway, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to pay essentially for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election – which may usher the even less pro-Brexit Labour Party into power – or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the delay signals that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear: the median voter is turning forcefully towards Bremain (Chart 28). It will soon become untenable to delay the second referendum. And even if the House of Commons passes the softest of Soft Brexit deals, we expect that the Norway+ option will prove to be unacceptable when Westminster has to vote on it again in two or three year’s time. Is it time to buy the pound, particularly cable, which is cheap on a long-term basis (Chart 29)? It is a tough call. On one hand, our confidence that the U.K. ultimately has to remain in the EU is rising. However, to get there, the U.K. may need one last major dose of volatility, either in the form of a slow-burn crisis caused by Tory indecision or in the form of a far-left Labour government that tries its own hand at Brexit while pursuing a 1970s style left-wing economic agenda. Can any investor withstand this kind of volatility in the short and potentially long-ish term? Only the longest of the long-term investors can. Question 5: Will Oil Prices Rally Substantively In 2019? Several risks to oil supply remain for 2019. First, there is little basis for stabilization in Venezuelan oil production, and further deterioration is likely (Chart 30). Second, sectarian tensions in Iraq remain unresolved. Third, supply risks in other geopolitical hot spots – like Nigeria and Libya – could surprise in 2019. The most pressing geopolitical issue, however, is a decision on the Iranian sanction waivers. President Trump induced considerable market-volatility in 2019 by signaling that he would use “maximum pressure” against Iran. As a result, the risk premium contribution to the oil price – illustrated in Chart 31 by the red bar – rose throughout 2018, only to collapse as the White House offered six-month sanction waivers. Not only did the risk premium dissipate, but Saudi Arabia then scrambled to reverse the production surge it had instituted to offset the Iran sanctions. We agree with BCA’s Commodity & Energy Strategy that oil market fundamentals are tight and numerous supply risks loom. We also struggle to see why President Trump will seek to pick a fight with Iran in the summer of 2019. Our suspicion is that if President Trump was afraid of a gasoline-price spike right after the midterm election, why would he not “blink” at the end of the spring? Not only will the U.S. summer driving season be in full swing – a time of peak U.S. gasoline demand – but the 2020 election primaries will only be six months away. Furthermore, it is highly unlikely that OPEC and Russia will do the U.S. president’s bidding by turning on the taps to offset any unforeseen supply losses in 2019. They did not do so even when President Trump asked, very nicely, ahead of the just-concluded Vienna meeting. Once Trump prioritized domestic politics over Saudi geopolitical interests – by backing away from his maximum pressure tactic against Iran – he illustrated to Riyadh that his administration is about as reliable of an ally as the Obama White House. Meanwhile, his ardent defense of Riyadh in the Khashoggi affair, at a cost of domestic political capital, means that he lost the very leverage that he could have used to pressure Saudi Arabia. We therefore remain cautiously bullish on oil prices in 2019, but with the caveat that a big-bang surge in prices due to a U.S.-Iran confrontation – our main risk for 2019 just a few months ago – is now less likely. Question 6: Will Impeachment Become A Risk In 2019? While we have no way to forecast the Mueller investigation, it is undoubtedly clear that risks are rising on the U.S. domestic front. President Trump’s popularity among GOP voters is elevated and far from levels needed to convince enough senators to remove him from power (Chart 32). However, a substantive finding by Mueller may leave the moderate Democrats in the House with no choice but to pursue impeachment. This may rattle the market for both headline and fundamental reasons. The headline reasons are obvious. The fundamental reasons have to do with the looming stimulus cliff in 2020. A pitched battle between the House Democrats and the White House would make cooperation on another substantive stimulus effort less likely and thus a recession in 2020 more likely. The market may start pricing in such an outcome at some point in 2019. Furthermore, sentiment could be significantly impacted by a protracted domestic battle that impairs Trump’s domestic agenda. President Bill Clinton sought relevance abroad amidst his impeachment proceedings by initiating an air war against Yugoslavia. President Trump may do something similar. There is also an unclear relationship between domestic tensions and trade war. On one hand, President Trump may want a clear win and so hasten a deal. On the other hand, he may want to extend the trade war to encourage citizens to “rally around the flag” and show his geopolitical mettle amidst a distracting “witch hunt.” While we have faded these domestic risks in 2017 and 2018, we think that it may be difficult to do so in 2019. We stick by our view that previous impeachment bouts in the U.S. have had a temporary effect on the markets. But if market sentiment is already weakened by global growth and end of cycle concerns, a political crisis may become a bearish catalyst. Question 7: What About Japan? Japan faces higher policy