BCA’s Latest Webcast – Is the beta rebound a sigh of relief or a sign of resilience?

The rebound in risk assets has largely priced out the macro tail risk of a deflationary spiral, but we are not yet ready to upgrade our macro outlook to a point that justifies wholesale portfolio repositioning into the global cyclical risk wind.

One catalyst for the relief rally has been hope that China’s policy reflation will shore up sagging global final aggregate demand. Chinese policymakers’ efforts to support domestic growth have pushed up monetary aggregates, but there is little reason to extrapolate that trend to any significant boost to global growth until we see evidence that the stimulus is lifting China’s industrial production, capital spending, and retail sales which fuel the import engine that drives the fortunes of China’s suppliers – namely the rest of the emerging world, from manufacturers to commodity producers.

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China’s policymakers are tackling incongruous objectives: capping the surge in corporate leverage which is weighing on profitability while trying to sustain the pace of overall growth. For the credit to GDP ratio to stop rising, never mind fall, the 12% level of credit growth needs to converge to the 6% nominal GDP growth. This process will be meaningfully negative for the annual rate of change in credit growth which we call the credit impulse. A negative credit impulse is invariably deflationary, thus offsetting the reflationary thrust of the government spending impulse. The 23% increase in total fiscal outlays in the last 12 months doesn’t constitute meaningful stimulus when netted against the drawdown in non –government borrowing and spending. But globally cyclically geared assets were so beaten up, the weakening in the trade weighted value of the RMB has eased Chinese monetary conditions; this has reduced the risk of further intensification of producer price deflation in the coming months.

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The negative impact of dollar strength on US corporate profit margins reduces firms’ willingness to take on more fixed costs. The strong dollar has been a major headwind for US corporate profitability because it has been less a result of the Fed firming policy in response to strong domestic growth and more a function of other central banks easing policy. If the rising dollar reflected firming domestic economic momentum, the yield on the Dec 2019 euro-dollar futures contract (a proxy for US short rates) would not have dropped 300 bps over the last 2.5 years. Instead, the dollar has been pushed up by the fact that all G10 central banks except the UK have eased policy over that period, leading to a breakout in interest rate spreads in favor of the dollar.

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Even though the dollar has stopped appreciating, it would likely need to depreciate significantly, particularly against the EM currencies, before deflationary pressure plaguing the profit picture can subside. Until then, deflationary revenue conditions will squeeze profit margins. Cyclical sector forward earnings estimates continue to slide, while defensives are steadily climbing. This trend is liable to persist based on the gap between consumer and producer price inflation. Most defensive sectors are consumer-oriented, while cyclical sectors are business to business. When producer price inflation lags consumer price inflation, as is currently the case, cyclicals sectors underperform.

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How significant is the rebound in oil for US credit-sensitive fixed income, particularly high yield? The deterioration in corporate profitability and credit quality has not been confined to the energy sector. Years of low rates spawned a wave of cheap debt issuance to reward shareholders via buybacks, without the commensurate increase in productivity that deploying debt capital into innovation-enhancing capital spending would otherwise have generated. On a volatility and default adjusted basis, the sector is not that attractive.

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The rally in risk assets will struggle to breach current resistance levels until the earnings outlook improves. A lift in profit prospects, both in the US and emerging markets, requires a recovery in corporate pricing power to reinvigorate revenue growth at a time when balance sheet constraints are weighing precipitously on margins. Watch for evidence of recovery in industrial activity in China, the global marginal pricing agent for most manufactured goods for export.

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To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s recent Webcast.

BCA Webcast – Global Markets Hit The Reset Button: Now What?

So far in 2016, equity and credit markets have discounted much lower long term global growth rates and constrained policy flexibility to lean against these negative trends. Several other market trends paint a similarly downbeat global growth picture: 1) growth sensitive sectors have underperformed defensives, 2) emerging markets have underperformed developed markets; 3) Long term earnings growth estimates have plummeted back to where they were during the financial crisis; and 4) and the whole commodity complex, not just the energy markets, is trading at multi-year lows.

