Just two weeks ago, Tim Hayes, global strategist at Ned Davis Research, made his final downgrade to equities, and in cutting the allocation to his downside limit of 40%, he anticipated a drop in the equity allocation to be recommended by NDR’s Global Balanced Account Model at year-end. Now that the model has updated, and Hayes observes that the equity percentage has dropped to just 38%, the lowest exposure since 2008, while the bond allocation has jumped to 59%, the highest exposure since then. Also recognizing that the cash exposure has slid to 3%, NDR is shifting 5% from cash to bonds. This brings their recommended balanced account strategy more in line with the model at 40% stocks (15% underweight), 55% bonds (20% overweight) and 5% cash (5% underweight). NDR is also upgrading their gold position, moving from neutral to bullish based on a seasonality component that sees gold typically rally in January, and its correlation to the dollar (dollar falling). Both moves are consistent with a global bear market that remains intact, as Hayes has viewed the recent rally as a selling opportunity rather than the start of a sustainable advance.
Today’s China RRR cut is partly about managing liquidity ahead of Chinese New Year. But it should also provide support for the economy. Policy easing will be stepped up further over coming months, say Capital Economics in a report published shortly after the announcement today. They remind clients that the message of the Economic Work Conference in December was that policy support will be stepped up, and as such, the consistently downbeat tone of the data released since then will only have underlined the strains the economy is facing. One shouldn’t be so surprised. Capital suspect the next major – and still not broadly anticipated – step will be a cut to benchmark lending rates. But with credit growth still slowing and, typically, a six-month lag before any turnaround in credit affects the economy, worries about the outlook for China will persist for several months yet.
The awful ISM manufacturing survey for December likely does not mark the low, says Ian Shepherdson from Pantheon Macro. In a report published yesterday Shepherdson shows that the fall in the main index closely mirrors the sharp weakness recently seen in the equivalent China PMI import sub-index. This is more proof, if needed, that President Trump’s trade actions against China are now hurting the US as much as they are China; rather than being, as Trump would have us belief, a zero sum game where the US takes the spoils at all others’ expense. More reason to think a Sino-US trade deal is in the offing in coming weeks. Still, the manufacturing mess will not trigger a Fed easing, says Shepherdson. He reckons the bar for the Fed to ease is much higher than markets want to believe, especially if, as he predicts, a trade deal maybe hatched.
In 2018 liquidity tightening in the US and China combined with trade war fears to make a miserable year for markets. In 2019 the same forces will be at work but the outcomes may differ, writes Arthur Kroeber from Gavekal Dragonomics. Kroeber says the key questions are whether the US and China can work out a trade deal, just how bad the current Chinese slowdown is and how bold a stimulus Beijing will organize to restore growth, and how tight the Fed chooses to be. On balance the odds favor a recovery for both US and Chinese assets, argues Kroeber, but much hinges on the outcome of trade talks, which face a March 1 deadline.
It’s worth remembering that although government shutdowns cause a lot of ruckus, usually they have been a largely non-events for equities, writes Andy Langenkamp, author of ECR Research’s Global Political Risks report. Indeed we haven’t witnessed major market reactions to shutdowns over the past four decades, and in the most recent ”extended” shutdown in the autumn of 2013, the S&P 500 even went up 3.1%. However, the current situation comes amid different circumstances, argues Langenkamp. Back in 2013, the economy was in humming along nicely , central banks were pumping money into the economy, and the recovery was not historically long yet. None of these circumstances hold now, and should US politicians fail to find a resolution soon, markets may take fright at a time where nervousness pervades already.
NDR make the case that the behaviour of corporations to buy Treasury strips for underfunded pension plans may tell us something about rates sentiment. This was most recently observed before the September 15 funding deadline, where they showed that the demand for strips had increased, and that the spread between the 30-year strip yield and the regular bond had shrunk to 1 bp. Following the deadline the spread widened out again, and the curve steepened. The larger point NDR attempt to make in this note is observation of the correlation between yields and the demand for bonds held in stripped form. For instance, when yields were over 5% before the financial crisis, the stripped share climbed above 30% at one point. That share plunged to a record low 11.7% in May 2016, two months before the low in yields. The yield surge during the taper tantrum of 2013 lacked bullish long-term conviction, as the stripped share drifted lower. Although yields have picked up, the stripped share remains historically low, suggesting that long-term investors expect higher yields, say NDR.
Investors will need much higher yields to justify buying debt in 2019, Strategas argues in a report published on November 15. Strategas uses two models to estimate the fair value spread for the Barclays High-Yield index, a macro regression model and a proprietary individual issuer default risk model. The resulting projection is for fair value in 2019 at or above 400 basis points, with a range around 380 to 440 bps. Compare that with the 2018 range of about 310 to 350 bps and the alarm bells start to ring – could the move be a leading indicator of recession?
German growth has relied on only two factors, exports and public spending on migrants, according to SouthBay, which predicted the third-quarter GDP contraction. Yet German exports now face an array of threats, notably slowing Chinese demand, and public spending on migrant integration is set to start falling in 2019. And the prospect of the country’s housing bubble coming to an end means that the worst is yet to come. SouthBay predicts further contraction in German GDP in either the fourth quarter of 2018 or the first quarter of 2019 – and that will be the trigger for a Europe-wide recession. SouthBay’s EU shipping index indicates that a fall in intermediate shipments will accelerate into the first half of 2019. Don’t expect any ECB rate hikes in such a context.
Rareview Macro ask whether there’s now a possibility that the ECB may backtrack on QE because the Brexit disaster is just as bad for Europe as it is for the UK, coming amid recent economic data. They say ”Add in Italy’s fiscal issues, Germany’s Merkel being the weakest in her tenure, France’s Macron low approval rating, and UK’s May’s potential departure, and it is easier to understand that the British pound sterling (GBP/USD) and Euro exchange rate (EUR/USD) are the same liability currency currently.” Which is why they argue EURJPY is a better vol proxy for Brexit than EURGBP. There’s also an interesting section that asks the question: ”Do I Need To Get Long Risk on Trade War Deal With China?” An interview with an unnamed hedge fund manager, who is considering getting large long on risk assets on the bet that a deal gets done between the US and China. And while it maybe tempting, Rareview suggests that this be just a little too late in the game (as in 2018) on a risk/reward basis to turnaround the unnamed hedge fund manager’s performance (A performance that reflects the overall YTD performance of active managers).
GE’s underfunded pension scheme and credit rating downgrade can be exaggerated in terms of the strength of the warning signal being sent to US credit markets, Gavekal Research argues. Financial conditions have tightened gradually from a low base, but are not yet bad enough to cause widespread problems for US corporates. Short rates remain low in relation to return on invested capital, which Gavekal favours as a credit risk metric. The metric needs to be watched going forward. Two to four rate hikes of 25 basis points each, along with a likely moderation in ROIC, would be enough to signal an underweight position in risky US credit. This could happen in the next six to 12 months.