uncertainty in 2019, after a period of calm following the 2015-16 global turmoil. We expect to see “peak Shinzo Abe” – in the sense that after this year, his political capital will be spent and all that will remain will be for him to preside over the 2020 Tokyo Olympics. The primary challenge for Abe is getting his proposed constitutional revisions passed despite economic headwinds. Assuming he goes forward, he must get a two-thirds vote in both houses of parliament plus a majority vote in a popular referendum. The referendum is unscheduled but could coincide with the July upper house elections. This will be a knife’s edge vote according to polling. If he holds the referendum and it passes, he will have achieved the historic goal of making Japan a more “normal” country, i.e. capable of revising its own constitution and maintaining armed forces. He will never outdo this. If he fails, he will become a lame duck – if he does not retire immediately like David Cameron or Matteo Renzi. And if he delays the revisions, he could miss his window of opportunity. This uncertain domestic political context will combine with China/EM and trade issues that entail significant risks for Japan and upward pressure on the yen. Hence government policy will resume its decidedly reflationary tilt in 2019. It makes little sense for Abe, looking to his legacy, to abandon his constitutional dream while agreeing to raise the consumption tax from 8% to 10% as expected in October. We would take the opposite side of the bet: he is more likely to delay the tax hike than he is to abandon constitutional revision. If Abe becomes a lame duck, whether through a failed referendum, a disappointing election, or a consumption tax hike amid a slowdown, it is important for investors to remember that “Abenomics” will smell just as sweet by any other name. Japan experienced a paradigm shift after a series of “earthquakes” from 2008-12. No leader is likely to raise taxes or cut spending aggressively, and monetary policy will remain ultra-easy for quite some time. The global backdrop is negative for Japan but its policy framework will act as a salve. Question 8: Are There Any Winners In EM? We think that EM and global risk assets could have a window of outperformance in early 2019. However, given the persistence of the policy divergence narrative, it will be difficult to see EM substantively outperforming DM over the course of 2019. Mexico Over Brazil That said, we do like a few EM plays in 2019. In particular, we believe that investors are overly bullish on Brazil and overly bearish on Mexico. In both countries, we think that voters turned to anti-establishment candidates due to concerns over violence and corruption. However, Brazilian President-elect Jair Bolsonaro has a high hurdle to clear. He must convince a traditionally fractured Congress to pass a complex and painful pension reform. In other words, Bolsonaro must show that he can do something in order to justify a rally that has already happened in Brazilian assets. In Mexico, on the other hand, Mexican President Andrés Manuel López Obrador (AMLO) remains constrained by the constitution (which he will be unable to change), the National Supreme Court of Justice, and political convention that Mexico is right-of-center on economic policy (an outwardly left-wing president has not won an election since 1924). In other words, AMLO has to show that he can get out of his constraints in order to justify a selloff that has already happened. To be clear, we are not saying that AMLO is a positive, in the absolute, for Mexico. The decision to scrap the Mexico City airport plans, to sideline the finance ministry from key economic decisions, and to threaten a return to an old-school PRI-era statism is deeply concerning. At the same time, we are not of the view that Bolsonaro is, in the absolute, a negative for Brazil. Rather, we are pointing out that the relative investor sentiment is overly bullish Bolsonaro versus AMLO. Especially given that both presidents remain constrained by domestic political intricacies and largely campaigned on the same set of issues that have little to do with their perceived economic preferences. They also face respective median voters that are diametrically opposed to their economic agendas – Bolsonaro, we think, is facing a left-leaning median voter, whereas the Mexican median voter is center-right. The macroeconomic perspective also supports our relative call. If our view on China and the Fed is correct, high-beta plays like Brazil will suffer, while an economy that is tied-to-the-hip of the U.S., like Mexico, ought to outperform EM peers. As such, we are putting a long MXN/BRL trade on, to capture this sentiment gap between the two EM markets. Investors will be receiving positive carry on Mexico relative to Brazil for the first time in a long time (Chart 33). The relative change in the current account balance also favors Mexico (Chart 34). Finally, the technicals of the trade look good as well (Chart 35). South Korea Over Taiwan Diplomacy remains on track on the Korean peninsula, despite U.S.-China tensions in other areas. Ultimately China believes that peace on the peninsula will remove the raison d’être of American troops stationed there. Moreover, Beijing has witnessed the U.S.’s resolve in deterring North Korean nuclear and missile tests and belligerent rhetoric. It will want to trade North Korean cooperation for a trade truce. By contrast, if Trump’s signature foreign policy effort fails, he may well lash out. We view deeply discounted South Korean equities as a long-term buy relative to other EMs. Taiwan, by contrast, is a similar EM economy but faces even greater short-term risks than South Korea. In the next 13-month period, the Tsai Ing-wen administration, along with the Trump administration, could try to seize a rare chance to upgrade diplomatic and military relations. This could heighten cross-strait tensions and lead to a geopolitical incident or crisis. More broadly, U.S.