Friday, January 19, 2018

Why the 2018 Consensus is Wrong?

Earier this week, Chen Zhao, chief global strategist at Alpine Macro, hosted a webcast to discuss their 2018 Macro Outlook and investment strategy, Coming Boom and Policy Clashes: Why the 2018 Consensus is likely Wrong.

The key questions that were addressed were the following:
  • Is the recent spurt of strong growth around the world a late cycle phenomena or mid-cycle expansion?
  • How long will the “sweet spot” last in the eurozone?
  • Why has U.S. wage growth been so tepid against the booming job market and low unemployment?
  • Is inflation in the U.S. economy a serious threat to the equity bull market?
  • With global equities in a melt-up, what is the sensible investment strategy?
  • What to do with emerging markets, international stocks, value and small cap equities?
  • How high will the 10-year Treasury yield go?
  • Is the recent rally in commodities a real breakout that will lead to a new bull market or a fake-out that will end in new lows?
Please note that a replay of this webcast is available to qualified investment professionals. For the access code, you can send an email to info@alpinemacro.com with your contact details including name, firm, phone number and country.

Before I begin, let me thank Chen for providing me his slides and notes for this webcast. I was hoping they would post it on YouTube so I can embed it here but I think it's best you contact them here, get a trial access to their research and watch a replay of the webcast (it was short, concise and thought-provoking).

For those of you who don't know, Alpine Macro was formed by three industry veterans, Tony Boeckh who led BCA Research from 1968 to 2001 (see company's history here), Chen Zhao who worked many years at BCA as a Managing Editor of the Emerging Markets and Global Investment Strategist publications before going to work at Brandywine Global and David Abramson who was the Managing Editor of BCA's F/X and commodities publications. You can read more about them here.

Collectively, Tony, Chen and David have many years of experience and they have seen it all, so I would definitely subscribe to their market research because as you'll see, it's not based on consensus. They have their own views on markets which you may or may not agree with but I guarantee it will make you think hard about where we're headed.

You'll recall I alluded to Alpine Macro's 2018 outlook in my comment after Christmas looking at whether it's time for the Santa rally:
It's particularly hard trading when markets enter a melt-up phase, where everything explodes up, and this in spite of the Fed raising rates.

In my experience, this is when the biggest gains are made. This is why I've been trading stocks over the last month like crazy, because I knew as long as that tax bill wasn't signed, markets will keep going higher in anticipation of  the new tax plan.

Now that we got this tax bill out of the way, it will be interesting to see if markets keep forging ahead despite the Fed rate hikes.

Personally, I'd love to see a healthy pullback on the S&P 500 (SPY) right back to its 50-week moving everage before it takes off again. It doesn't mean it's going to happen, especially in these markets where traders chase momentum.

But these markets aren't just about momentum and chasing trends. Some argue the fundamentals warrant more upside in stocks.

In fact, Chen Zhao, Chief Strategist at Alpine Macro, sent me this in an email Friday morning:

Alpine Macro’s 2018 Outlook, titled “Unanticipated Boom and Coming Clashes”, is currently being completed and will be released on January 5th . The report’s release will be followed by a live Webcast where I will answer your questions. Here is a preview of the report:

Entering 2018, the investment community has comfortably converged to the view that economic growth in the U.S. will be around 2.5%, growth in the Eurozone will decelerate to about 2% and China’s economic growth will soften to 6.3%, ergo the consensus calls for a replay of 2017 in 2018. As for markets, most investors are cautious on stocks, bearish on bonds and uncertain about commodities and emerging markets.

Maybe the consensus is right, but we disagree. We are looking for a low-inflation economic boom, driven by private capex, re-leveraging and an possible “race to the bottom” in tax cuts around the world. We are looking for much stronger growth in G7 in 2018, while China’s economy could also deliver a positive surprise.


As for financial markets, our research suggests that the bull market in U.S. stocks has not yet matured. Despite the recent price gains, the total return index for the S&P 500 has not even returned to its long-term trend (see chart above). Should a low inflation boom indeed develop, a “melt-up” in global equity prices could be the big surprise in 2018. We are not particularly bearish on US treasury bonds, but the dollar story will become complicated in the New Year.

