Hiatus In The Dollar Bull Market

The latest Global Investment Strategy report is entitled “Hiatus In The Dollar Bull Market”, and examines why the greenback has sold off this year and what the path forward is. The Weekly Report also discusses the Fed and the U.S. economy, the BoJ, and China, namely arguing the following points:

  • The FOMC statement underscored the Fed’s willingness to take a ‘go slow’ approach to raising rates. While a June rate hike looks increasingly unlikely, a September and December hike remain in play.
  • The lagged effects from the easing in U.S. financial conditions over the past few months should boost growth in the second half of the year. Diminished labor market slack is also likely to put upward pressure on wages.
  • The BoJ’s reluctance to admit that NIRP has been a flop so soon after it was launched helps explain why it failed to provide more monetary support at this week’s meeting. We expect a new round of easing measures this summer.
  • Chinese stimulus efforts should last a few more months, after which time commodity prices will resume their structural downward trend.
  • As such, while the greenback could weaken over the next few months, this will simply be a hiatus in the dollar bull market.
  • Investors should remain tactically bullish risk assets for now, but be prepared to shift to a more cautious stance in the second half of the year.

To access the report entitled “Hiatus In The Dollar Bull Market”, please click here.

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Investors Left Shocked And Awed By BoJ Inaction

By standing pat, the Bank of Japan delivered a different kind of “shock and awe” overnight. Clearly, expectations were running high that Governor Kuroda would introduce another large stimulus program. Despite the bravado displayed by Kuroda, the BoJ really does not have many options at the moment.

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The BoJ is currently buying ¥80 trillion of JGBs at an annual rate, more than double the net issuance of ¥30-40 trillion. The central bank is on track to hold nearly 40% of the outstanding stock of JGBs by the end of the year. One reason that the BoJ has been able to almost seamlessly purchase so many JGBs in the last three years is that GPIF, the public pension fund, has been unloading government bonds as it diversifies into riskier assets. However, the GPIF’s asset re-allocation is largely complete now. This will make it more difficult for the BoJ to continue its current pace of JGB purchases, let alone increase them substantially.

For the BoJ to boost the pace of bond purchases, there needs to be a concomitant easing in fiscal policy that leads to a greater net issuance of JGBs. This seems unlikely with the government still committed to increasing the VAT next year. Even with a supplementary budget for rebuilding following the recent earthquakes, there is unlikely to be a significant net easing in fiscal policy.

As for other asset purchases, they are simply too small to matter. The BoJ is buying ¥3.3 trillion of equity index ETFs and ¥90 billion of J-REITs. Even doubling these purchases will amount to less than ¥4 trillion, which is trivial compared to the BoJ’s balance sheet of around ¥400 trillion. Moreover, the BoJ already owns over 50% of the equity market ETF, making it a top 10 shareholder in 90% of Nikkei stocks. As for corporate bonds, this asset class barely exists in Japan. Japanese companies are flush with cash (which is the source of Japan’s large current account surplus) or tend to borrow from the banks.

Finally, the fiasco following the introduction of negative interest rates in January must have put the BoJ off on going further down that path today.

The Japanese yen soared and stocks tanked overnight on the lack of new measures by the BoJ. This is not surprising as Japanese equities have essentially been a BoJ/currency call. As investors come to realize that it will be difficult for the BoJ to ease policy further, the risks are tilted to further yen strength. A dovish Fed will only accentuate the downtrend in USD/JPY.

Uncertain Global Growth And Policy Environment

2016 is turning out to be a year where global central bankers are finding out what they cannot do.

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China found out early in the year that currency depreciation can no longer be used as a source of stimulus without causing panic in their equity markets and large capital outflows. The ECB and the BoJ later discovered that policy rates cannot be pushed deeper into negative territory to boost growth without damaging domestic banks’ profitability and share prices. Even the Fed has come to the realization that interest rates could not be increased as much as planned without causing troublesome gains in the overvalued U.S. dollar.