-China trade and tech tensions create a negative investment outlook for Taiwan. Thailand Over India Five state elections this fall have turned out very badly for Prime Minister Narendra Modi and his National Democratic Alliance (NDA). These local elections have a negative impact, albeit a limited one, on Modi’s and the NDA’s reelection chances in the federal election due in April (or May). Nevertheless, it is entirely possible to lose Chhattisgarh, Madhya Pradesh, and Rajasthan while still winning a majority in the Lok Sabha – this is what happened to the Indian National Congress in 2004 and 2009. So far federal election opinion polling suggests anything from a hung parliament to a smaller, but still substantial, BJP majority. Modi was never likely to maintain control of 20 out of 29 states for very long, nor to repeat his party’s sweeping 2014 victory. He was also never likely to continue his reform push uninhibited in the lead up to the general election. Nevertheless, the resignation of Reserve Bank of India Governor Urjit Patel on December 10 is a very worrisome sign. Given that Indian stocks are richly valued, and that we expect oil prices to drift upwards, we remain negative on India until the opportunity emerges to upgrade in accordance with our long-term bullish outlook. By contrast, we see the return to civilian rule in Thailand as a market-positive event in the context of favorable macro fundamentals. Thai elections always favor the rural populist “red” movement of the Shinawatra family, but presumably the military junta would not hold elections if it thought it had not sufficiently adjusted the electoral system in favor of itself and its political proxies. Either way, the cycle of polarization and social unrest will only reemerge gradually, so next year Thailand will largely maintain policy continuity and its risk assets will hold up better than most other EMs. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?” dated March 28, 2017, available at gps.bcaresearch.com. 2 Yes. He literally said that. Geopolitical Calendar
Highlights The delay to the U.K. parliamentary vote on the current Brexit deal has edged up our assessed probability of no-deal to 20 percent. Our probability-weighted value of the GBP is still around 5 percent higher than today. Nevertheless, the optimal moment to buy the GBP lies ahead, as the Brexit catharsis cannot properly begin until the U.K. parliament expresses its will. Following the recent 35 percent plunge in the crude oil price, both headline and core inflation rates are very likely to fade in the coming months, but this fading is going to be less pronounced in Europe than in the United States. These relative inflation dynamics should give EUR/USD a leg up in 2019. But given the euro area’s connection with the U.K., await more clarity on Brexit before committing to EUR/USD. Chart of the WeekThe Pound Has Decoupled From British Public Opinion On Brexit Feature Please note this report was written before the outcome of Conservative MPs vote of no confidence in Theresa May held on the evening of December 12. To assess the impact of Brexit on the financial markets, we are going to turn to a fundamental concept in physics – the concept of a ‘phase transition’. In physics, a phase transition is a disruptive tipping point at which a body transforms from one state into another. The classic example is when water transforms into ice. If the temperature drops from 10 degrees (Celsius) to a degree or so lower, you will experience no discernible difference in water. Even if the temperature drops to 2 degrees, the difference is only slight. But if the temperature drops to minus 2 degrees, water transforms into ice – and you will experience a huge difference as roads freeze over, pipes burst, and so on… Beware A Sudden Phase Transition We can draw a powerful analogy for how the various forms of Brexit would impact the British economy and financial markets. If the current membership of the EU equates to water at 10 degrees, a ‘Norway plus’ arrangement – European Economic Area (EEA) plus a customs union – might be a temperature only a degree or so lower, a barely noticeable difference. The Brexit deal negotiated by Theresa May (or an amended version of it) might be a temperature of 2 degrees, so a somewhat discernible change. But crashing out of the EU to WTO trading rules would equate to minus 2 degrees, or lower. This Brexit would be hard (Chart I-2). Its properties would be very different. Chart I-2Goods Still Dominate U.K. Exports Also important is the speed of the phase transition. If winter arrives gradually, over the course of several weeks, we can generally prepare, and adapt our behaviour and habits. Thereby, we can even enjoy and thrive in a new climate. But if winter arrives overnight, it causes severe disruption and suffering.1 As Brexit reaches its denouement, the options for the future EU/U.K. relationship – full membership of the EU, a ‘Norway plus’ arrangement, the Brexit deal negotiated by Theresa May, or complete and overnight detachment – are each quite differentiated from the perspective of politics and law. For example, EEA plus a customs union is politically sub-optimal compared with the U.K.’s current full membership of the EU which includes the bonus of precious legal