Great chart: China excess liquidity (6M Lead) vs. Australia housing market

In the past few years, a significant amount of economists and practitioners have warned of a potential hard landing in the Australian housing market, as property prices have been growing at unsustainable rates with first-home buyers having difficulties saving a significant deposit to get a foothold in the market. According to the Australian Bureau of Statistics, the total value of residential property in Australia is now exceeding 7 trillion USD, by far the economy’s largest asset. As there are no ‘vehicles’ to short the Australian housing market as during the US subprime crisis, two alternative ways to short the property market was through either going short the Australian Dollar or short the banks.  Prior the Covid19 crisis, banks’ mortgages were equivalent to approximately 80% of the country’ GDP, with most of them piled into the top 4 banks (Commonwealth, WestPac, ANZ and NAB).

Even though house prices were starting to decline significantly in 2018 and the beginning of 2019, with investors speculating that it was the start of the ‘hard landing’, the reversal in the global stance of monetary policy (from quantitative tightening to quantitative easing) combined with the surge in Chinese liquidity have generated strong support for the Australian property market in the past year. This chart shows an interesting co-movement between China excess liquidity (6M lead), which we compute as the difference between real M1 money growth and industrial production, and the Australian housing market. It seems that the downside risk in the Aussie property market should remain limited as money growth keeps accelerating in China.

Source: Eikon Reuters, RR calculations

It is time to diversify the traditional 60/40 equity bond allocation

With interest rates trading at or close to zero percent in most of the developed world, investors have been questioning if government bonds still act as a hedge against periods of market stresses, which are usually negative for equities. One of the most important characteristics of the traditional 60/40 equity bond (and also the ‘all-weather’ portfolio risk parity) has been the negative correlation between equity returns and changes in long-term bond yields. Figure 1 shows that the 3-rolling correlation between US equity returns and the 10Y bond yield turned negative in the beginning of 2000s after being positive for decades (using weekly times series)

However, we are not confident that the correlation will remain negative (implying that bonds are rising when equities are falling) in the medium term, especially if we switch to more inflationary environment after restrictions are lifted. Even though the disinflationary forces will remain significant in the coming 12 to 24 months due to social distancing, investors must not assign a zero-percent probability of a sudden rise in inflation expectations in the future.

Figure 1

Source: Eikon Reuter, RR calculations

Why not swap some of your bond allocation, which currently offers a very limited upside, for gold, which offers ‘unlimited’ upside gains as money supply continues to grow dramatically in most of the economies. Figure 2 shows the performances (and drawdowns) of four different portfolios:

  1. A equity long-only portfolio
  2. A 60/40 equity bond portfolio
  3. A 60/35/5 equity bond gold portfolio
  4. A 60/30/10 equity bond gold portfolio

We can notice that investors would have got similar returns if they had held 5 to 10 percent of gold in their portfolio instead of bonds in the past 50 years. It is time to diversify the traditional 60/40 equity bond portfolio.

Figure 2

Source: Eikon Reuters, RR calculations

EURCHF is the FX ‘value’ trade according to PPP

Unlike bonds or equities, currencies do not carry any fundamental value and have historically been known as the most difficult market to predict. In our FX fair value model page, we look at different ways of estimating a ‘fair’ value for a bilateral exchange rate. One of the simplest models is based on the Purchasing Power Parity theory, which stipulates that in the long run, two currencies are in equilibrium when a basket of goods is priced the same in both countries, taking the account the exchange rates. We know that the OECD publishes the yearly ‘fair’ exchange rate based on the PPP theory or each economy.

Based on the OECD calculations, it appears that the Euro is the most undervalued currency among the G10 world relative to the US Dollar, as PPP prices in a fair rate of 1.42 (implying that EURUSD is 18% undervalued). On the other hand, the Swiss Franc is the most undervalued currency (+26%). Therefore, if we were to believe that exchange rates converge back to their ‘fundamental’ value in the long run, being long EURCHF is the position with the most interesting risk premia among the DM FX world.

Source: Eikon Reuters, OECD

2020 onwards: struggling economy, more QE?

In the past cycle, central banks have been constantly intervening in the market to counter the strong disinflationary force coming from the 3D: Debt, Demographics, Disruption. Figure 1 shows that between the beginning of 2008 and early 2020, the assets from the major 5 central banks grew steadily by a annual pace of $1.25tr per year, for a total of $15tr in 12 years.

As a response to the Covid19 shock, central banks just printed more in order to prevent the economies from falling into a deflationary depression, which resulted in a 7-trillion-dollar increase in central banks’ assets in the past 8 months. The titanic liquidity injections resulted in a significant rebound in equities, especially in the US with the SP500 trading over 100 points above its February high.

