December 2019 Global Macro

What an astounding year it has been for risk assets in general as equities, fixed income (high yield) and commodities posted double digit returns in 2019. All eyes will be on the November 2020 election with hedge funds betting that an Elizabeth Warren (if she makes it as the primary candidate) win bodes ill for the financial markets – it seems that Trump is the new normal and his unpredictability is now predictable. This is even more evident now as he decided to take out General Suleimani via a drone strike in Baghdad, which proves again that he is a man who cannot sit still. Those who have been pondering what next after a Phase One trade deal have gotten their questions answered. Majority of banks are bullish on equities in 2020, citing a recovery of global growth and detente between US and China. However, it remains to be seen if Trump wants to shift his focus to Europe and rest of the world to bully them into signing protectionist-style trade deals. One important development in 2020 that could give way to an out-performance of Emerging Market assets would be a chronic weakness of the US Dollar, which is already trending downwards. This would also provide a further boost to gold – which I am still bullish on.

Figure 1. US Retail Sales & Consumer Confidence (Mthly % Change)

Figure 2. US Corporate Profits (% of GDP)

US retail sales and consumer confidence (Figure 1) remains intact to offset any manufacturing related weaknesses. However, US corporate profits as a % of GDP (Figure 2) has continued to suffer amidst peaking of the US earnings cycle. In fact, the current trend is ominous as this preceded recessions in the past, for example in 2000 and in 2007. It is just baffling that global equities are hitting historical highs now. Earnings is a core factor that drives equity performance so this divergence should not be overlooked.

Figure 3. ISM Manufacturing PMI. Source:

Figure 4. Services PMI. Source:

The manufacturing PMI (Figure 3) fell to 47.2 from 48.1 in December, under-performing expectations of 49 and this is the lowest since June 2009. This was the 5th straight month of decline due to contractions in new orders, production, employment and new export orders. Services sector (Figure 4) fell to 53.9 from 54.7. Business activity was sluggish while new orders and employments increased faster.

Figure 5. US Non-Farm Payrolls

Based on the US jobs data (Figure 5), we can see that the employment market remains strong. Unemployment rates held steady at 3.5% while private jobs creation came out at 266,000 in November 2019 beating market consensus of 180,000. One vital measure of cost-push inflation – average hourly earnings measured on YoY basis, stayed at 3.1% while MoM fell to 0.2% from 0.4%.

Figure 6 . AAA-BB Corporate Bond Spread. Source: Fred St. Louis

The credit spreads in bond markets hit another low as US high yields were the star performers in the credit space (Figure 6) hence depressing yields relative to investment grade corporate. Low interest rates and a subdued inflation environment helped in prolonging the current bull market. If risk assets can continue their star-studded performance from 2019, spreads in the high yield space will remain narrow but seeing how US is still weaker from a macroeconomic perspective relative to few years back, there is little doubt that spreads will widen again as the market corrects. With the USD weakening, Asian credit this time round may lead the pack instead though one should be tactical with high yield at this juncture.

Figure 7. US 10-year Treasury Yields VS. Effective Federal Funds Rate. Source: Fred St. Louis

The spread between the US 10-year Treasury and Fed Funds Rate (Figure 7) has returned to normal with the former being above the latter. This would not have been possible if the Fed had not cut rate three times in 2019. Pull-back in safe haven assets also helped as markets cheered a so-called Phase One trade deal, which content no one knows.

Figure 8. 10-year UST & 10-year TIPS. Source: Fred St. Louis

Figure 9. US Flow of Funds.

It seems that the spread between the US 10-year Treasury (UST) and 10-year TIPS have recently widened (Figure 8). The spread between both would give the inflation premium. Investors are expecting inflation to increase so the selling has been more intense in the UST while a demand in TIPS have helped suppress yields although it looks certain that a certain portion of outflows from UST were diverted to equities. The US flow of funds and debt growth (Figure 9) shows that leverage is still constrained relative to history. The home mortgages trend also re-affirms a bullish view on the real estate sector in the US.

As a summary, it looks like US equities have gotten ahead of themselves and are pricing in news to perfection. Overall macroeconomics still remain bullish but a major pull-back looks imminent if corporate earnings do not pick up. There are no recessionary signs within the next 6 to 9 months.

US Sector/Earnings Outlook

                                                                                                                                                               Figure 10. S&P 500 Earnings Growth 
On the Q4 earnings front, the estimated earnings decline is -1.5% wheh: End of Qtr Estimate vs. if realized, this will be the first time since Q3 2015 where the index has reported four straight quarters of YoY earnings decline. As per Figure 10, earnings actually peaked in Q3 2018 and have been declining ever since.