opt-outs. However, from the perspective of an investor in the markets, the first three types of arrangement are not really that different (Chart I-3). Only the last type – complete and overnight detachment from the EU – constitutes a severely disruptive phase transition. Chart I-3For Investors, Brexit Simplifies To A Binary Outcome For Investors, Brexit Simplifies To A Binary Outcome We can simplify the various Brexit possibilities into a binary investment outcome: The complete and overnight detachment ‘no-deal’ outcome – in which GBP/EUR would collapse to below parity. All other outcomes – in which GBP/EUR would initially rally through 1.20, by liberating the BoE to remove its precautionary monetary policy (Chart I-4 and Chart I-5). Chart I-4U.K. Economic Fundamentals... Chart I-5...Would Require Higher U.K. Interest Rates Absent The Risk Of A No-Deal Brexit This makes the key question: what is the probability of no-deal? No-deal is the default outcome if a deal or extension to the Article 50 process is not agreed (by both sides) before March 29 2019. Therefore no-deal can happen either if: The U.K. parliament cannot coalesce a majority around a course of action that is also acceptable to the EU27. Or if: The Prime Minister and government – the executive branch – ignores the will of parliament and runs down the clock to no-deal regardless. Looking at the parliamentary arithmetic, it is conceivable that a majority could exist for either ‘Norway plus’, or a new referendum, or no confidence in the current government leading to a general election. As for the Prime Minister ignoring the will of parliament, this is legally possible though politically improbable. Nevertheless, the Article 50 clock is running down. The delay to the parliamentary vote on the current deal, possibly until January 21, has edged up our assessed probability of no-deal to 20%, slightly reducing our probability-weighted value of GBP/EUR to 1.175.2 On a one year horizon, this still offers respectable upside for the GBP versus the EUR or the USD (Chart of the Week). But the Brexit catharsis cannot properly begin until parliament gets a chance to express its will, meaning that the optimal moment to buy the pound still lies ahead. Explaining Central Banks’ Obsession With 2 Percent Inflation Back in 1979, Daniel Kahneman and Amos Tversky formalized a new branch of behavioural finance called Prospect Theory, which would ultimately win Kahneman the Nobel Prize for Economics. One of the key findings of Prospect Theory is that we are incapable of distinguishing the meaning of very small numbers. In the case of price inflation, we cannot really distinguish inflation rates between 0 percent and 2 percent. Anything within this range is indistinguishably perceived as ‘price stability’. Given that we cannot distinguish inflation rates between 0 percent and 2 percent, it is impossible for monetary policy to fine-tune our inflation expectations to a point-target such as 2 percent. And given that it is impossible to fine-tune our inflation expectations, it is also impossible to fine-tune inflation itself to a point-target such as 2 percent. Prospect Theory says it is much wiser to define price stability in terms of an inflation range such as 0-2 percent, because this is how we actually perceive price stability (Chart I-6). But despite this compelling Nobel Prize winning academic evidence, central banks remain obsessed with an inflation point-target, most commonly 2 percent. Why? Chart I-6Price Stability Means An Inflation Range Of 0-2 Percent, Not A Point-Target The reason is that central banks have created a rod for their own back. Once a central bank has staked its credibility in terms of impossibly precise ‘data-dependency’ – such as an inflation point-target – it becomes extremely difficult to move the goalposts without risking accusations of bias, partiality and exceptionalism. Future generations will judge the inflation point-target as one of the monumental errors of early twenty-first century economic policy. But for the time-being this flawed policy will nonetheless govern central bank behaviour, and as investment strategists we must see it in that light. Following the recent 35 percent plunge in the crude oil price, both headline and core inflation rates are very likely to fade. But this fading is going to be less pronounced in Europe compared with the United States (Chart I-7 and Chart I-8). The main reason is that tax rates on fuel are much higher in Europe compared with the United States, and this attenuates the proportionate pass-through into European retail fuel prices from lower (or higher) oil prices. Chart I-7The Connection Between Falling Oil Inflation And Falling Core CPI Inflation Is Weak In Europe... Chart I-8...But Strong In The U.S The ECB has, in any case, committed to keep its policy rates on hold for most of 2019. By contrast, the Fed has been on a one hike per quarter tightening path. Hence, relative to this behaviour, the surprise could be that the Fed indicates an open-ended pause in its tightening. Even if this is discounted to some extent, weak prints on reported inflation in the coming months could still move the rates and currency markets. After a spectacular gain for the EUR in 2017, our stance turned broadly neutral in early 2018 by adding a short position in EUR/JPY to counterbalance a 50:50 long position in EUR/USD and SEK/USD. Overall, this has proved to be a successful strategy (Chart I-9). Chart I-9The Euro Consolidated In 2018. Another Leg-Up Is Likely In 2019 Looking ahead to the first half of 2019, the aforementioned relative inflation dynamics should give EUR/USD another leg up. But given the euro area’s connection with the U.K., await more clarity on Brexit before committing to EUR/USD. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week, we have spotted an excellent tactical opportunity in EUR/NZD which is at a technical level that has signaled several previous tuning points. On this basis, the recommended trade is long EUR/NZD setting a profit target of 2.5% with a symmetrical stop-loss. In other trades, long EM versus DM achieved its profit target while long banks versus healthcare reached the end of its 65 day holding also in profit. Against this, long nickel versus palladium and short Australian telecoms versus insurance both reached their stop-losses. This leaves two open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: 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. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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 Footnotes 1 This analogy can also apply to the arrival of spring. If the spring thaw arrives in one day, the consequent severe flooding can also cause terrible disruption and suffering. 2 1.225*0.8 + 0.98*0.2 Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades 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
Highlights The relative performance of developed market (DM) versus emerging market (EM) equities just corresponds to the relative performance of healthcare versus financials. On a six month horizon, DM will underperform EM. Within Europe, overweight Poland, Hungary and Czech Republic, but steer clear of energy-heavy Russia. Wait for the 10-year BTP yield to move closer to 3 percent before buying Italian assets, either in absolute or relative terms. Buy the pound on any sharp sell-offs during the Brexit psychodrama. Our medium-term expected value of pound/euro equals 1.18. Chart of the WeekDeveloped Vs. Emerging Markets = Healthcare Vs. Financials Feature They say that to capture the Zeitgeist at any moment, all you need to do is name the top five companies in the world. So here are the top five companies in the developed equity markets (DM): Apple, Microsoft, Google, Amazon, and Facebook (Table I-1). Table I-1Developed Markets: Top 5 Companies These five names do perfectly capture the spirit of our time and should not surprise you. Now look at the top five companies in the emerging equity markets (EM): Tencent, Taiwan Semiconductor, Samsung Electronics, Alibaba, and Naspers (Table I-2). Table I-2Emerging Markets: Top 5 Companies What may surprise you is that technology titans dominate in EM markets too. In fact, the technology sector's weighting in EM, at 25 percent, is even larger than in DM, at 19 percent. If technology looms even larger in EM than in DM, what is the defining sector difference between the two regions? The answer is that emerging markets have almost no healthcare stocks, and an offsetting substantial overweighting to financials (Table I-3). Table I-3Developed Markets Versus Emerging Markets: Sector Weights Developed Vs. Emerging Markets = Healthcare Vs. Financials The following is a very different way of looking at the DM versus EM investment decision and, as such, may differ from the BCA house view. As we have demonstrated time and time again on these pages, an equity market's dominant sector skew is of critical importance to investors (Chart I-2). This is because equity sector skews almost always drive regional and country relative performance. Crucially, this fundamental truth applies at the highest level too: the relative performance of DM versus EM. The Chart of the Week should leave you in absolutely no doubt that the relative performance of DM versus EM just corresponds to the relative performance of healthcare versus financials. Chart I-2Developed Versus Emerging Markets: Sector Weight Differences Nevertheless, this striking observation raises a fascinating question: what is the direction of causality? Does healthcare versus financials drive DM versus EM, or in fact does DM versus EM drive healthcare versus financials? The answer is sometimes the former, and at other times the latter. For example, a major slump in emerging economies would undoubtedly drag down global equities. In the ensuing synchronized bear market, the more defensive healthcare sector would almost certainly outperform the financials, and under these circumstances the direction of causality would clearly be from DM versus EM to global sector performance. On the other hand, absent a major bear market, if a reappraisal of sector relative valuations and growth prospects caused a rotation in sector leadership, the causality would run in the other direction: from global sector performance to DM versus EM. Such a reappraisal of sector relative valuations and growth prospects appears to be underway at the moment, and is likely to persist for the next few months. This is because the very sharp down-oscillation in global credit growth which occurred from February through September has now clearly flipped into an up-oscillation. For investors, these oscillations in global credit growth provide excellent tactical opportunities because the oscillations are very regular and therefore predictable; and the cyclical versus defensive sector performance closely tracks the oscillations. So after healthcare's strong outperformance versus financials from February through September, sector relative performance has now flipped into a reverse configuration (Chart I-3). Chart I-3An Up-Oscillation In Global Credit Growth Technically Favours Financials To be clear, this is likely a tactical opportunity lasting no more than six months or so. Nevertheless, from a DM versus EM