With most of the European economies entering a second lockdown, and restrictions also expected to be announced in the US (as the elections are now over), governments will again run aggressive fiscal policies and extend the furlough schemes in order to avoid the rise of social unrest, which will result in more money printing from central banks in the coming months.

Is it as simple as this: the worst the economy gets, the better it is for stocks as it will result in more liquidity injections?

Image
Source: Eikon Reuters, RR calculations

Steeper yield curve or stronger US Dollar?

In the past few months, we argued that the rise in uncertainty over inflation expectations and economic output will certainly levitate the term premium and therefore steepen the 2Y10Y yield curve. For instance, figure 1 (left frame) shows that the US 10Y term premium has historically strongly co-moved with the unemployment rate and that the deterioration in the job market amid strict lockdown measures could lead to higher long term yields. Figure 1 (right frame) shows that the sharp yield curve ‘steepener’ that occurs prior or during economic recessions is mainly coming from the dramatic rise in the term premium.

Even though we do not expect the 2Y10 yield curve to dramatically steepen as during the Great Financial Crisis (by 3 percent), we still see a higher retracement on the 2Y10Y towards 1% (currently trading slightly below 70bps).

Figure 1

Source: NY Fed, Eikon Reuters

At the same time, we are also bullish on the US Dollar as a hedge against rising uncertainty over a range of macro events (US elections, Brexit, new lockdowns imposed by governments…). In the past 18 months, it is interesting to see that a cheaper US Dollar has usually coincided with higher equities (SP500) and vice versa (figure 2); therefore, we think that being long the US Dollar at current levels offer investors a good hedge against a sudden reversal in equities.

Figure 2

Source: Eikon Reuters

However, the question now is: can the US Dollar appreciate as the yield curve continues to steepen? Figure 3 shows an interesting relationship between the greenback and the 2Y10Y in the past 15 years; a steeper yield curve has generally been associated with a cheaper US Dollar and not a stronger USD.

Figure 3

Source: Eikon Reuters

Great Chart: Bitcoin vs. FANG+ stocks

Since the start of the year, we saw that the dramatic liquidity injections from central banks to prevent the economies from falling into a global deflationary depression has led to a sharp depreciation of most of the currencies, especially against assets with limited supply such as Gold, Silver and Bitcoin. The liquidity also generated a strong rebound in risky assets such as equities, reinforcing the trend on the mega-cap growth stocks (FAAMN companies). The NYSE FANG+ index, which provides exposure to 10 of today’s highly-traded tech giants, is now trading nearly 50% higher than its February peak, which has massively contributed to the recovery in the SP500.

In the past few months, we have noticed an interesting observation: it seems that the Fed (and other central banks) interventions have led to one ‘global trade’ as a significant amount of assets have strongly co-moved together in 2020. This chart shows the strong relationship between Bitcoin prices and the FANG+ index; a few weeks ago, cheaper equities due to the rise in uncertainty over US elections and the lack of stimulus has led to also lower Bitcoin prices. Are ‘Bitcoin bulls’ really hedged against a sudden reversal in equities?

Source: Eikon Reuters

Go long the US Dollar as a hedge against rising uncertainty

In the past few weeks, US equities have shown some signs of ‘fatigue’ amid rising uncertainty over US elections and the lack of stimulus from both the Fed and the government. Most of the rise in risky assets such as equities in the past few months has been mainly attributed to the massive liquidity injections from major institutions to avoid economies from falling into a deflationary depression.

It is interesting to see that in the past year, a cheaper US Dollar has been mainly associated with stronger US equities, especially since the pandemic (figure 1). Hence, the ‘close elections’ may certainly lead to a choppy equity market in the last quarter of 2020 and therefore should result in a strong demand for safe assets such as the USD. We think that going long the Dollar could offer a good hedge against a new round of equity selloff in the coming weeks.

Figure 1

Source: Eikon Reuters

In addition, long the USD remains a contrarian trade as the ‘short Dollar trade’ is still very crowded (figure 1). We are confident that the US Dollar will remain strong if price volatility rises in the near term, especially against risk-on currencies such as the British pound or the Australian Dollar.

Figure 2

Source: CFTC

Silver: Mind the June correction!

Even though price volatility has eased significantly across all asset classes amid the massive liquidity injections from central banks, the market could experience another little selloff in the near term due to the rising uncertainty coming forward. In addition, we know that most of the risky assets tend to perform poorly in the ‘summer’ period that runs from May to October.

Although some investors may define silver as a risk off asset, we recently saw that the precious metal has performed very poorly during periods of market stress. We think that silver could experience some weakness in the short run, especially now that we are approaching the month of June. In figure 1, we compute the average performance of silver for every month of the year since 1982; interestingly, June has historically been the worst month with silver falling by nearly 2% on average.  Time to sell and go away?

