Great chart: TOPIX vs. USDJPY

In the past 15 years, we have seen that the dynamics of the exchange rate in Japan (JPY) has had a significant impact on equities; it has been described as a negative ‘Pavlovian’ relationship where a cheaper currency has usually been associated with higher equities. This chart shows the significant co-movement between Japanese equities – TOPIX – and the USDJPY exchange rate; hence, we are confident that policymakers in Japan are strongly aware of that relationship and therefore the BoJ is carefully and constantly watching the exchange rate.

It is interesting to see while the Japanese Yen has been constantly appreciating against the US Dollar amid the aggressive liquidity injections from the Fed (relative to BoJ), equities have strongly recovered from their March lows and are currently trading at their highest level since October 2018. However, we do not think that this relationship will persist in the medium term; as we previously mentioned, a strong Yen will not only dramatically impact the economic ‘recovery’ but also weigh on LT inflation expectations. The last time the relationship broke down between the two times series was in the beginning of 2018, with the TOPIX rising to nearly 1900 while the Yen was gradually strengthening against the USD, but it did not take long for equities to converge back to their ‘fair’ value.

We are not suggesting that trend in equities is about to revert, but investors should be careful as the ‘Short USD / Long The Rest’ trade has become very crowded.

Source: EIkon Reuters

Great Chart: Nasdaq 2020 vs. 1998

Even though some analysts have compared the 2020 rebound in equities to the 1930 ‘hope’ phase following the 1929 crash, we think that this year has shown some strong similarities with the 1998 / 1999 period. While tech stocks were experiencing strong inflows in the second half of the 1990s amid the dotcom boom, the Nasdaq suddenly fell by 30% in the third quarter of 1998, before starting to reach new highs and surging by over 120% in the following year.

This year, tech companies’ valuations are up 90% in the past 9 months following their dip reached on March 23rd and seem on their way to reach new all-time highs in the coming months as another 3 trillion USD is expected to reach markets in the coming year.

This chart shows some strong co-movements between the Nasdaq index in 1996 – 2000 and in August 2018 – December 2020. Even though market sentiment has reached extreme levels, the bullish trend in mega-cap growth stocks could easily continue for another year amid the surge in liquidity coming from central banks to support the economies and finance the high costs of lockdowns.

Is it really a good time to short equities?

Source: Eikon Reuters

SP500: average strategists’ forecast for 2021 reaches new high

As we previously saw, the massive liquidity injection from major central banks to prevent the economies from falling into a global deflationary depression has generated a significant rebound in equities prices, especially for the mega-cap growth stocks. Figure 1 shows that the FANG+ index is trading over 50% higher than its February high, which was mainly driven by the surge in global liquidity.

Figure 1

Source: Eikon Reuters, RR calculations

In addition, the major 5 central banks (Fed, ECB, BoJ, PBoC and BoE) are expected to increase their balance sheet by another 5 trillion USD in the coming 2 years, to a total of 33 trillion USD, to cover the high costs of national lockdowns.  As a result, ‘Wall Street’ strategists have constantly reviewed their SP500 forecasts for 2021 to the upside in recent months, with the average forecast rising to 4,035 in December according to Bloomberg.

With central banks ‘ready to act’ as soon as we see a sudden tightening in financial conditions (due to a drop in equities), the risk reward in the SP500 is currently skewed to the upside with all the liquidity injections expected to reach markets in the coming months.

Figure 2

Source: Eikon Reuters, Bloomberg

Growth stocks loves liquidity

Even though a significant amount of investors have become increasingly worried about the current state of the equity market and how ‘extremely stretched’ the equity positioning has been in recent weeks, they must not underestimate the force of the liquidity injections coming from central banks. Figure 1 shows the evolution of the major 5 central banks’ assets since 2002 (Fed, ECB, BoJ, PBoC and BoE); after rising by over 7 trillion USD since March, assets of the top 5 central banks are expected to grow by another USD 5tr in the coming two years up to USD 33tr in order to support the high costs of running restrictive economies to fight the pandemic.  