perspective, it would imply a countertrend move within a structural trend - in which the outperformance of DM versus EM temporarily ends, or even flips into an underperformance (Chart I-4). Chart I-4An Up-Oscillation In Global Credit Growth Technically Favours EM For European equity investors, the important implication is that developed Europe versus emerging Europe closely tracks broad DM versus broad EM (Chart I-5). Of course, 'emerging Europe' is a misnomer because Poland, Hungary, Czech Republic, and even Russia are developed economies and markets. Nevertheless, as they fall within the MSCI EM index, they tend to move with EM. Chart I-5Developed Europe Vs. Emerging Europe = Developed Markets Vs. Emerging Markets The upshot is that on a tactical horizon, emerging Europe is likely to outperform developed Europe. However, given our high conviction view that non-energy commodities will continue to outperform energy, focus on Poland, Hungary and Czech Republic and steer clear of energy-heavy Russia. European Psychodrama 1: Italy Vs. The EU In the low-level game of chicken between Italy and the EU Commission over Italy's 2019 budget, the bond market will determine who swerves first. If the 10-year BTP yield rises and stays well above 4 percent, the weakened capital position of Italian banks from lower bond prices combined with deteriorating funding conditions will weigh on bank lending and economic growth. This will put pressure on the Italian government to swerve first and concede ground to the EU's demands. That said, it is hard to know the exact level of yields at which the government would reach its pain threshold. On the other hand, if the 10-year BTP yield falls and stays well below 3 percent, the bond market's insouciance would embolden the Italian government. Moreover, this apparent vote of confidence would be based on sound economics. Italy likely has a very high fiscal multiplier, meaning that a modest increase in its budget deficit to 2.4 percent would more than pay for itself through higher economic growth. Under these circumstances the EU would be under pressure to swerve first and give Italy some room for manoeuvre. The long-term investment opportunity is the Italy versus Spain sovereign 10-year yield spread. At 200 bps, the spread is at its all-time widest, and incongruous with the vanishing gap between the non-performing loans ratios in Italy and Spain. Nevertheless, our recommendation is to wait for the 10-year BTP yield to move closer to 3 percent before buying Italian assets, either in absolute or relative terms (Chart I-6). Chart I-6Remain Neutral Italian Assets Until The 10-Year BTP Yield Moves Closer To 3 Percent European Psychodrama 2: Brexit In the psychodrama called Brexit, every new plot twist and turn has the potential to move the pound up or down by a few cents in a day. The next such major twist is the passage of the withdrawal bill through the U.K. parliament in early December. The ultra Brexiteer Conservative MPs and Northern Ireland Unionists will almost certainly vote against the agreement that Theresa May has forged with Brussels. This is because the agreement conjures up the Brexiteers' worst nightmare: a potentially indefinite customs union with the EU27, making it impossible for the U.K. to strike free trade deals with the rest of the world. Hence, for Theresa May to get her agreement through parliament, she will require the support of a substantial number of Labour MPs. But the substantial numbers just aren't there. The upshot is that she is likely to lose the vote, at which point the pound will tumble. For medium-term investors, this would be the moment to buy the pound, and we now explain why. On a six month horizon, the crucial question is: what will happen when the Article 50 process for the U.K. to leave the EU expires at 11pm on March 29, 2019? There are only three possibilities: 1. The U.K. doesn't leave the EU. At this advanced stage on the timeline, not leaving the EU on March 29 2019 effectively means an extension of the Article 50 process. This would require the U.K. to apply for an extension, and for the EU27 to agree to it. But realistically, the EU27 would only agree to it to facilitate a general election and/or a second referendum which could reverse Brexit. Probability = 45%. With the parliamentary arithmetic pointing to a rejection of May's Brexit deal as it stands, an amendment to the withdrawal bill forcing a second referendum, or a lost vote of no confidence in the government could lead to this outcome. Pound/euro = 1.20, because of the realistic prospect of reversing Brexit (Chart I-7). Chart I-7British Public Opinion On Brexit Is Shifting 2. The U.K. enters a transition period to leave the EU with a negotiated agreement. Theresa May's proposed withdrawal deal, or a variation of it, is approved by the U.K parliament (and the EU27) Probability = 45%. Appropriate amendments to the withdrawal agreement might sufficiently reduce the parliamentary rebellion. Pound/euro = 1.20 because the removal of the 'no deal' outcome would liberate the BoE to hike interest rates. 3. The U.K. crashes out of the EU with 'no deal'. Probability = 10%. This outcome would be the result of a gridlock in the U.K. parliament, with no majority formed for any Brexit strategy. Unlikely, but not impossible. Pound/euro = 1.00 because the U.K. economy would face months of severe disruption and uncertainty. Based on these three possible outcomes on March 29 2019, our expected value of pound/euro equals 1.18. Meaning that any sharp sell-off during the ongoing psychodrama constitutes a medium-term buying opportunity. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* Supporting the thesis in the main body of this report, the 130-day fractal dimension of EM versus DM recently hit its lower bound, suggesting an oversold extreme and a likely countertrend move. For a short-term trade, position for a 2.5% profit with a symmetrical stop-loss. In other trades, long Portugal / short Hungary hit its stop-loss and is closed, leaving four open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 The post-June 9, 2016 fractal trading model rules are: 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. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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 Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades 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
