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.
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?
The past few months have been marked by a significant depreciation of the US Dollar relative to major currencies. The massive liquidity injections from the Fed to desperately avoid the country from falling into a deflationary depression combined with the risk of a second ‘strict’ lockdown in some southern states (Sun Belt) have left the greenback vulnerable, with some investors speculating that the ‘Bear Market of the USD’ has eventually begun. The USD index is now down 1.7% year-to-date, following two years of positive momentum, and currently trades at its lowest level since September 2018. The US Dollar has significantly weaken against the major currencies and particularly the Euro as EU leaders have recently shown improving signs of coordination and the ‘better management’ in the Covid19 crisis will surely be reflected in the real growth differential between the two economies, which is one of the key drivers of currencies over the long run.
However, as the USD index is heavily weighted on the Euro (57.6%), it may show a misleading picture of the current state of the US Dollar. If we look at a broader measure of the US Dollar – Nominal Effective Exchange Rate (NEER), which measures performance of the USD against a broader rage of currencies weighted according to the value of trade with the domestic country – we can notice that USD NEER is up 3.1% YtD and still trades higher than its early March level. The chart below shows the interesting ‘divergence’ we observe since the start of the crisis. At this stage, the USD NEER index has given up most of its March gains, but is clearly not showing any signs of massive weakness coming ahead. Hence, we will need to see more downside on the USD NEER to confirm that a LT bear market on the USD has eventually started.
As more and more regions in developed economies have been put under a dramatic total lockdown amid growing concerns over Covid-19, central banks have started to cut rates aggressively in order to avoid a complete market meltdown. We saw in the previous week that both the Fed and the BoE held emergency meetings and cut rates by 50bps, the most since the Great Financial Crisis, benefiting from their positive benchmark interest rate to act faster than the rest of central banks. Economies already experiencing a NIRP policy (i.e. Sweden, Euro area) will probably implement or expand asset-purchase programmes in order to fight against a significant economic shock and therefore implicitly reduce their ‘shadow rate’, a rate first introduced by Fischer Black (1995) that can measure the effects of QE, to lower levels.
However, it is important to note that a significant reduction in benchmark policy rates globally has been associated with sharp equity sell-offs. This chart shows that in the previous two downturns, the GDP-weighted G10 policy rate was cut by approximately 4 percent and coincided with a global equity sell-off of 45% to 55%. Are we set for a similar story in 2020?
Chart. G10 policy rate vs. World equities (source: Eikon Reuters)
In the past two years, the elevated economic and political uncertainty in addition to the lagged effect of quantitative tightening have significantly weakened growth expectations and as a consequence increased demand for safe assets such as the US Dollar and US Treasuries. While the situation seems to have improved slightly in the past 6 months on the back of aggressive rate cuts from central banks globally, business surveys are still pricing in further deterioration in the US economy. For instance, the ISM manufacturing PMI hit a low of 47.2 in December 2019, diverging significantly from the 50-percent threshold that separates growth from contraction. CEO confidence also dropped to its lowest level in a decade and is currently pricing a much higher probability of recession than other popular indicators. On the other hand, consumer confidence indicators have remained strong in the US as consumption remains solid (real PCE expenditure has been averaging 2.5% in the past few quarters).
How long can that divergence persist until US consumer sentiment starts to fade away? This great chart shows that the CEO confidence survey has acted as a good 12-month leading indicator of consumer confidence (University of Michigan) since 1980. We can notice that top executives in the US are currently pricing a significant deterioration in consumer sentiment for the next 12 months to come. However, some divergences occurred in the past, particularly in the late 1990s when CEO confidence started to fall drastically in 1998 and 1999, but consumer confidence was constantly rising during that period mainly due to the tremendous rise in equities that was inflating household wealth. Even though we are concerned about the deterioration of those business surveys, we may continue to see a divergence within the next twelve months between business and consumer confidence surveys as equities keep reaching new all-time highs and interest rates remain ‘too low’ relative to the current pace of nominal GDP growth in the US.
