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Editor's Note: Hamish Risk | July 31, 2020
In today’s Macro Briefing we highlight a range of themes to close out the week. On credit, Goldman Sachs say the recent decline in the US dollar shouldn’t impact demand for US corporate credit. On US equities, Cornerstone Macro’s Mike Kantrowitz provides some excellent analysis on his so-called recovery portfolios, which he says provides useful perspective on what’s happening “on the ground” of equity markets. He shows that the “W” shaped factor portfolio is outperforming across every time period on his Recovery Portfolio Dashboard. This portfolio contains mostly secular growers that are more likely to lead in a wavy recovery fraught with uncertainty, he says. We then turn to the UK, where Brexit negotiations are heating up as the final deadline comes ever closer, and where investors are increasingly falling out of love with UK equities, according to Pantheon Macro. On the commodities front, Longview Economics take a look at the price drivers of copper after a 33% rally in past 4 months. In the short-term they think the metal is likely to give back some of these gains, but they make a more interesting point on what really drives the price. While many people think it’s a function of supply and demand, Longview beg to differ. They say that over recent decades there’s been an increasing ‘financialisation’ of the metal, and its price is now dominated by changes in market sentiment around the outlook for Chinese economic growth. Finally, as we continue our increasing focus on ESG research, we highlight a new publication recently launched by Standard & Poor’s, called the ”ESG Pulse”. In this first note they highlight how social factors are increasingly driving ESG-related ratings actions.
credit ratings ESG Standard & Poor's
1. The ESG Pulse – Social factors could drive more ratings actionsOf the close to 1,200 ESG-related rating actions during April and May, 98% were triggered by the COVID-19 pandemic according to Karl Nietvelt of S&P Global Ratings. He says the pandemic has highlighted the importance of social factors, which could drive more rating actions given the increased awareness and credit relevance of health issues, diversity, inequality, and social unrest. Nietvelt explains S&P classifies the pandemic as a health and safety-related social factor in its rating actions, if it believes health concerns and social distancing measures directly affect the entity. Put differently, he says, for the purpose of classifying ESG impacts, he excludes rating activity in sectors indirectly affected by the pandemic, i.e. they were more affected by the broader consequences of the recession than by health and safety (e.g. financial institutions, ABS or RMBS, and various corporate sectors like media, consumer products, and oil and gas). Consequently, Nietvelt says ESG factors directly accounted for only 40% of COVID-19-related downgrades in the corporate sector in April and May. The sectors most directly affected by the pandemic, he says, have been governments and corporates, while within corporates and infrastructure, airlines and airports, hotels, entertainment, automotive, non-food retail, and commercial real estate saw the highest share of ESG-driven rating changes. For US public finance, public transport, not-for-profit airports, and higher education ratings have been most affected, adds Nietvelt, while some local governments are facing more elevated social risk based on protests and community unrest. Structured finance transactions most affected, he says, are business securitizations (e.g. pubs, fast-food restaurants, gyms, stadiums, and leisure parks), dealer floorplan and rental car ABS, aircraft ABS, and CMBS with hotel and retail exposure.
Commodities Copper Longview Economics
2. Copper – what (actually) drives price direction?With the copper price up 33% in the past 4 months, the long copper trade has become increasingly crowded, with growing question marks around how much further copper can rally says Brad Waddington at Longview Economics. He says sentiment readings are bullish (at a 10-year high); net long positioning is close to record highs; and his market timing models are increasingly generating strong sell signals. As such, says Waddington, some copper price giveback, or consolidation, is likely over the coming months. Beyond that timeframe, though, he says, on a 1 to2-year view, the key question becomes what drives the medium term copper price trend? The consensus view, says Waddington, is that changes in the global supply and demand balance are the main drivers of copper price direction. However, he says while that’s the case for some commodities (most notably oil), the supply and demand balance is not a key driver of the copper price. Instead, says Waddington, the copper price is much more tightly correlated with net speculative positioning in the futures market than with the supply and demand balance, a fact that most likely reflects the ‘financialisation’ of copper in recent decades. In that respect, and while supply and demand changes in the physical copper market are interesting, he says according to his copper multi-factor model, copper price direction has become dominated by changes in market sentiment around the outlook for Chinese economic growth.