 Figure 1

Source: Eikon Reuters, RR calculations

One particularity of a safe-haven asset is that it is negatively correlated with the performance of equities during periods of panic and selloffs. For instance, we saw that gold performed strongly in the past two equity selloffs, up 7% in Q4 2018 and 3.5% in Q1 2020 while equities were down by 14% and 20%, respectively. Figure 2 shows that silver did not act as a zero-beta asset and co-moved strongly with equities during the February / March panic. We strongly believe that investors have this chart in mind for the coming months and that a little 10%-15% drawdown in stocks in the near term will certainly lead to a little (bear) consolidation in silver.

Figure 2

Source: Eikon Reuters

Even though some analysts are currently saying that silver looks extremely undervalued relative to gold (gold-silver ratio is still elevated relative to its long-term average), we do not think that the ratio will matter in the near future and we could have another divergence between the two precious metals. Figure 3 (right frame) shows that prior the Covid19 crisis, a surge in gold prices had historically been followed by a surge in silver 3 weeks later since the start of 2015. However, we can notice that the two assets have strongly diverged in the past few months.

Figure 3

Source: Eikon Reuters

In short, stay away from silver in June!

Rate cuts were unnecessary in a shutdown economy

Introduction

As a consequence of the Covid-19 pandemic and the potential catastrophic impact on the global economy, the Fed slashed interest rate to zero in March after four years of effort to increase its benchmark rate. In addition, it has also increased drastically the size of its balance in order to prevent the whole market from collapsing; the Fed’s balance sheet is now expecting to grow to USD 8/9 trillion by the end of the year, twice more than the high reached in October 2014. Even though there is no question that the whole economy was healthier this time than prior to the Great Financial Crisis and that the Fed’s interventions and liquidity injections were timely and mandatory to save the whole market, we believe that the rate cuts were unnecessary.

A slowing economy pre-virus

As we know, the US economy peaked in the last quarter of 2018 and was already considerably slowing down in 2019 due to the high uncertainty in the market (Brexit, followed by the China-US trade war). Figure 1 (left frame) shows the global and US manufacturing PMI overlaid with the US 10Y yield. After the global economy peaked in Q4 2017, the outperformance of the US relative to the rest of the World in 2018 led to a rising USD and a rising 10Y yield, but eventually the slowdown of the US economic growth brought the long-end of the Treasury curve to the downside.

In addition, the sharp sell-off in equities in Q4 2018 (nearly 20 percent from peak to trough) reversed the Fed’s policy guidance with the famous ‘Powell pivot’ from ‘a long way from neutral’ in October 2018 to ‘appropriate stance in January 2019. Policymakers even cut rate three times in the second half of 2019 in order to stimulate demand after the 2Y10Y yield curve inverted in August.

Figure 1

RR1Source: Eikon Reuters, Bloomberg

Hence, the reversal in global central banks’ policy (from global tightening to global easing) combined with the significant increase in global liquidity led to a sharp recovery in stocks, with the SP500 recording one of its best year in the past 30 years (figure 2, right frame). However, the 2020 events generated a global panic and equities sold off aggressively in February/ March amid concerns of the global supply shock will soon spill over demand. Did the Fed increase volatility at first by just cutting interest rates to zero? Even though we understand that policymakers globally wanted to quickly reassure markets by hinting participants that it will not let the whole market fail, there has been very few debates on whether rate cuts are useful in a shutdown economy. In theory, rate cuts should decrease the incentives to save and increase demand for credit and the incentives to consume. We think that the massive liquidity injections would have been enough this time to halt the global panic and that policymakers should have save the little room left in the benchmark rate for later (i.e. when the economy reopens). In addition, we believe that the aggressive rate cuts may have increased price volatility in March; figure 2 (right frame) shows that stocks tend to sell rapidly in when Fed cut rates aggressively.

Figure 2

RR2Source: Eikon Reuters

US shadow rate to hit -5 percent in 2020

Even though some economists have been speculating that the Fed will adopt a negative interest rate policy (NIRP) in the coming months as a response of the Covid-19 crisis, we are not convinced of that and we think that policymakers will first wait and see if the massive liquidity injections will be enough to stimulate the economy. Figure 3 shows the historical path of the Fed Funds rate since 1960, including the ‘shadow rate’ based on Wu-Xia calculations (2015),a tool that researchers have proposed in recent years to estimate how low would the benchmark rate be had the the Fed not used unconventional monetary policy.

This time, the shadow rate is expected to fall down to -5% by the end of the year, 2 percent lower than the -3 percent low reached in the third quarter of 2014 (due to QE3), which should in theory represents a massive stimulus for the economy.