Highlights The long term direction for the pound is higher... ...but as the EU withdrawal bill passes through the U.K. parliament, expect a very hairy ride. The stock markets in Norway, Sweden and Denmark are driven by energy, industrials, and biotech respectively. Upgrade Sweden to neutral and downgrade Denmark to underweight. Think of semiconductors as twenty-first century commodities. Overweight the semiconductor sector versus broader technology indexes. Chart of the WeekBritish Public Opinion On Brexit Is Shifting Feature The Brexit drama is playing out exactly as scripted (Chart I-2). Chart I-2The Pound Is Following The Brexit Drama In July, we wrote: "The U.K. government's much hyped 'Chequers' proposal for Brexit risks getting a cold shower... the EU27 will almost instantaneously reject the proposed division between goods and services as 'cherry-picking' from its indivisible four freedoms - goods, services, capital, and people... the rejection will be based not just on the EU's founding principles, but also on the practical realities of a modern economy - specifically, the distinction between goods and services has become increasingly blurred." 1 Hence, the Chequers proposal to avoid a hard border between Northern Ireland and the Irish Republic is just wishful thinking: "The Irish border trilemma will remain unsolved, leaving a 'backstop' option of Northern Ireland remaining in the EU single market - an outcome that will be politically unpalatable." 2 What happens next? Understanding Brexit In a sense, Brexit is very simple. The EU27 sees only three options for the long-term political and economic relationship between the U.K. and the EU. Remain in the EU (no Brexit). Plug into an off-the-shelf setup, either the European Economic Area (EEA), European Free Trade Association (EFTA), or a permanent customs union, which already establish the EU relationship with Norway, Iceland, Liechtenstein, and Switzerland (soft Brexit). Become a 'third country' to the EU like, for example, Canada (hard Brexit). The first option, to stay in the EU, is politically impossible unless a new U.K. referendum overturned the original referendum's vote to leave. The second option, to join the EEA, EFTA, or permanent customs union is very difficult for Theresa May - because it is strongly opposed by many of the Conservative government's ministers and members of parliament who regard the option as 'Brino' (Brexit in name only). However, in a significant recent development, the opposition leader Jeremy Corbyn has committed the Labour party to a Brexit that keeps the U.K. in a permanent customs union.3 The third option, to become a 'third country', would very likely require some sort of border in Ireland. As already discussed, the only way to avoid a border would be a perfect alignment between the U.K and EU on tariffs and regulations for goods and services. But then, there would be little point in becoming a third country. Here's the crucial issue. The EU27 does not know which option the U.K. will eventually take, yet it must provide an 'all-weather' safeguard for the Good Friday peace agreement, requiring no border between Northern Ireland and the Irish Republic. Therefore, the EU27 will need the withdrawal agreement to commit: either the whole of the U.K. to a potentially permanent customs union with the EU; or Northern Ireland to a potentially permanent customs separation from the rest of the U.K. - in effect, breaking up the U.K by creating a border between Britain and Northern Ireland. Clearly, the hard Brexiters and/or Northern Ireland unionist MPs will vote down a withdrawal bill which contains either of these commitments, thereby wiping out Theresa May's slender majority. The intriguing question is: might Labour MPs - or enough of them - vote for a potentially permanent customs union to get the soft Brexit they want? Labour would be torn between the national interest and the party interest, as it would be missing a golden opportunity to topple the Conservative government. If the withdrawal bill musters a majority, it would remove the prospect of a 'no deal' Brexit and the pound would rally - because it would liberate the Bank of England to hike interest rates more aggressively (Chart I-3 and Chart I-4). If the bill failed, the government and specifically Theresa May would be badly wounded. She might call a general election there and then. Chart I-3Absent Brexit, U.K. Interest Rates Would Be Higher Chart I-4Absent Brexit, U.K. Interest Rates Would Be Higher If May limped on, parliament would nevertheless have the final say on whether to proceed with a no deal Brexit. And the parliamentary arithmetic indicates that a clear majority of MPs would vote against proceeding over the cliff-edge. At this point with the government paralysed, the only way to unlock the paralysis would be to go back to the people. Either in a general