Brexit UK equities Pantheon Macro
3. UK equities are becoming ever more unloved, chiefly due to BrexitUK equities are falling ever further out of favour and the scale of the underperformance in 2020 is startling says Samuel Tombs at Pantheon Economics, who notes, in dollar terms, the MSCI UK index is currently 22% below its January 1 level, while the US MSCI has risen 3 % over the same period and the MSCI Europe ex. UK is down just 3%.He says while the earnings of UK listed companies have been hit harder than those overseas, the chief problem is that investors are prepared to pay much less for the expected earnings of UK firms. According to Tombs, investors’ recent zeal for tech stocks over financials goes some way to explain why the P/E ratio for UK stocks is so low, but nonetheless, the gap between sector-adjusted P/E ratios for UK stocks and those in the US and Europe has widened. Indeed, he calculates that UK equity prices currently are approximately 12% below the level for those in the US and the rest of Europe, after adjusting for sectoral composition and the long-run average gap between P/E ratios. The UK government’s gung-ho Brexit stance appears to be the main reason for this difference, according to Tombs, who notes the underperformance of UK stocks has worsened since June, when Britain allowed its option to extend the transition period from its EU withdrawal beyond December to expire. He says it remains his view that that the UK will secure an extension of trade talks with the EU at the very last minute, but even so, the underperformance of UK stocks likely will worsen, as the clock ticks down towards December 31 without a breakthrough.
Economic recovery sector allocation US equities Cornerstone Macro
4. Equity Strategy; “W” for the win thus farGiven the concentrated nature of leadership within US equity indices, it’s becoming increasingly difficult to use the market as a read on the economic backdrop, says Michael Kantrowitz at Cornerstone Macro. He says if the NASDAQ were a proper reflection of the US economy, it would be booming, and while five stocks might dominate the S&P 500, they do a poor job in representing the US economy. Therefore, to use markets to better understand the economic backdrop, Kantrowitz has built recovery portfolios from the bottom up, using factors instead of indices. The “V” factor portfolio contains highly cyclical stocks most likely to outperform in a rapid and broad-based recovery, he says; the “W” factor portfolio contains mostly secular growers that are more likely to lead in a wavy recovery fraught with uncertainty: the “U” factor portfolio focusses on high-quality names likely to lead in a more gradual, drawn out and moderate rebound; and the “L” factor portfolio contains highly defensive stocks likely to outperform in a prolonged period of stagnation. Kantrowitz has provided an update to these portfolios, so investors can better understand and track what’s happening “on the ground” of equity markets. The “W” factor portfolio, he says, is outperforming across every time period on his Recovery Portfolio Dashboard. Supported by high alpha and strong sales growth, these stocks have outperformed in an environment still fraught with uncertainty, says Kantrowitz, who continues to recommend stocks with stronger fundamentals, despite their high price tag – many of which can be found in his “W” and “U” portfolios
Credit cross border flows US dollar Goldman Sachs
5. Four questions on the interplay between the dollar an cross-border flows into credit marketsThe continued slide in the Dollar has prompted many market participants to question the implications for cross-border flows into the primary and secondary US credit markets, says Lotfi Karoui at Goldman Sachs. For fixed income investors, he says, the most frequently-encountered concerns relate to the impact of dollar depreciation on supply and demand technicals. On the demand side, many worry about dwindling foreign participation, after a decade of solid growth, according to Karoui, while on the supply side, the key questions relate to how corporate borrowers, especially those with multi-currency capital structures, will respond to a weaker dollar. Accordingly, he has set out to address those concerns in a Q&A format. Karoui says there is no evidence that a prolonged period of dollar depreciation hurts foreign demand for dollar-denominated bonds, rather it is declining dollar funding and hedging costs that matter. Again, he finds there is little evidence that a weaker dollar has an impact on non-financial Yankee and reverse Yankee issuance, with neither exhibiting correlation with dollar moves. Perhaps counterintuitively, Karoui finds a weaker dollar does not stimulate cross-border M&A.