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Fears about the distortive effect of negative interest rates on banks’ willingness and ability to extend credit are underscoring weakness in the financial sector. The rout in banking shares has prompted a flight to safe assets, depressing both German and US term premia further into negative territory. Curiously, while the selloff in Euro Area and US financial shares has been quite savage, Euro area banks are down 21%, and US are off 12% already in 2016, credit risk premia have only widened between 50 and 36 bps respectively, on an option adjusted basis, big moves, but nothing compared to the spread widening seen during the crisis.

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The divergence in the relative performance of bank debt and equities stems from two dynamics:

1) The post crisis regulatory backdrop boosts banks required capital ratios and forces them to diversify their sources of earnings away from high risk proprietary trading and market making back to traditional lending; in that sense bank balance sheets are actually safer.
2) On the other hand bank profitability is hamstrung by having to abandon those high margin lines of business, by sluggish global growth, the prospect of souring commodity-geared loans, flat yield curves compressing net interest margins, and now the added tax of negative deposit rates on excess reserves.

Balance sheet risk does not appear to be systemic, but banks do face weaker earnings prospects, the primary macro impact of which is the risk of stricter lending standards, which tightens aggregate financial conditions.

Given how wise markets are to growth risks and policy constraints, the 10 year Treasury yield fell back to 1.54% on an intra-day basis two weeks ago. BCA’s out of consensus 1.5% target for the 10 year has all of a sudden been nearly realized. Our valuation model suggests that the forward curve is now fairly valued in a stable dollar environment and fully valued should the Fed be forced to downgrade its rate forecast further, taking the dollar down a little, with it. In either case, it no longer makes sense to be structurally overweight interest rate duration.

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While valuation has grown relatively less attractive in the Treasury space, the savage widening in credit spreads has caught the attention of every yield hungry fixed income investor who is wondering if it’s safe to wade back into high yield. The answer is not yet. Contrary to the popular claim that a souring of credit quality in the energy space has prompted indiscriminate, unjustified widening in other sectors, our research shows that US corporate health has deteriorated across all sectors.

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A recovery in the price of oil and softening in the dollar could spark a hefty counter trend rally in all the assets that have endured such a drubbing from energy weakness and dollar strength – commodity-related assets – all the deep global cyclical plays. The question is, what would turn a technical bounce in oversold markets into a playable rally and new cyclical uptrend in risky assets outside of just energy? We’d need to see evidence of a recovery in global growth which doesn’t seem imminent at present, judging by the lack of turn in global leading indicators and global trade volume. Excess supply in commodities and capital goods continues to put downward pressure on inflation expectations, not just in market-based barometers, but even in survey based measures such as the U Michigan long term inflation expectations index, which is still breaking down.

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The reason we doubt that any rally in equities can stick is the fact that the FOMC is still stuck in a stalemate with markets: the Fed’s continued espousal of a desire to ‘normalize policy’ means that policy divergence will continue to put upward pressure on aggregate financial conditions which are already tight. If it isn’t explicit Fed tightening, it’s the Fed’s bias to want to tighten that keeps the dollar strong while the rest of the world remains in easing mode. Further, the widening in credit spreads and tightening in lending standards constrains corporate financing flexibility and thus the ability to protect profit margins from the savage deflationary pressure we see percolating through the US corporate sector.

To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s recent Webcast.

 

 

Webcast Replay – The 2016 Outlook: Stuck In A Rut

Crusty old Mr. X, BCA’s loyal client paid us his annual visit to discuss the economic and market outlook. Regrettably, neither his December meeting with BCA’s Strategists nor the rough start markets are off to this year did much to assuage his concerns about the uncertain macro environment that investors face in 2016.