election or in a new referendum, the key issue for the public would be a choice between one of the three aforementioned options for the U.K./EU long-term relationship - because by then, it would be clear that those are the only options on offer. Based on a clear recent shift in British public opinion, the preference is more likely to be for a soft (or no) Brexit than to become a third country (Chart of the Week). Bottom Line: The long term direction for the pound is higher but, as the withdrawal bill passes through parliament, expect a very hairy ride. Understanding Scandinavian Stock Markets The Scandinavian countries - Norway, Sweden, and Denmark - have many things in common: their languages, cultures, and lifestyles, to name just a few. However, when it comes to their stock markets, the three countries could not be more different. Looking at the three bourses, each has a defining dominant sector (or sectors) whose market weighting swamps all others. In Norway, oil and gas accounts for over 40 percent of the market; in Sweden, industrials accounts for 30 percent of the market and financials accounts for another 30 percent; and in Denmark, healthcare accounts for 50 percent of the market (Table I-1). Table I-1The Scandinavian Stock Markets Could Not Be More Different! In a sense, the dominant equity market sectors in Norway and Sweden just reflect their economies. Norway has a large energy sector; Sweden specializes in advanced industrial equipment and machinery and it also has very high level of private sector indebtedness, explaining the outsized weighting in banks. However, Denmark's equity market - dominated as it is by Novo Nordisk, which is essentially a biotech company - has little connection with Denmark's economy. The important point is that the four dominant sectors - oil and gas, industrials, financials, and biotech - each outperform or underperform as global (or at least pan-regional) sectors. If oil and gas outperforms, it outperforms everywhere and not just locally. It follows that the relative performance of the four dominant equity sectors drives the relative stock market performances of Norway, Sweden, and Denmark. Norway versus Sweden = Energy versus Industrials (Chart I-5) Chart I-5Norway Vs. Sweden = Energy Vs. Industrials Norway versus Denmark = Energy versus Biotech (Chart I-6) Chart I-6Norway Vs. Denmark = Energy Vs. Biotech Sweden versus Denmark = Industrials and Financials versus Biotech (Chart I-7) Chart I-7Sweden Vs. Denmark = Industrials And Financials Vs. Biotech Last week, we upgraded some of the more classical cyclical sectors to a relative overweight. Our argument was that if an inflationary impulse is dominating, beaten-down cyclicals have more upside than the more richly-valued equity sectors; and if a disinflationary impulse from higher bond yields is dominating, its main casualty will be the more richly-valued equity sectors. On this basis, our ranking of the four sectors is: Industrials, Financials, Energy, Biotech. Which means the ranking of the Scandinavian stock markets is: Sweden, Norway, Denmark. Bottom Line: From a pan-European perspective, upgrade Sweden to neutral and downgrade Denmark to underweight. Understanding Semiconductors The best way to understand semiconductors is to think of them as twenty-first century commodities. In the twentieth century, many everyday goods and products contained a classical commodity such as copper. Today, the ubiquity of electronic gadgets, devices, and screens contains a twenty-first century equivalent: the microchip. Hence, semiconductors are to the tech world what classical commodities are to the non-tech world. They exhibit exactly the same cycle of relative performance. If, as we expect, beaten-down industrial commodities outperform, it follows that the beaten-down semiconductor sector will outperform broader technology indexes (Chart I-8). Chart I-8Semiconductors Follow The Commodity Cycle Bottom Line: Overweight the semiconductor sector versus technology. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, the sale of a car is no longer the sale of just a good. As car companies often structure the financing of the car purchase, a car purchase can be a hybrid of a good - the car itself, and a service - the financing package. Therefore, a single market for cars requires a single market for both goods and services. 2 The Irish border trilemma comprises: 1. the U.K./EU land border between Northern Ireland and the Irish Republic; 2. the Good Friday peace agreement requiring the absence of any physical border within Ireland; 3.the Northern Ireland unionists' refusal to countenance a U.K./EU border at the Irish Sea, which would entail a customs border between Northern Ireland and the rest of the U.K. 3 At the Labour Party's just-held 2018 conference, Jeremy Corbyn made a commitment to joining a permanent U.K./EU customs union. Fractal Trading Model* This week's recommended trade comes from Down Under. The 25% outperformance of Australian telecoms (driven by Telstra) versus insurers (driven by IAG and AMP) over the past 3 months appears technically extended, with a 65-day fractal dimension at a level that has regularly indicated the start of a countertrend move. Therefore, the recommended trade is short Australian telecoms versus insurers, setting a profit target of 7% and a symmetrical stop-loss. In other trades, long CRB Industrial commodities versus MSCI World Index achieved its profit target very quickly, leaving four open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: 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. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations