As The Tri Polar World Turns - No FOMO Here
MACRO THEMES
It's often difficult to tell in advance what will cool off a hot equity market; witness the coronavirus, which took the steam out of global risk assets just as things were getting overheated - thus representing a healthy, if brief, market pullback. Abundant liquidity (St Louis Fed financial stress indicator at record low) & good economic data (JPM Global Econ Surprise Index 1st positive reading since October) coupled with better than expected earnings in both the US and Europe, have effectively inoculated risk assets against the virus.
Perhaps more importantly from an investment perspective, the equity rotation trade highlighted by JPMorgan and based off of upward inflecting Manuf PMIs has NOT been working. The nascent trends visible in Q4 reversed as the year turned with January one of the worst months in a decade for US Value vs Growth. Tech helped the US top the January global leader board supported by Defensives which sharply outperformed Cyclicals. It appears that folks late to the Fall risk asset rally jumped back on the prior winners resulting in US Growth/Tech exposure at 100% of 2010-2020 levels vs 2% for US Cyclical exposure according to Morgan Stanley.
We remain in the Reflation 2020 camp and have taken advantage of virus related commodity weakness to add to our broad commodity position. Commodities have been deeply oversold as a result of the coronavirus while long bonds have rallied back to the 1.5% resistance level on the US 10 year. Our view is that the virus has temporarily slowed rather than reversed the global growth recovery and as growth recovers, driven by what is likely to be a large inventory rebuild, we expect long rates to back up, growth stocks to reverse ( they have been trading off the 10 yr) and ex US/Value/Cyclical equities to do well. In many respects these are all one trade as we discussed previously. (See Chart 1)
Chart 1: Global Growth Pickup to Lead Rates Higher
Source: JPM
Given how far inventories were run down last year during the US - China trade tussle coupled with the current China virus related shut down, the risk is growing of a more powerful V shaped economic pick up towards the middle of the year, supporting global equities and challenging long bond yields.
ECONOMICS
Pre virus data flow has been supportive of a global econ bottom and 1H 20 pickup. The virus effect should be limited; a Reuter’s poll of economists see China Q1 GDP at 4.5% and full year GDP at 5.5%. If the virus does worsen significantly (signposts to watch include factory reopening’s - in process and a peak in new cases - expected over next 1-2 weeks) then the growth recovery could be called into question. (See Chart 2)
Chart 2: Virus Effect on China GDP Likely to be Short Lived
Source: NBS, JPM
The widespread nature of the positive data flow: 80% of Countries reporting Composite PMIs over 50, strong semi & export orders together with a better than expected German ZEW survey (best forward expectations since 2015) suggest the growth bottom is in. The BOJ upgraded Japan’s GDP forecasts for this year and next while the German Government actually UPGRADED its 2020 GDP forecast from 1.0 to 1.1%.
Poor Dec IP numbers for Germany casts a shadow over this narrative but we expect that to lift as we progress through Q1 and into Q2-3. BofA’s EU Composite Economic Indicator just had its strongest month in almost 3 yrs while none of its Asian econ indicators show bearish signals. The EC just reaffirmed Europe’s 2020 and 2021 GDP forecast at 1.2%, the same as in 2019, reflecting TPWIM’s Lower for Longer Global Growth outlook.
Inflation remains quiescent and the Fed is on hold while the PBOC has added between $150-$300B of liquidity to China’s financial system in an effort to offset the virus effects. These numbers suggest the PBOC is now the world's leading liquidity provider while the Fed and ECB remain determined to let inflation run hot. Given such a supportive global liquidity backdrop, it's hard to be negative risk assets.
