Gold: No Reward For Being Early

There is no compelling reward/risk tradeoff in either direction for gold prices.

Gold No Reward For Being Early

Gold and silver market positioning reveals no major extremes and plenty of mixed signals:

  • Gold: The spot price is hovering around the 200-day moving average, which itself has gone flat after falling for much of 2013. Trading sentiment is neutral at 50%. Net speculative futures positions as a percent of open interest (OI) are stuck below the 30-50% zone common during the bull market and above the 10-20% zone during last year’s washout. ETF holdings and futures market open interest have fallen substantially, but downward momentum is ebbing.
  • Silver: Trading sentiment and speculative futures positioning are oversold. The caveat is that there are plenty of “stale ETF longs”. Silver prices peaked more than three years ago at $48.55, versus $19.42 currently. Yet silver ETF holdings are close to an all-time high and futures open interest is at the high end of its four-year range.

Gold and silver prices face fundamental headwinds, but they are only slowly taking shape. Fed normalization, higher real interest rates and a firm dollar will eventually prompt new lows in safe haven precious metals.

In the interim, gold and silver could benefit from a combination of low real interest rates, higher investor risk aversion and a firm euro. Potential drivers include softer U.S. housing data, simmering tensions between Russia and the West over Ukraine, a global equity correction and/or ECB unwillingness to undertake quantitative easing despite near-zero consumer price inflation.

Bottom Line: There is little reason yet to aggressively position in gold or silver, given the absence of a fundamental trend and/or market positioning extreme.

U.S. High-Yield: Maximum Overweight

U.S. high-yield bonds remain one of the most favored sectors of our U.S. bond strategists.

U.S High Yield

Our model predicts that the default rate for speculative grade bonds will average near 3.0% during the next year. Moody’s latest estimate for the 12-month trailing default rate is much lower at 1.7%. Our view is that the U.S. and global economies will continue to expand (and recession will be avoided) over at least a one-year investment horizon. In this case, default losses could remain less than that projected by our model which is calibrated to pre-crisis macro factors. The current cycle could see the default rate move lower still given the scope of deleveraging that followed the financial crisis and Great Recession. Corporate balance sheets are in excellent shape, and there is still an ample cash cushion available to fund operations in the event of a growth setback.

We continue to monitor three key factors for evidence of a turn in default risk: our Corporate Health monitor, bank lending standards, and Fed policy. None of these yet signal cause for concern.

Other measures of credit market excess bear watching as well: investor use of leverage is rising; the covenant quality of high-yield bond issuance has begun to erode; valuation is compressed; and fund flows into corporate bonds have been firm. In aggregate, these measures are emblematic of the late stages of the credit cycle, but have room to deteriorate much further before the cycle ends.

Bottom Line: Continue to overweight high yield bonds within a U.S. fixed income portfolio.

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Chinese Growth: What Went Wrong?

At 7.4%, China’s annual GDP growth rate in the past quarter matched some of the lowest growth numbers in China’s recent history. According to our China strategists, the slowdown is due to a combination of both global and domestic factors.

Chinese Growth, What Went Wrong?

From a global point of view, post-crisis demand destruction has clearly taken a heavy toll on Chinese growth. Deleveraging pressure among American households was a major headwind for exporters. In addition, external demand destruction has exaggerated the overcapacity problem and depressed manufacturing-related capital spending activity, leading to a broad-based growth downturn.

While weakness in global demand is a universal problem, Chinese growth has suffered particularly badly from its excessively tight monetary conditions. Amid fears of lending bubbles and liquidity overflow, the Chinese authorities aggressively tightened credit and liquidity. High borrowing costs have dampened aggregate demand, compounding difficulties for debtors to honor their obligations and amplifying risks in the financial system. Meanwhile, the Chinese currency has also appreciated significantly over the past several years, adding pressure to an already tight monetary environment.

All of this has become a major detriment for corporate profits and business activity. Taken together, high borrowing costs and an expensive RMB have choked off margins, leading to tremendous difficulties in some low-margin export-oriented sectors.

In short, global headwinds and self-imposed policy restraints have been the main reasons behind China’s growth problems in recent years. By the same token, improvement in the global outlook and prospects for some policy loosening, even marginally, should be good news. In the past several weeks, China’s policy settings have clearly shifted toward growth boosting. Meanwhile, we expect continued improvement in global demand, especially from developed economies. This should help the Chinese economy stabilize and strengthen in the coming quarters.

U.S. Consumer Spending: A Positive Surprise!

U.S. retail sales in March popped higher, while February revisions were positive.

U.S. Consumer Spending

After hibernating this winter, U.S. consumers appear to be opening their wallets again. March retail sales data were strong across the board – the only exceptions were spending on gasoline and electronics, which contracted month-over-month.

Fundamentals for consumer spending remain solid: the consumer deleveraging cycle is very mature, policy uncertainty has finally subsided, business confidence is improving, and the wealth effect is still positive, despite equity market volatility in recent weeks. Most importantly, job prospects are gradually improving and this is beginning to be reflected in overall consumer confidence, a pre-condition for more vigorous spending.

Overall, we expect the U.S. economy is on track for 3% growth or better over the next year.

Brazilian Banks: Not Out Of The Woods Yet

The carnage in Brazilian assets over the past three years has not spared the country’s banks. According to our EM strategists, bank stocks in Brazil have not yet priced in the economy’s most likely path toward recession and the ensuing negative effect on their profits, via a worsening of credit quality.

There are several reasons why we expect banks’ credit portfolios to deteriorate considerably:

  • Ongoing monetary tightening suggests that growth is about to relapse anew, which threatens to toss the economy into recession by the end of this year.
  • Borrowing among companies and households (domestic and foreign) has risen from 40% to 90% of GDP in 10 years.

Brazilian Banks Not Out Of The Wood Yet

  • Household debt servicing costs are elevated, taking up 22% of disposable income. The recent rate hikes and flagging income growth will only further depress households’ ability to service debt.
  • With respect to the corporate sector, even though businesses are not particularly leveraged, a recession will depress revenues and a rise in corporate defaults is likely.
  • Furthermore, the foreign debt rollover rate among Brazilian companies has dropped below 100%, a sign that foreign lenders are getting wary of their credit exposure to Brazilian debtors. We expect the rollover rate to drop further as foreign lenders seek to limit/curtail their exposure to Brazil. Given that Brazil runs a current account deficit of 3.7% of GDP, a lack of new foreign capital will put pressure on debtors’ finances and force them to delever. The outcome of deleveraging will be a further slump in the economy, resulting in additional credit quality aggravation.

Bottom Line: A marked deterioration in banks’ credit portfolios poses the largest threat to Brazilian banks. We continue to recommend that investors underweight Brazilian banks versus their EM peers.