Chart. US CEO Confidence (12M Lead) vs. Consumer Confidence (Source: Eikon Reuters)
Empirical researchers have demonstrated that gold has had many drivers over the past few decades, but has been mainly influenced by interest rates, inflation trends, the US Dollar, stock prices and central banks reserve policies. Baur and McDermott (2010) also shows that the precious metal plays the of a safe ‘zero-beta’ asset in periods of market stress and equity selloffs. For instance, in the last quarter of 2018, US equities (SP500) fell by 14% while the price of gold in US Dollars was up 7.6%. In the short run, participants usually look at the co-movement between gold price and real interest rate (TIPS) to define a fair value of the precious metal (gold price rises when real yields fall and vice versa).
However, gold has shown a stronger relationship with another variable in recent years: the amount of negative-yielding debt around the world. This chart shows us the striking co-movement between the two times series. After oscillating around USD 8 trillion between the beginning of 2016 and the end of 2018, the amount of negative-yielding debt doubled to nearly USD 17 trillion in the first half of 2019 amid political uncertainty and concerns over global growth, levitating gold prices from $1,280 to $1,525. However, we have noticed that investors’ concern has eased in the past two months, normalising global yields (to the upside), increasing the US 2Y10Y yield curve back to 25bps after turning negative in the end of August, therefore reducing preference for ‘safe’ assets such as bonds. The amount of debt yielding below 0% has dropped significantly since the end of August to USD 11.6 trillion this week, dragging down gold prices to $1,460. We think that market participants have overreacted to the global growth slowdown in the first half of the year and that the rise in leading indicators we have observed in the past three months (i.e. global manufacturing PMI) will continue to push preference for risk-on assets. The amount of negative-yielding debt could easily come back to its 2016-2018 8-trillion-dollar average in the following months, hence emphasising the downward pressure on gold prices. It looks like gold is set to retest the $1,350 – $1,400 support zone in the short run (which used to be its resistance zone before the 2019 rally).
Chart. Gold price (in USD) vs. amount of negative-yielding debt (tr USD) – Source: Bloomberg, Eikon Reuters.
In this chart, we look at the performance of US equities relative to Treasuries over time. As you know, price volatility differs among different asset classes; hence, in order to compare the relative performance of equities versus risk-free securities, we need to vol adjust. Using monthly times series of total returns of the Bloomberg Barclays US Aggregate Bond Index and the SP500 index, we calculate monthly returns of each asset class and then adjust our US Treasuries exposure using the 1-year realised volatility of equities. We also rebalance our portfolio every single month so that the volatility of each asset remains constant.
As you can notice, the SP500 index has lost 65% of its value relative to bonds since January 1974, with a high of 77% reached in the last quarter of 2010. Moreover, in the past two economic downturns, equities have lost 20% of their values between 1999 and 2002 and 12% of their value between 2007 and 2009. We saw last year that US 10Y nominal yield topped at 3.25% and struggled to break higher despite a nominal growth close to 6% in the United States. With yield plummeting to 2% in the past 6 months, the bond market is currently pricing in a sharp deceleration of economic activity and some practitioners are expecting rates to fall to zero percent as fear over a 2020 recession have increased dramatically. This raises the following question: should we expect Treasury bonds to significantly outperform US equities once again in the next economic downturn?
Chart. SP500 vs. US Treasuries – Total Return. Source: Bloomberg, Eikon Reuters
On Friday (March 22nd), the disappointing German PMIs led to little sell-off in global equities and a rise in risk-off assets such as government bonds and safe-haven currencies (i.e. JPY, CHF). For the past month, we have been warning that the elevated uncertainty in addition to the low level of global yields were challenging the healthiness of the equity recovery since the beginning of the year. Moreover, fundamentals have been fairly weak overall (in the US, China and even in the Euro area), with leading economic indicators diverging from equities’ performance. For instance, many indicators have been pricing in a slowdown in the US economic activity, however the SP500 index is up approximately 14 percent year-to-date and trading 100pts short from its all-time highs reached in the end of September last year.