Continued solid employment growth and wage gains in the DM support our Lower for Longer Global Growth thesis. Central Banks are likely to maintain easy policies until the virus threat is well resolved. The potential is growing for a sharper than expected global growth rebound as inventories, first run down aggressively due to 2019 trade friction and then again bc of the virus, could lead to surprising growth in the middle of this year. This should sharpen the distinction between ebbing US growth and ROW recovery & support ex US equity. We continue to think inflation could be a negative surprise for long duration US - EU bonds as we move through the year. (See Chart 3)
Chart 3: Post Virus Inventory Rebuild Could be Stronger than Expected
Source: JPM
POLITICS
We are only six weeks into 2020 and already investors have had to deal with the US - Iran tussle, Brexit, Xi risk, the Trump Impeachment and the start to the US presidential race. While still early it looks as if the Democratic Party will take its time deciding between its center and left wing with candidates lining up neatly behind those two banners. Much ink will be spilled on US politics with many quick to claim Trump reelection bets as rationales for higher markets or Bernie fears for lower. It's worth remembering that history shows the market does pretty much the same regardless of which Party controls the White House, though it's fair to say US equity would be at risk to a pullback on a Sanders victory.
China’s handling of the coronavirus has led to much talk about risk to President Xi’s leadership position should the virus continue to shut down the Chinese economy. This seems overheated as does the critique of the Chinese governing system for either limiting information flow once the outbreak began or shutting in 60-70 million people in an overarching effort to halt its spread. From this armchair China seems to be moving faster and more openly than during the SARS epidemic in 2003. Today’s dual challenge to stop the virus and restart the economy is a big one; the apparent decision to lower the standards to determine infections, leading to 15,000 new cases in Hubei Province coupled with new leadership there suggest the focus remains ring fencing Hubei and getting the rest of the country back to work.
In Europe the apparent implosion of Germany's leading party, the CDU, has garnered headlines as has Italy’s Salvini losing his 2nd straight election, reducing Italian populist risk & leading to a sharp bond rally. The Cabinet reshuffle in the UK is a reminder that disengagement from the EU is likely to be laborious. One learns that European politics take time, a lot of time to move and so we expect limited market impact from these maneuvers though Germany’s upheaval could affect the EU given its taking up the EU Presidency later this year. More importantly, the EC continues to move forcefully on the Green Deal while also starting to prepare for trade talks with the US as well as with the UK. Expect these talks to be tortured.
POLICY
US policy levers are likely stuck until Jan 2021. Post virus the market is forecasting an 80% chance of a Fed rate cut this year; we see this as quite unlikely & remain focused on the Fed’s desire to allow inflation to run hot, together with the ECB. The ECB’s strategic review is also unlikely to produce a lot of immediate news & is thus not likely to be market moving. The PBOC is the Central Bank to watch given its role in buffering the Chinese economic response to the coronavirus.
Fiscal policy is also likely to be on autopilot with some additional spending in Europe, the US running a trillion dollar deficit during a growth cycle (a first) and Japan already having presented its fiscal stimulus plans. India and Indonesia are among the EM that are committed to spending more as well as others. Europe’s Green Deal should unlock considerable spending but most likely not in 2020.
The trade front will be active and could represent wild card risk given President Trump’s appetite for confrontation; Europe’s apparent decision not to ban Huawei could leave it open to Trump attack. The Digitax issue is also one to keep an eye on. US - UK trade talks will be worth watching but the big deal is US - EU; the EU has been moving fast to try and find some common ground.
MARKETS
As noted, the short & sharp risk asset pullback in the wake of the coronavirus was healthy; the failure of the growth bottom rotation over the past month is not. JPM argues to stay the course, noting that the upturn is only 5 months old and prior history implies upturns have always lasted at least a year. It also notes that EPS expectations for the coming Qs are too low and positive EPS surprises will support equity upside. Q4 EPS reports have been strong in both the US and Europe (both up y/y) with Europe EPS x Energy +7% y/y. We note that of our Big Four Signposts the EPS bottom was the last outstanding item (following Global easing cycle, global Manuf PMI bottom and US - China trade truce) and it seems as if it has arrived. (See Chart 4)
Chart 4: Last of Big Four Signposts in Place- EPS Bottom
Source: Jones Trading
There are two market questions one needs to wrestle with:
1a. Should the coronavirus cause the global growth recovery to elongate does it mean that the equity response might run into US election risk and not happen or
1b. Alternatively could it happen in a rush as the two issues combine - US political risk and ex US growth recovery - leading to a surge into non US equity?