Finally, various risks will also escalate next year, suggesting that financial market volatility will be sharply higher. Investors should think about hedging strategy, especially now with VIX index at extremely low levels.
Chen is right, don't discount the low-inflation melt-up in global equities in 2018, it might happen and take everyone by surprise.

Importantly, after years of quantitative easing (QE), there is still a tremendous amount of liquidity in the global financial system driving stocks and other risk assets higher. And all this talk of rate hikes and reducing central banks' balance sheets is much ado about nothing.

Where I disagree with Chen and the folks at Alpine Global is on their "particularly bearish" call on US Treasuries (TLT) as we head into 2018. Why do I disagree with this call? Simply put, deflation remains the biggest threat as lofty stock markets head into the new year.

This is why I'm still recommending buying the dips on US long bonds (TLT) and still believe that melt-up or meltdown, Treasurys offer the best risk-adjusted returns going forward:


I realize this is counterintuitive but think about this way, if stocks keep melting up, downside risks will soar too, and if they melt down, well, there won't be many places to hide except for US long bonds, the ultimate diversifier in these insane markets.
So far this year, US long bonds (TLT) haven't been performing well as the 10-year Treasury yield jumps to its highest level since 2014 (remember, bond prices are inversely related to yields, so if yields rise, bond prices decline).

According to J.P. Morgan Asset Management, the 10-year Treasury yield will edge higher throughout 2018 towards, but not above 3 percent, as central banks relax their stimulus.

This remains to be seen but there is no doubt that with the 10-year yield breaching the 2.63% technical level (it's at 2.64% at this writing), US long bond prices are getting hit and bond bears like Jeffrey Gundlach and Bill Gross feel vindicated (for now). More on that later.

Back to Alpine Macro's webcast. Chen kindly provided his notes and charts to this webcast (added emphasis is mine; click on each image to enlarge):
Before I start my presentation, let me share a piece of good news with our clients. Many of you might have known Yan Wang, who was BCA’s chief China strategist and managing editor of BCA China Investment Strategy from 2003 to 2017. Effective this week, Yan has joined us to head up our emerging market and china research.

I think that Yan is probably one of the best China experts around the world and he is known for thoroughness, objectivity and contrarian ideas for his research. I am really thrilled that Yan is now with us. He will launch our EMC strategy in due course. So, stay tuned.

Back to the outlook, I will spend about 20-25 minutes to lay out the key points of our macro story and investment strategy for 2018 and this will be followed by a Q & A session.

Throughout the webcast you may send in your questions via email and I will try to answer them as much as I can. In case I don’t have enough time to handle all the questions, I will email you with my answers separately.

The world economy has entered 2018 with a strong note. Everyone understands that the world economy is in a synchronous economic expansion for the first time in eight or nine years.

The consensus view suggests that the latest spurt of strong global growth is a late cycle phenomenon. This is primarily based on the fact that US economic expansion has lasted eight nearly nine years and the Fed has already begun to raise rates. In history, the combination of strong growth and tightening monetary policy almost always leads to an end of a business cycle expansion.

Maybe this consensus is right, but I would like to offer you an alternative view. That is, while everyone is trying to figure out when the next recession will hit us, the world economy has just gone through a recession in 2015/2016. If So, the latest strength in economic growth is likely to be a mid cycle expansion instead of an end of a cycle phenomenon.

Here a few points are worth sharing with you:
  • Chart 1 on page 2 shows nominal GDP growth in the US. The US economy grew 2.5% nominally in 2015/16. This is a nominal growth rate was often seen in past economic recessions.
  • Even in real terms, you could say that the U.S. is in a mild recession. Chart on page 3 is the growth rate of real GDP created per labor, or real growth in GDP relative to labor force. On per-labor basis, we had a mild recession in 2015. Actually, the depth of that recession was comparable to 2001.