With the German 10Y yield falling in the negative territory, the amount of debt trading below 0 percent reached $10tr, up $2tr since the beginning of the year. In addition, the divergence between the 3M10Y and 5Y30Y yield curved have continued; while the 3M10Y turned negative (gaining all the market’s attention), the 5Y30Y has been trending higher in recent months, up 40bps to 66bps in the past 6 months. In this great chart, we can notice an interesting observation: each time the 5Y30Y has started to steepen before the end of the economic cycle, the 3M10Y followed the move 6 months later. We know that the critical moment of the business cycle is when the yield curve is starting to steepen dramatically. Hence, should we worry about the steepening of the 5Y30Y?
Chart. 3M10Y vs. 5Y30Y (6M Lead) – Source: Eikon Reuters
An interesting observation arises when we plot the annual change in the US Dollar with the relative performance of US vs. World (ex-US) equities. As you can notice it in the chart, the World (ex-US) equity market tends to outperform the US market when the US Dollar is weakening. For instance, the US Dollar (USD REER) performance in 2018 led to an outperformance of US equites (SPY) over World (VEU) up to 20% before the last quarter.
In addition, this chart shows that the annual change in the USD tends to mean revert over time, fluctuating between -10 and +10 percent. Hence, investors could not only benefit from playing the range on the greenback, but also speculate on equity relative performance between US and non-US stocks. As we expect the US Dollar to weaken through the course of the year, this could lead to a significant performance of the world (ex-US) equities. A weaker USD also eases the pressure in the EM corporate bond market, which is heavily USD-denominated, and therefore loosens financial conditions.
Chart. USD REER vs. US / World (ex-US) equities – YoY Change
Prior the Financial Crisis, the carry trade strategy in the currency market was perceived to be a profitable and generated significant returns for traders seeking for yields. In the appendix A, we show the performance of the carry strategy between 1975 and 2008, along with the performance of equities and fixed income according to a 2008 publication from JP Morgan. We can notice that the funded carry strategy, which invested equally in three currencies with the highest yields funded by borrowing from the three currencies with the lowest yields, outperformed both fixed income and equity returns during that period. According to JPM calculations, if you invested $1 in 1975 in each of the strategy, the initial investment in funded carry grew to $84.16 in early 2008 (vs. $15.25 in fixed income and $51.74 in equities), whilst experiencing volatility levels between those two assets.
However, the situation changed abruptly during the financial crisis when the carry currencies (i.e. AUD) plummeted and funding curries (i.e. JPY) experienced significant appreciation. For instance, if we take the AUDJPY exchange rate as a proxy of the traditional G10 carry trade, we can see in Appendix B that the strategy followed the same pattern as the (US) equity market and hence experienced a sharp correction between July 2008 and March 2009 (AUDJPY was down 45%). Since then, many investors have considered the carry trade strategy to be a risk-on strategy, exhibiting strong co-movements with DM equity markets (hence poor for diversification) and described it as a ‘gradual appreciation punctuated by sudden crashes’ type of behavior (the famous quote: ‘going up by the stairs, and coming down by the elevator’). It is quite usual for an EU/US global macro trader or investor to watch the overnight Yen developments to see if anything major happened in Japan or China for example (strong Yen appreciation usually means bearish macro news for equities).
Even though the co-movement between AUDJPY and US equities (SP500) has been inexistent over the past 5 years, an interesting observation emerges when we overlay the AUDJPY exchange rate with EM equities. As you can see it on the chart, EM equities have moved in tandem with the ‘carry’ exchange rate; the 3M daily realized correlation stands now at 92%. AUDJPY is almost down 10 figures (i.e. 12%) since mid-January, and traded below 79 earlier this month, its lowest level in two years. We will see if the correlation persists in the months to come and if a rebound in the Aussie (or Yen weakness) will benefit to EM equities, which are down more than 25% since January highs.
Chart: AUDJPY vs. EM Equities (Source: Eikon Reuters)
Appendix A: Carry Strategy vs. Equities and FI (Source: JP Morgan)