                                                                                                                               Figure 11 . Change in S&P 500 Price vs. 12-Month Forward EPS

Looking at the forward 12-month EPS against the S&P 500 (Figure 11), it is clear that earnings and the S&P 500 are diverging further from each other. However, over the past 5 years on average, actual earnings reported have exceeded estimated earnings by 3.6% due to the number and magnitude of positive earnings surprises hence there is a possibility that earnings will turn out positive.

Figure 12. S&P500 Q4 2019 Earnings Guidance.

Based on Figure 12, the consumer discretionary sector recorded the largest decrease in expected earnings growth since September 30. For guidance, 72 S&P 500 companies issued negative EPS guidance for Q4 while 35 companies issued positive EPS guidance. Analysts are projecting flat earnings for CY 2019 at +0.3% and an expected earnings growth of 5% – 7% in Q1 and Q2 2020.

Global Economic Outlook (Ex. US)

Figure 13. Emerging Market CPI (12-mth % Change)

Figure 13 above shows that since 2017, inflation has stabilized in emerging markets on the low side. Not only that, countries within EM do not deviate too much in CPI numbers among each others, possibly showing how globalization has caused nations to be inter-connected and correlated to one another. One notable observation in 2019 is that CPI numbers were trending downwards, with the exception of India, whose inflation has been surging due to rising food prices. Current inflation trends will still place emerging market central banks on hold and to possibly ease further if inflation expectations do not pick up. It is unlikely that interest rates will take a 180 degrees turn to the upside although rising commodity prices in 2019 is expected to cause bond investors to mull the implications of these on inflation break-even rates in 2020.

Figure 14. Ten year Govt. Bond Yields

As in Figure 14, we see that bond yields overall have dropped since 2018 which is not surprising given a falling interest rate environment and also market volatility. Brazil and Russia government bonds rallied the most among the BRICS although moves in South African and Chinese bonds were more constrained. Recently, yields rose the sharpest in India as investors asked to be compensated for surging food inflation. In addition, one would notice the relative flat and stable yields in China, which is attributable to the closed nature (around 3% foreign participation) of their bond market and an iron-grip control by the Chinese government. With programs to gradually open their onshore bond market, initial volatility may creep in as investors scramble to re-price risk and the lack of liquidity would also concern foreign funds. South African bond yields have been rising since 2013 due to poor macroeconomic conditions there.

Figure 15 . Trailing 12-months Earnings Growth

Looking at the trailing 12-months earnings growth (Figure 15), this clearly justifies why the sensational performance of global equities were nothing much to shout about. Improving trade sentiment alongside accommodative central banks were the main drivers of equities but earnings have not improved to support higher valuations. In fact, Europe’s earnings have stayed negative while Japan’s are still in free-fall. Moreover, S&P 500 is at all-time highs while US corporate is languishing at the borderline of growth and contraction. If equities in 2020 keep climbing on optimism but earnings have nothing to show for, then participants will be in for a rude awakening.

Figure 16. Eurozone Economic Sentiment Indicator

Euro Area (Figure 16) is particularly concerning as not only its earnings are contracting, but its economic data still remains uninspiring overall while its GDP is in the lower range since it recovered from the Eurozone Debt Crisis in 2013. What’s baffling but not surprising is the fact that European equities joined the global rally, with nothing much to show for other than optimism that things will get better hereon. Twelve-month forwards earnings are expected to pick-up but still forecasts are nowhere as near to the peak in 2015, yet European equities are already challenging the 2015 market highs, evident by he current performance of the Stoxx 50 index.

Figure 17. EM Equity Market Performance Since 2006 (relative to USD Index)

The decision to overweight either emerging market or developed market has always been a fascinating one. Based on Figure 17, the deciding factor has always been the USD strength. This is evident where (1) when the DXY (Dollar Index) weakened from 2006 to 2008, the MSCI EM outperformed MSCI World and (2) as the DXY gradually climbed up to current times, we can see how MSCI World gradually caught up with MSCI EM and then overtook to become the best choice for equity investment. For the past few years, financial institutions have been harping on a weakening dollar but the bears could not find solace as the DXY stood strong. However, it has been obvious in the past months that the DXY is starting to tire while gold and oil have been stellar performers in 2019. In a bull market moving forward, it would be prudent to overweight quality emerging market assets relative to developed markets to capitalize on this scenario.

Figure 18. China Interest Rates & 10-year Government Bond Yields

Interest rates in China (Figure 18) have not budged since 2015 as the PBOC is worried of another property bubble should they lower rates even further. Instead, they have been focusing on fiscal stimulus and also targeting the RRR of banks. There have been indications that the PBOC is even comfortable to let China go into a mild recession and allow institutions to deleverage. Risk-off sentiment has been the norm since 2018 as depicted by falling bond yields but a surging inflation in China due to pork prices have capped the fall in yields. Consumer and entrepreneur confidence has stabilized on the upside alongside an overall improvement in positive surprises of economic data. On the other hand, car production and automobile sales volumes have contracted while non-performing loans have climbed steadily although the ratio is still below 2, indicating that this is due to an increase in loan issuance and not due to a deteriorating credit landscape.