One of the primary axes of debate in macro circles centers on whether the current slow pace of global economic growth and uncomfortably low inflation are cyclical or secular phenomena. Several structural forces hinder the global economy’s ability to return to normal. 1) The first structural headwind relates to the theme from last year’s Outlook, the view that the end of the debt Supercycle marks a major regime shift that will cast a long shadow on the global economy. 2) Second, the global economy has harvested the maximum growth thrust attributable to globalization. Trade volumes are no longer growing faster than GDP thanks to technological innovation and narrowing labor cost differentials. 3) Third, demography is patently deflationary for global growth. The aging of the developed world population is not news, but the trend is accelerating making its effects more pronounced. The working age population is poised to decline .3% / year over the next few decades.

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From a cyclical perspective, the global industrial sector is taking its cue from the deleveraging in China’s manufacturing sector. Global trade volumes are flat. While China’s transition from a heavy industry/export led growth model to a consumption and services-geared economy will take years, the early innings of this tectonic shift are having an immediate deflationary effect on the rest of the Asian manufacturing complex as export volumes decline and inventories swell forcing prices down. The slowdown in EM economies is not just hitting commodity producers but capital goods manufacturers as well.

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The underbelly of the US business cycle right now is the profit cycle, which is gasping for air. Unit labor costs are creeping higher as labor market slack is absorbed, while businesses are suffering from a lack of pricing power because of dollar strength which is more a function of weakness abroad than absolute strength at home. Profit margin pressure, sagging revenue growth, and tighter aggregate financial conditions are toxic for US corporate earnings. Earnings weakness is likely to lead to a more defensive corporate spending mindset which could put the brakes on spending and hiring plans.

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Credit markets confirm that the US business cycle is indeed mature. Our corporate health monitor shows that balance sheets are deteriorating, mostly as reduced cash flow generation erodes interest coverage.

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The fate of global equity risk, credit, and term premia will hinge on the trajectory of the US dollar and commodity prices. The dollar’s appeal is only relative. The broad-based nature of the decline in resource prices suggests a deceleration in demand growth, likely driven by the deterioration in emerging markets. Trend reversals require a catalyst. For now, the rot in the global industrial sector has further to run and we see no such trigger for a revival in emerging world growth relative to the US.

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To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s recent Webcast replay.

Webcast Replay – Navigating Macro Divergences: The Devil Is In The Dollar

The global macro divergences driving the dollar up highlight economic weakness outside the US that may be structural, not just the fact that the U.S. is leading the rest of the developed world’s recovery from the global financial crisis on a cyclical basis. If structural in nature, the need for easier monetary policy globally may last for years, in which case the dollar’s recent strength will be sticky, and the headwinds that poses to growth will linger. To the extent that the global growth outlook remains uncertain, a stronger U.S. dollar constrains the Fed’s ability to raise interest rates.

The Fed trapped itself in a policy feedback loop at the September meeting when the FOMC postponed the first rate hike and ostensibly linking future policy decisions to financial market stability.  The Fed’s policy decisions are directly tied to global macro dynamics, not just the US economy’s idiosyncratic performance, since global factors influence US financial conditions. A more hawkish monetary policy narrative fuels dollar strength and equity and credit market weakness, which together constitute tighter financial conditions, raising downside risks to the US growth and inflation outlook, then prompting the Fed to soften its hawkish narrative. This triggers a rebound in markets which by definition eases financial conditions again, paving the way for the Fed to restart the countdown to rate liftoff; markets riot again, and the loop recirculates. This feedback mechanism exists because of the perception that easy Fed policy is the only variable sustaining financial markets in a growth and income-starved world.

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An improvement in global growth is a prerequisite for severing the Fed’s dollar-feedback loop. Better global growth would trigger an improvement in non-US asset market sentiment and ease global financial conditions by spawning a durable rally in global equity and credit markets. This would weaken the dollar as capital flowed back into non-US markets, and as the dollar weakened from the stronger pulse of global growth, US inflation expectations would rebound, allowing for a steeper path for Fed rate hikes.

Unfortunately, such a scenario doesn’t appear likely over a 6 to 9 month horizon.

 

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To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s recent Webcast replay.