What To Expect In Q2 2015?

Our Global Investment Strategy service recently published their Strategy Outlook for Q2 2015.

The quarterly report highlights the following points:

  • Global growth should remain broadly unchanged over the balance of the year, as stronger activity in most developed markets offsets a worsening outlook in emerging markets.
  • A modestly pro-risk stance is warranted. Remain overweight global equities and corporate credit, neutral on government bonds, and underweight cash.
  • Global bond yields will remain subdued as reflationary central bank policy takes center stage. The 10-year Treasury yield is heading to 1.5%.
  • Overweight euro area and Japanese equities. Reduce exposure to the U.S. on valuation concerns and margin pressures. An overall underweight in EM equities is warranted, but China deserves to be bought.
  • The commodity supercycle is over. There is little reason for oil or most metals to rebound anytime soon.

The dollar bull market is entering its final innings. While the greenback should be able to extend its gains against the commodity currencies and to a lesser extent, the yen, the pound, and the RMB, it will struggle to rise much further against the euro.

Clients interested in reading the full Report can access it here: Strategy Outlook Second Quarter 2015.

China: The Feedback Loop Of A Bull Market

The tug of war between growth and policy reflation will remain the dominant theme this year, in which weak growth numbers will force policymakers into more aggressive reflation efforts. This is already turning out to be good news for stock prices. Indeed, even though the equity market in China is far less important than in developed countries, rising stock prices will still offer important benefits for the economy.


Rising stock prices increase household wealth and boost confidence, which in turn supports consumer demand. This could be true everywhere, but may have just started to become relevant for China, given the rapid increase in investors’ participation in the equity market in recent years. The numbers of investor accounts in the Shanghai Stock Exchange recently hit 125 million, almost triple the level in 2007 during the previous equity mania. This amounts to over 16% of the urban population, compared with a mere 6% eight years ago. Meanwhile, there has been explosive growth in investment funds in recent years, which has also increased households’ exposure to the equity markets.

The chart above shows that consumer confidence has surged to its highest level in recent years, a highly unusual development considering the weak growth environment. We suspect this has to do with the sharp rally in stock prices and growing participation in stock equity investment. Rising consumer confidence will eventually benefit retail sales.

From policymakers’ perspective, however, a much more important consideration is the funding mechanism of the stock market.

Dollar Strength, EM Stresses = Ongoing U.S. Equity Risk

Today, a discussion about to what extent dollar strength, that leads to EM stresses, will infect U.S. bourses.


Our EM team has been warning for some time that sharply higher foreign-currency debt levels among emerging market (EM) companies and banks will pose a formidable challenge to EM. Indeed, we have written about the risks associated with the end of the “dollar carry trade” (i.e. EM companies’ and banks’ borrowing in U.S. dollars).

With the dollar still rising, concerns about the impact of EM weakness on the U.S. and other developed markets are mounting. Could EM vulnerability to a rising dollar trigger a global financial accident? “Crises” are inherently difficult to time – it is impossible to know when investor behavior/psychology will turn. There are two points that make us leery about EM risks as they relate to U.S. (and other developed markets). First, EM is far more important in terms of its global GDP weighting than in previous decades, implying that when EM catches a cold, the rest of the world will more than just sneeze. Second, with policy options in developed economies nearly exhausted, the tool to deals with a crisis are more limited than, for example the 1990s.

At a minimum, slower demand from emerging markets and dollar strength risk creating earnings disappointments for globally-exposed sectors in developed market bourses. Indeed, the rise in the dollar and poor EM demand have been key reasons why we have advocated a domestic vs. global approach within the U.S. stock universe. A cautious approach is still warranted.

Chinese Debt Swap Program: A Potential Game Changer?

The Chinese government is planning a massive debt swap program to deal with local government liabilities. This could fundamentally change investors’ perceptions about a key risk factor that has plagued China’s macro picture in recent years.

The Chinese press has reported that the Ministry of Finance is planning a RMB 3 trillion debt swap program, which will allow local governments to directly raise debt in exchange for their borrowings accumulated by various local government financing vehicles (LGFVs) in recent years. Although this program has not been officially unveiled, Finance Minister Lou in a press conference on the sidelines of the NPC confirmed such a program has been put forward for approval. If true, it would signify that Beijing’s overhaul of local government debt has reached a final stage.

Last year’s fiscal reforms enabled local governments to raise debt “legally”, which provided a transparent mechanism to address their “incremental” fiscal shortfalls. The proposed debt swap program would be utilized to deal with existing liabilities accumulated at localities in previous years. As the LGFV debt issue has been flagged as a key macro risk, the swap program holds the promise of dissolving a major concern that investors have had with respect to China’s macro picture. It would significantly reduce the perceived credit risk within the financial system and the banking sector.

For now, we remain upbeat on H shares and neutral on A shares, mainly due to valuation concerns. However, the debt swap program, if implemented, will be unambiguously good news for the bank-heavy Chinese stock markets. We will reassess our view in the coming weeks on any material progress on this front.

ECB: A QE Update

Apart from setting a date (March 9th) for the beginning of its asset purchase program, the ECB filled in some other details around its policies.

In the press conference introductory statement, President Draghi announced upward revisions to growth over the next year, but revisions to inflation forecasts were down (to 0% for 2015). But it was in the Q&A that more light was shined on QE policy. The major point gleaned from the Q&A is that the central bank is not prepared to buy bonds yielding less than the deposit rate.

That stipulation then begs the question: What happens if there is not enough liquidity for the ECB to buy €60 billion per month if the central bank will not buy any asset with a yield below the deposit rate? One answer is that the ECB could lower the deposit rate. We believe that given the choice between a lower deposit rate or not attaining the €60 billion in monthly purchases, the ECB would likely do the former. The ECB will be disposed to finishing the 19 months of quantitative purchases in order to protect its credibility, unless of course the economy is strong enough to warrant stopping early.

So far, the ECB is not showing concern that there will not be enough sellers of high-quality bonds for the ECB to buy. Draghi more or less dismissed the question during the Q &A and also alluded that he thought there were plenty of foreign sellers.

We have pointed out in Daily Insights that, in fact, the shortage of government paper is acute, especially in Germany, where there will be very little net new issuance. The government last week issued a 5-year Bund for the first time sporting a negative nominal yield (-8 basis points). Almost 30% of the continental European bond market is currently trading in negative territory, and the ECB hasn’t even started buying yet.

Negative yields are helping keep the euro weak, which, much like QE elsewhere in the world, is giving a definitive boost to local growth, and for the time being, equity markets. We maintain overweight positions in euro area stocks relative to the U.S. and global benchmarks.