Figure 3

Source: Eikon Reuters, Wu-Xia (2015)

Key economic measures such as r-star have become less relevant in the past cycle

Unlike most of the central banks, the Fed follows a triple mandate when conducting its monetary policy, which is to achieve the following goals: maximum employment, stable prices and moderate long-term interest rates. In addition, policymakers have tried to estimate the dynamics of the (unobservable) neutral rate of interest, r-star, which can be defined as the interest rate that supports the economy at maximum employment while keeping stable prices. Figure 4 (left frame) shows the relationship between r* (estimated by Holston et al. (2017)) and the implied Fed Funds rate (including the shadow rate). Policymakers’ have usually immediately been reacting by lowering the FFR when the r-star was starting to decrease due to an economic shock / recession.

We do not have the recent Q1 updates for r-star, but it is fair to say that it will decrease drastically, which would support the argument of a lower FFR. However, the Fed should just have increased the size of its balance sheet this time (which would have lowered the shadow rate) while keeping extra room for FFR intervention in the coming months when economies reopen.

In addition, we can also see that the relationship between the implied FFR and the US saving rate has broken down in the past cycle (figure 4, right frame). Before 2008, lower FFR was usually leading to a lower saving rate in the following 2 to 3 years (lower rates decrease the incentive to save and should increase the incentive to consume). However, since 2009, while interest rates reached the lower bound and even decreased if we look at the shadow rate, the saving rate has increased. The saving rate could actually go even higher given the uncertainty that households will face post lockdown.

Figure 4

RR4

Source : EIkon Reuters, Holston et al. (2017), Wu-Xia (2015)

In short, more rates cuts are useless in a shutdown economy; policymakers should leave some room for later in case of a ‘Wsss – shape’ recovery.

 

Jobless claims and non-farm payrolls

Two popular indicators that investors frequently watch to measure the temperature of the labor market in the US are the jobless claims and the non-farm payrolls. Historically, the market has been focusing more on the monthly NFP prints, but the recent waves of selloffs due to the Covid-19 crisis has raised investors’ interest on the weekly jobless claims figures as the number of Americans filing for unemployment benefits has surged to over 6 million in the past two weeks.

In this post, we try to answer the following two questions that have been making the headlines in recent weeks:

  • Is there a link between jobless claims and non-farm payrolls?
  • As jobless claims are updated every week, does it lead NFP?

 

Jobless claims are a statistic that is reported every week by the US Department of Labor and counts the number of people filing to receive unemployment insurance benefits. There are two categories: initial – with people filing for the first time – and continued, which comprises of unemployed people who have been receiving unemployment benefits for a while. What is surprising this time is the recent rate of change of the initial jobless claims, which surged from multi decades lows of 200+ thousands to over 3.3mil, 6.8mil and then 6.6mil on April 4th. Prior Covid-19, initial jobless claims have generally averaged 360K since the 1960s, from lows of 200K to highs of 700K (figure 1, right frame). The number of continued jobless claims is now greater than the one experienced during the Great Financial Crisis, which reached a peak of 6.6 million in June 2009.

Figure 1

FI1

Source: Eikon Reuters

Non-farm payrolls are also released by the Department of Labor on a monthly basis as part of a comprehensive report on the state of the labor market, but do not include farm workers, private household employees or non-profit organization. It was reported that the US lost 701K jobs in March, which brought the unemployment rate to 4.4%. Figure 2 (left frame) shows a scatter plot of the continued jobless claims with the NFP monthly; we are currently sitting at uncharted territories, and we would expect the next prints of NFP to collapse to much lower levels in the coming months, which would raise the unemployment rate to more than 20 percent. According to the fitted line, a 701K drop in NFP would coincide with continued jobless claims of 4.5 to 5 million.

In figure 2 (right frame), we look at the yearly gains (losses) in NFP overlaid with the continued jobless claims times series. We can notice that to the exception of the Great Financial Crisis, the amount of people filing for unemployment benefits has always been greater than the number of jobs lost in the US economy. This is what we expected as the NFP do not include a little portion of US employees. If you add the number of jobs lost in the agricultural industry in addition to the local government, private household and non-profit employees, you will certainly reconcile the two figures (i.e. number of total jobs lost = continued jobless claims).

Figure 2

FI2

Source: Eikon Reuters

It is difficult to infer a level of unemployment rate from the jobless claims data, but we just know that the level will be elevated in the coming months. Some economists have forecasted a 10% unemployment this summer, but we think it could actually reach 20 percent as the uncertainty around employees’ status will surge to historical highs. US households will start to save more as most of the companies are now very vulnerable to the demand shock, which would in theory be deflationary (at first).

Even though the chart is far from being perfect (figure 3), we like to look at the 3-year returns in stocks (in order to smoothen the volatility in equities) as a leading 1-year leading indicator of unemployment. Sharp and sustain selloffs in equities are usually associated with rising unemployment as equities’ valuations directly reflect the level of consumer sentiment in the market.

Figure 3

FI3

Source: Eikon Reuters