2. The outcome of the duration trade noted at the top: long duration debt, US Growth & Defensives vs non US equity, Value and Cyclicals needs to be determined. Was the Q4 bounce in the unloved assets it - are we back to the 2019 playbook of all US Growth, all the time? (See Chart 5)
Chart 5: Opportunity to Reload in Value/Cyclicals
Source: BofA Global Research, Bloomberg
It seems as if there are two inflated segments of the financial markets: long term USD debt represented by the 10 yr UST offering negative real yields and US growth represented by Big Tech responsible for the bulk of US equity appreciation. BofA notes the flows into bonds are running at record levels; as rates fall, the cash flows of the Big Tech co become more valuable supporting further price rises, outperformance and a narrow equity leaderboard. Big Tech is also benefiting from massive ESG related equity flows which also serve to hammer Value sectors such as Energy. This has led to many stretched relationships across financial markets.
Concurrently, key Value/Cyclical sectors like US financials (XLF) are testing important technical levels ($31 - 13 yr resistance in this case) while broad indices such as the Euro Stoxx 50 test 20 year resistance levels. As the S&P hits new highs almost daily, ACWX remains roughly 10% below its 2018 high while ACWI is roughly 5% above 2018 peak levels (hint the only difference is US OP). At the recent Inside ETF Conf down in Florida ESG was all the talk - Japan is one area where the G is in action as corporate Governance takes a front seat in an equity market that some suggest is as cheap relative to the US as it has been since the early 1970s. (See Chart 6)
Chart 6: Looking for Cheap Call Option on Global Growth?
Source: Variant Perception
How this rotation plays out will be more determinative of 2020 investment returns than the coronavirus. It's clear that global growth has to materialize for these relationships to unwind and reverse - either on a tactical or strategic basis. The stronger the ex US growth pick up the greater the rotation is likely to be. A tactical move would seem easier and still worth playing for versus a strategic, multi-year shift given the old adage that bull market leadership does not change and often narrows and accelerates as the bull market top approaches. This decision can wait in our opinion.
PORTFOLIO STRATEGY AND ASSET ALLOCATION (GMMA)
The year has started off with a curveball with bonds outperforming stocks and the US, Growth & Defensives leading within equities. We continue to believe not all assets will rise in 2020 & remain overweight Equities vs debt, non US DM equity vs US equity, Value vs Growth and Cyclicals vs Defensives.
Within fixed Income we expect the 10 yr UST and BUND to trade back towards fair value (above 2% on the UST and back toward .25% on the 10 yr BUND) as growth recovers. Our Reflation 2020 scenario suggests that one can continue to Search for Yield in the credit space as well in EM$ debt. We remain convinced of a possible inflation scare as the year progresses and maintain a healthy TIPs position.
FX has been quiet with JPM reporting FX volatility recently made an All TIme Low. Over the past two weeks or so, some Euro weakness has been visible as it quickly dropped to multi year lows vs the USD. GIven the need for a European economic pickup this may be healthy for corporate profits and thus stock prices. While drifting higher, the USD remains broadly range bound while the A$, a global growth proxy, has sold off fairly sharply. China’s RMB has been stable, notwithstanding virus related uncertainty.
In the Alts space we have added to our Commodity position believing the space to be deeply oversold on an absolute and especially a relative (to stocks) basis. With energy stocks under pressure to deliver the “holy trinity” of continued fossil fuel production, investment in the transition to renewables and high dividend payouts, the ESG focus is challenging the space in a major way. We continue to explore the impact of ESG flows on various segments of the equity markets.
GLOBAL MACRO SUITE PORTFOLIO CHANGES
Global Macro Multi Asset (GMMA)
In ALTs, we exited our Residential Mortgage position and added to our broad Commodity position.
Global Macro Income (GMI)
We reduced our cash position and added to our US HY position as well as our International Equity Value position.
Global Macro Equity (GME)
We exited our International Value position and replaced it with a broad Commodity position
I hope you find this monthly piece of value and look forward to engaging with you on a monthly basis as we move through 2020.
Jay Pelosky, CIO & Co-Founder
TPW Investment Management
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