  • Chart on page 4 shows China’s nominal GDP dropped to very low levels in 2015. In fact, it was the first time when nominal GDP was even lower than real GDP in China’s post reform history. It is not an exaggeration to say that the growth slump in China in 2015 was worse than 2008 when global financial crisis struck.
  • Of course, there was severe recession in many resource-heavy economies in the EM universe. Russia, Brazil, South Africa and Indonesia were all in deep recession between 2014 and 2016.
  • Only Europe and Japan were doing ok during 2015/16, but these two economies came out of extremely depressed bases so one would hardly feel that they were in recovery during these two years.

  • Chart on page 5 shows that the SPX stayed flat for nearly two years from early 2015 to late 2016, while EM equities collapsed during this period
  • Other market signals were also consistent with that of a mild recession. Chart on page 6 shows that stock bond ratio collapsed in 2015 along with profit recession in the US. Bond yields made new lows. Chart on page 7 shows that Commodity prices collapsed, while junk spread blew up.



All of these market signals are consistent with a mild recession during 2015. Therefore, it is legitimate to argue that the recent economic strength around the world is actually a mid cycle story. My judgment is that the world economy is probably still in its most dynamic phase of economic recovery.

This is a key reason why we are calling for a mini boom around the world this year.

There are several key developments supportive of our assessment: a few reasons for this call:
  • Chart on page 8 Consumer deleveraging is drawing a close. We know that the consumer deleveraging has been the key reason causing recovery to be anemic for the last several years because consumers have been preoccupied by saving more and spending less to pay down their debt. The good news is that this process is ending, as evidenced by a flattening debt-to-disposable income ratio.
  • Importantly, consumer debt creation is way below historical average and it has a lot room to accelerate. This would suggest that consumer spending can now grow at the same rate or even stronger than income growth, if they begin to take on leverage again.

  • Please go to Chart on page 9 In recent months, falling unemployment and tight labor market have fostered a sense of optimism. This is reflected by surging Consumer confidence, suggesting that a spurt of strong consumption growth will likely follow.

  • Chart on page 10…Corporate Capex has been very bad for the advanced economies throughout the post 2008 period and the U.S. is no exception. There is a net depletion in corporate capital stock in the US since investment growth has fallen short of deprecation rate for the last few years. As a result, capital-labor ratio has also fallen, perhaps to a point that is causing problem for profit maximization (left panel of chart on page 10)
  • If you look at the right-hand side of this page it shows that capex cycle is already beginning to unfold even without the enacted tax cuts. This process will be further enforced by GOP tax reform.
  • There are all kinds of estimates on the impact of Trump tax cuts and most tend to believe that the impact is modest.
  • On this issue, the best analysis is the one done by professor Robert Barro of Harvard University. He estimates, based on cross-country analysis, that the full expensing of capital expenditure, plus lower tax rate, should add about 0.4% to GDP growth in the next five years as firms front-load capex. The longer-term impact should be around 0.3% p.a.
  • Importantly, lower corporate tax rates in America, plus cheap energy and land cost, can indeed attract much FDI into the country, adding strength in growth. All of this is to say that GDP growth in the US could accelerate towards 3% this year, or better.


Turning to China, the investment community has formed a unanimous view that the Chinese economy will be softer in 2018 than 2017. Everyone thinks that the Chinese government’s deleveraging effort will shave some growth from the economy.

We take a different view. We feel that growth will not be any different from 2017 and in fact could even be a tad stronger. Three key driving forces for China’s economy:
  • First, Chart on page 11: inventory-sales-ratio the residential market has dropped precipitously in the property sector, suggesting that the inventory has been depleted quickly as a result of sustained deceleration in real estate investment.
  • This week the Chinese government has announced a major land reform package. Essentially, this package breaks the state monopoly of land supply, allowing private sector to participate in the land supply formation process. This is a big deal.
  • I think that the low inventory, strong demand and flexible land supply will lead to a significant rebound in real estate investment this year. This is something many people do not anticipate now.
  • Second, corporate profit and private investment: Private sector has run down its investment for years and much overcapacity has largely been worked off. With corporate profit rising strongly, private capex should strengthen.
  • Finally, Chinese exports are bouncing back quickly. Strong global demand is clearly helping the Chinese manufacturing businesses that are exporting their products at a double-digit rate.
  • As for Europe and Japan, these economies are still in a “sweet spot” where policy is ultra easy, inflation is low, and growth is recovering from a depressed base. This means that that growth in these areas can sustain at their current rates without provoking serious inflation threat. Policy is still focusing on protecting growth.