Figure 19. India Composite Leading Indicator

India (Figure 19) is possibly facing a stagflation scenario with sluggish growth on top of a surging inflation due to rising food prices. The leading indicator is pointing to an annual growth of approximately below 6% this year. It’s slowing labor market is not helping remedy the slowdown as it also deals with negative industrial production, falling gross fixed capital formation, contracting car sales (-15% YoY) and plummeting business expectations (worst ever since the 2008 Global Financial Crisis). Despite being the 2nd largest population in the world, India is not efficiently utilizing its workforce given its dropping labor participation rate (from 59% in 1990 to 52% currently) and this will be a prevailing demographic theme as the number of those aged 0 – 14 are falling while those aged 65+ have been steadily increasing which means that a graying population will hit consumption and increase social spending burden down the road.

Figure 20. Japan Bank Lending, M2 and Bankruptcies

For Japan (Figure 20), its M2 money supply have bottomed YoY in the current cycle since the 2008 financial crisis. The M2 has been a reliable indicator of fund flows into Japanese equities where an increase in money supply translate into higher asset prices. With bankruptcies picking up, it is seen that banks have curtailed their lending operations. Japan’s industrial production and machinery orders have been contracting, underpinning a backdrop of plummeting consumer and business confidence.

Global Technicals

                                                                                                                         Figure 21. MSCI All-Country World Index ETF (Weekly)

The MSCI World Index (Figure 21) is lingering at historical highs but a pull-back is expected to $77.22 for a test of this newly-formed support.

Figure 22. MSCI Emerging Market ETF (Weekly)

Emerging markets (Figure 22) have broken out reliably from a down-trending channel. pulled back to successfully test the new support and rallied higher from there. The uptrend is expected to continue barring any recession and the momentum moving forward could be stronger than those in the developed market.

                                                                                                                                 Figure 23. ISHARES Europe ETF (Weekly)

Europe (Figure 23) looks no different from Emerging Markets and is near a crucial resistance – $47.46.

                                                                                                                                                 Figure 24. ISHARES Japan ETF (Weekly)

                                                                                                                                        Figure 25. Nikkei 225 Seasonality (20-year average)

Japan (Figure 24) is still showing a surprising resilience albeit a gloomy outlook in the world’s 3rd largest economy. Dip is expected in January before supposedly making a bottom in mid-February and then rallying all the way to “Sell in May and Go Away”.

Figure 26. MSCI China ETF (Weekly)

MSCI China (Figure 26) is testing a vital resistance and a break above would mean a possible $10 upside to historical highs.


Figure 27. US Housing Construction.

Figure 28. US Existing Home Sales & Inventory.

One feature about macroeconomic data is that the ranges can be rather predictable. Thus, if we can determine a high and a low, we can anticipate if there is room for further upside or growth and translate that observation into a practical trade. Looking at Figures 27 and 28, because the subprime crisis hit the property market so hard in 2008, the real estate sector has not fully recovered from the aftermath. Therefore, housing construction still has room for upside because supply has tightened in the US while demand has considerably increase. Moreover, current levels are nowhere near the bubble in 2007/2008. Also, mortgage applications still have room for growth so the property market has not reached full capacity. Home builder stocks, IYR (real estate ETF) or REIT stocks would be good options to consider.

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                                                                                                         Figure 29. EMLC: VanEck Vectors J.P. Morgan EM Local Currency Bond ETF

Figure 30. EMLC ETF Top 10 Holding

Looking at Figure 29, this is the price chart of the EMLC ETF or the Emerging Market Local Currency Bond exchange-traded fund which tracks the J.P. Morgan EMBI Global Core Index. EMLC is a large and liquid ETF that holds sovereign debt issued by emerging market governments (Figure 30). EMLC’s holdings are denominated in the local currencies of issuance, giving investors pure exposure to the markets it covers at the cost of added FX volatility. The bulk of EMLC is in debt expiring in 10 years or less and this ETF aims to cover the EM space in a balanced manner where where no country has more than a tenth of the overall portfolio weight.

It has 276 holdings and has an expense ratio of 0.3% with a median daily share volume of 1.6 million. Around 51% of its holdings are of investment grade quality. It has an annual dividend yield of 6% which makes it attractive from an income standpoint. Prices were severely beaten down and has been stabilizing with great volumes since 2018. One vital catalyst for the EMLC to start moving up is the secular weakness of the USD which will benefit EM assets tremendously for at least the next cycle.

In a nutshell, it does not seem fully right that global equities are at all time highs. Markets seem over-optimistic at this juncture and earnings have a lot of catching up to do to justify current valuations. Promises of further deescalation of trade threats are not sound reasons for markets to stay at present levels. Macroeconomics are the strong fundamentals that equities lack right now to make this bull run convincing.

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