The move to less-active central banks has been very supportive for global fixed income markets over the past couple of months. Government bond yields remain at very low levels with monetary policy still highly accommodative and global inflation subdued. Overall market volatility has declined, supporting rebounds in beaten up credit markets. Some tentative evidence of an improving Chinese economy is also helping support the rally in global credit markets (please see the latest Inside BCA for a set of charts that will help track Chinese and global growth dynamics).

Nevertheless, the investment backdrop remains challenging. The U.S. remains stuck in a strange world where corporate profits are contracting yet employment and consumer prices are both growing fast enough that additional Fed rate hikes are possible, perhaps as soon as June. Growth and inflation are slowing in Japan and the euro area, yet governments there remain unwilling or unable (or both) to boost growth via fiscal stimulus, forcing the BoJ and ECB to consider more radical easing measures with lower chances of success like negative policy rates, corporate bond purchases and even so-called “helicopter money”.

Amid an uncertain growth and policy environment, the current low volatility backdrop is unlikely to be sustained, according to our global fixed income strategists. Investors should maintain a defensive stance in fixed income portfolios, remaining underweight credit while minimizing exposure to the negative-yielding bonds in core Europe and Japan.

U.S. Equities: Is Sentiment Truly Bearish?

While not an exact science, a number of metrics suggest that investors are far more bullish than sentiment readings imply.

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True bearishness elicits a rush for the equity exits, which prompts position deleveraging, a valuation squeeze, a dramatic increase in cash levels and a premium on portfolio protection, as measured by the VIX and SKEW indexes.

None of these conditions exists yet. Valuations are probing historic highs, as measured by the median industry group price/sales ratio. This metric is more reliable than any forward earnings measure, as the collapse in commodity-related profits can artificially inflate P/E ratios. Ergo, thin equity risk premiums are not consistent with doubts about earnings prospects. Also, investors are not nervously hedging long positions, as evidenced by historically depressed readings in the VIX and SKEW indexes.

Meanwhile, margin debt remains near record levels, both in absolute terms and compared with market cap and/or GDP. This is worrisome because it implies a paltry overall cash flow cushion to cover margin calls in the event of a decline in collateral values, i.e. share prices.

Moreover, investor cash holdings are historically low, the opposite of a bearish signal. Other indicators also suggest a lack of fear among investors. Please see the next Insight, (Part II) U.S. Equities: Is Sentiment Truly Bearish?

China: Fiscal Spending And Credit Impulses

In its latest Special Report, our Emerging Market Strategy service provided estimates for China’s fiscal boost this year.

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The 2016 budget was approved last month at National People’s Congress. It has penciled in that central government spending (excluding transfers to local governments) will rise by RMB 180 bn, while local government expenditures are projected to rise by RMB 270 bn.

In addition to traditional revenues and expenditures, there are off-budget categories of government revenues and spending in China. The largest impact on growth will come from the Special Infrastructure Fund (SIF) – a scheme established in August 2015. Given that this is infrastructure spending, it will have a considerable impact on China’s demand for commodities and capital goods. This initiative will have more influence on global financial markets than traditional government spending in China. Our EM strategists believe that the potential fiscal impulse from the SIF quasi-fiscal measures could total up to RMB 800 bn.

Summing up the impulse from general government spending (RMB 450 bn) and the potential impulse from the SIF program (RMB 0-800 bn), we end up with fiscal and quasi-fiscal spending impulse that equals between 0.62% and 1.72% of 2016 projected nominal GDP.

Notwithstanding the fiscal spending impulse, our EM strategists note that credit growth dynamics could play a big role in shaping the growth outlook. To illustrate that they have calculated the rate of credit growth necessary to generate a credit impulse that completely offsets the fiscal spending impulse. They found that it will only take a marginal slowdown in (bank and non-bank) credit growth to offset a possible increase in fiscal spending. Specifically, If China’s credit growth decelerates below 9.4% by the end of 2016 from the current rate of 11.7%, the negative credit impulse will overwhelm any plausible fiscal spending impulse and China’s capital spending will weaken in the second half of this year. The basis is that outstanding credit and credit flows are so large that it will require only a moderate slowdown in credit growth to overwhelm the fiscal stimulus.