Inflation Scare?

  • With the world economy being strong, there is a natural concern that inflation could soon become a problem.
  • Chart on page 12 Inflation scare is possible, and we mean a few months of creeping inflation could scare off investors. Should a mini boom develop, nominal pressures will build, leading to some increase in inflation. It is not clear how central banks will react.
  • But historically, central banks are always fighting the last war. ECB is clearly fighting collapses and deflation at a time when deflation risk has subsided.
  • However, I doubt that inflation will become a major threat. It shows that total private credit creation remains weak, and usually inflation does not develop a sustain uptrend if credit creation is tame.
  • Chart on page 13 also shows that inflation rates in most parts of the world are still below central bank targets. That would also encourage central banks to err on the side of being too easy for too long.


Investment Strategy

Against this background of strong growth and low rates and modest inflation, it is reasonable to believe the financial markets will be dominated by risk-on trades.

Our main calls can be summed up as the following: Long equities versus bonds, long international stocks versus the SPX, long commodities and stay short the USD.

Equities
  • We believe that the US stock market will underperform the global counterparts. It has proven that an lukewarm economy is great for stocks, but the odd is that the US economy will be running much hotter than it is now. This means that both profit growth and interest rates will head higher, with latter probably being faster than what is discounted now. The higher rates will not kill the bull market, but will curtail the speed of price advance in SPX. As a result, an underperforming SPX is likely, but price volatility will rise sharply.
  • We are much more bullish on international stocks, EM equities in particular. We are also bullish on values versus growth, bullish small caps versus large caps in anticipation of leadership changes.
  • Chart on page 14 (EM relative performance) tells me that the relative cycles between EM and SPX go by decades. Now, the secular bearish phase for EM is over.
  • Chart on page 15 Valuation for EM is better, especially considering the possibility of a large drop in interest rates in LatAm. EM profit growth has surged, and P/E is significantly lower than SPY.
  • European stocks have a lot room to expand their multiples. Dividend yields are high, at over 3% and the spread over SPX is over 100 basis point. I think that that the rates will head higher in Europe but at equilibrium discount factor is much lower than that of the US. As a result, on valuation basis, EFEA stocks look attractive.


Bonds
  • Central bank policy from US to Europe to Japan has been geared towards fighting deflation and for a long time G7 government bonds priced in high probability of widespread deflation. However, with global mini-boom developing, the risk or danger of deflation has subsided. As a result, bond yields will likely back up globally to reflect a more normal economic condition.
  • Chart on page 16 is our bond model for 10-year US Treasury bonds. It looks that bond yields will likely touch 3% before the market could settle down, so my projection is that 10-year Treasury yields will rise towards that levels soon. At that point, it would probably trigger some negative reaction from the stock market and this would create a reason for the bond market to rally.
  • German bunds are much more vulnerable. We wrote a piece titled “Sell Bunds” and it argued that the ECB would have to end QE earlier than expected. Now, it is beginning to do so. The bunds market is in max. danger. We made good money on this. More price weakness to come.

Currencies and Commodities

On the currency front, I like EM currencies, especially resource-based currencies.

I think that the US dollar topped out more than a year ago and it is already in a bear market, but conditions for a counter-trend rally are in place.
Chart on page 17 The Yen is a flat story because Abnomics aims at reflating nominal GDP so Japan cannot afford a stronger yen.

I like MXN BRL and Chilean peso. A virtuous circle is developing where a steady to strong currencies led to falling rates….pretty similar to the 2000s.

I also watch to buy EUR on major pullback. I think CAD will reach 1.10 this year so any pullback in CAD is worth buying. I am bullish on AUD too.

There are lots of dollar bulls because tax cuts and tighter money seems bullish for currency. I take a different view. Tax cuts and tighter money are known story for a long time and these are well digested by the market.

If you look at the recent history, the dollar tends to weaken at the time when the Fed lifts rates. The key point here is that growth outside the US is accelerating but rates are still suppressed by the authorities. As a result, the currency markets will have to strengthen more other they would otherwise do to compensate for excessively low interest rates that are still available outside the US.

Chart 18-19 suggest that commodity prices are in a new bull market, especially against the SPX. This asset class goes for 10-year cycle and the current position appears to be very bullish. Good global growth, a weakened dollar and much-reduced production capacity argue for a sustained bull market in CRB, crude market in particular.



Finally, a few risks for 2018:
  • Trade war: Trump will likely turn to trade after the tax cuts and regulatory reforms. I am concerned that a tit-for-tat trade war and retaliation could be quite disruptive. The biggest weapon the US has is its trade surplus with China, and the biggest weapon China has is its dollar asset holdings.
  • Beijing has hinted that it may not want to hold the treasury bonds. In case of a trade war, China may seek a RMB devaluation to fend off higher US tariffs. In the meantime, Beijing may offload its US papers, prompting a selloff in bonds. In the end, it is difficult to know what the dollar would do but bond yields could be a lot higher, thus hurting the economy
  • Panic reaction of the Fed to an inflation scare. The Fed is willing to err on the side of being too easy, but in case of a mini economic boom and core PCE inflation creeping up, the hawks at the Fed may push for quicker rate hikes. This in turn may curtail stock market performance.
I thank Chen for sharing his notes and slides with my readers. Once again, you can contact them here, get a trial access to their research and watch a replay of the webcast or just email them at info@alpinemacro.com.

Also, please remember you cannot redistribute these charts without permission from Alpine Macro.

Needless to say, January isn't over yet and I provided you with my Outlook 2018 featuring insights from Cornerstone Macro's Francois Trahan on why we need to focus on stability, another comment earlier this week discussing the great market melt-up of 2018 featuring some insights from David Rosenberg and Martin Roberge (the latter is in line with Chen's views) and now this comment going over Chen Zhao's outlook.

After reading these three comments you might be confused but that's what makes a market. I can give you strong arguments for and against why global synchronized growth will or won't continue this year and this will turn out to be the most important question to ponder when determining your asset allocation.

The key thing to remember is if you believe global growth will continue to surprise to the upside, you should overweight cyclical sectors like energy (XLE), metals and mining (XME), financials (XLF), and industrials (XLI) and underweight less cyclical sectors like healthcare (XLV), consumer staples (XLP) and utilities (XLU). You should also overweight commodity currencies like the Canadian dollar (FXC) as well as emerging market stocks (EEM) and bonds (EMB).

If you believe things are going to cool off this year, you need to position your portfolio more defensively and even buy US long bonds (TLT) as they sell off (like now).

Hope you enjoyed this market comment and my other comments. Please share this blog with your contacts and kindly remember to support it via a donation or subscription on the top right-hand side under my picture. I thank all of you who take the time to donate to support my efforts in bringing you great insights on markets and pensions.

As far as clips, Chen Zhao, chief strategist at Alpine Macro, was on BNN Friday explaining why investors should be long international stocks and why oil could climb to US$100/bbl. I cannot embed but you can watch Part 1 this interview here and Part 2 here.

Below, the “Fast Money Halftime Report” traders discuss the volatile week for stocks with Tom Lee, Fundstrat, and Mike Wilson of Morgan Stanley who says stocks will handily beat bonds this year.

Lee also said that he and the firm's technical strategist think stocks will likely run higher for annother 11 years:
"Both [Fundstrat technical strategist Rob Sluymer and I] think it's more like 2029 is the peak of this equity market cycle and then, the S&P is 6,000 to 15,000," said Lee, head of research at Fundstrat Global Advisors, on CNBC's "Halftime Report" on Friday.

"So I think it's just important to be long-term oriented right now."
Take that Jeremy Siegel! To be fair, Lee is talking about the long run but I still think he's way too bullish.

Lastly, David Riley, head of credit strategy at BlueBay Asset Management, discusses monetary policy and the US bond market. Like I've said before, prepare for a bumpier ride ahead.



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