Figure 1

Source: Eikon Reuters, RR calculations

Therefore, although some fundamental ratios such as price-to-sales or the traditional P/E ratio have reached stratospheric levels for some companies and also for the entire equity indexes (for instance, Robert Shiller’s CAPE ratio was of 33.1 in November, far above its 140-year average of 17.1), the constant liquidity injections could continue to support the equity market in the near to medium term, especially the FANG+ stocks. Figure 2 shows the strong co-movement between the total assets from the major 5 central banks and the FANG+ index; we can notice that the titanic rise in central banks assets has ‘perfectly’ matched the strong rebound in the mega-cap growth stocks in the past 8 months.

With 5 trillion USD of assets expected to be added in the coming 24 months, is it really time to be bearish on tech stocks?
Figure 2

Source: Eikon Reuters, RR calculations

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

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

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

Is it time to go long UK financial assets?

Last year, there were worries that the continued depreciation of the British pound was going to increase inflationary pressure in the UK economy and therefore force policymakers to start a hawkish tightening cycle. With uncertainty still significantly elevated, demand for Gilts would keep UK LT years at low levels and many analysts predicted a potential ‘yield curve inversion’ as one of the main outcomes for this year.

However, over the past few months, the fall in oil prices in addition to the 12M lagged currency ‘effect’ have been pressuring inflation expectations to the downside. Our model, which incorporates the annual change in currency and oil prices as two key inputs, has been predicting a correction in future inflation prints in the UK (figure 1, left frame). Therefore, with the short-term implied yield curves Dec19 Mar19 and Dec20 Dec19 trading at 19.5bps and 15bps, respectively, the market expects slightly less than two hikes by the end of 2020 (figure 1, right frame). This leaves policymakers more flexibility concerning their interest rate normalization policy after warning that Brexit uncertainty ‘intensified considerably’ in the end of last year.

Figure 1

Inflation model

Source: Eikon Reuters, RR

Mixed signs from leading indicators and surveys

As for many developed countries, industrial production has contracted significantly in the few couple of months of 2018, down 1.5% YoY in November. However, we can notice that our leading indicator recently ticked up and therefore is pricing a stabilization in the UK business activity (figure 2, left frame). It is still too early to switch our forecast to positive and therefore the next few data points will be important to watch in order to take a fundamental view on UK financial assets. On the other hand, the CFO survey from Deloitte is standing at 2016 critical levels, as CFOs expect uncertainty to impact business spending and lower hiring in the medium term.

Figure 2

Leading

Source: Eikon Reuters,

Uncertainty and firms’ investments

Empirical studies from the Bank of England found significant negative relationship between uncertainty and firm’s investments. For instance, Melolinna et al. (2018) found that the uncertainty, along with the cost of capital and macroeconomic fundamentals, has been an important driver of investment. The authors measure the uncertainty at a firm-specific level, which is the daily volatility in individual stock prices that cannot be explained by general market variation (CAPM model). Figure 3 (left frame) shows negative co-movement between uncertainty (HFM) and the UK business investment.

In another study, Smietanka et al. (2018) look at the macroeconomic uncertainty, which looks at the dispersion in surveys of professional forecasters. Figure 3 (right frame) also demonstrates a negative relationship between uncertainty (U) and the level of investment (dash line is a fitted line based on post-2008 sample).

Figure 3

Mel

Source: Melolinna et al. (2018), Smietanka et al. (2018)

Interesting risk premia for the long-run

Hence, the elevated uncertainty, combined with low consumption growth (consumption growth decreased from 0.9% annual prior the financial crisis to 0.3% post-Brexit) and a sluggish growth in the housing market are all going to weigh on the 3 to 6-month outlook, which may be reflected in asset prices. However, fundamentals in the UK have not deteriorated as in some of the European countries (i.e. France), and therefore we could expect an outperformance of UK assets relative to European ones. Figure 4 (left frame shows that the UK stock market appears cheap relative to the US and Europe.

Figure 4

Excess liquidity

Source: Bloomberg, Eikon Reuters, RR

What does it mean for the pound?

As we mentioned it in our latest FX Weekly, the British pound got strong support when it fell below the 1.25 level against the US dollar, therefore we think that buying Cable below that support could offer interesting returns for longer-term investors. As we expect the US dollar to weaken within the next 12 months (in our base scenario), currencies such as the euro and the pound could offset some of the USD weakness.

As we can see it in Figure 5, Cable is currently flirting with the 1.29 level, which corresponds to the 61.8% Fibo retracement of the 1.1975 – 1.4350 range and the 100-day SMA. A breakout of this area could lead us to the next retracement at 1.32. However, GBP may stabilize in the short term and therefore we think it could be interesting to play the crosses (long EURGBP and short GBPJPY). In addition, we can notice an interesting observation in figure 6, which shows the strong co-movement between GBPJPY and the world (ex-US) equities; we usually tend to look at AUDJPY as a proxy for risk-on / risk-off environment. Therefore, GBP could also be impacted by a small consolidation in the stock market.  

Figure 5

Cable

Source: Eikon Reuters

Figure 6

GBP and VEU

Source: Eikon Reuters

March: ECB’s painful month?

As you know, the Euro has been massively under pressure since the ECB’s May meeting last year and decreased from 1.40 to a low of 1.11 before edging back to 1.14. In my article The Euro Strength and The ECB’s options, I explained the ‘Euro strength story’ (July 2012 – May 2014) by the following three factors:

  • Narrowing peripheral-core spreads (After Draghi’s ‘Whatever it takes’ and OMT introduction)
  • Divergence between the ECB and the Fed’s balance sheet total assets
  • Current Account back into positive territories

During this ‘prosperous’ period, nothing was able to stop the Euro despite poor fundamentals (i.e. flat growth, high unemployment rate and declining inflation). Then, Draghi’s promise ‘the Council is comfortable with acting in June’ completely broke the upside trend and the market has been totally relying on the ECB’s balance sheet expansion plan. It is clear now that EZ policymakers’ goal is to see the central bank’s balance sheet expend by 1.14tr Euros within the next 18 months and reach June 2012 levels (approximately 3.1tr Euros). As you can see it on the graph below (EURUSD monthly chart), the market got really excited about this news and traders and investors have completely switch to a bearish view when it comes to EURUSD (and EURGBP). We saw that Bulge Bracket banks reviewed their EURUSD forecasts for 2015. Sell-side research predicts a EURUSD between 0.90 and 1.00 within the next 6 to 12 months. Moreover, if we have a quick look at the last CFTC’s Commitments of Traders report, ‘net speculative’ positions were approximately -186,000 in the week ending February 17, and are closely approaching June 2012 low of -215,000.

Screen Shot 02-23-15 at 12.44 AM

(Source: Oanda, CoT)

If you ask me where I see EURUSD in the long term, there is no doubt that my answer is ‘South’. With the Fed considering starting its monetary policy tightening cycle (June meeting for a first 25bps shift probably), monetary policy divergence will weigh on the currency pair in the LT and parity looks like a reasonable level to me. In addition, Grexit contagion effect to ‘scarier’ countries such as Spain could also trigger another episode of peripheral-core yield spread divergence and therefore add more selling pressure on the single currency.

However, I think that traders and investors should be careful at the moment. Over the past two weeks, volatility has dropped in the market and EURUSD has been trading within a tight 180-range (1.1270 – 1.1450). Based on the last discussions I had, some of the traders were clearly waiting for a breakout ahead of the Greek deal, therefore the 1.1270 support was carefully watched on Friday (this is the reason why I put my take profit slightly above at 1.1300, see article Pocketful of Miracles). However, the Euro looks resilient based on current market conditions and I have to admit that I see potential Euro strength in the month coming ahead. As you can see it below, EURUSD reached a 11-year low at the end of last month at 1.11 before coming back to 1.14. The Fibonacci retracements were built based on October 200 low of 0.8230 and July 2008 high of 1.6040 range. Unless contagion risk spreads to other EZ countries (i.e. higher core-peripheral risk), the bullish trend could last for a month or two (based on previous bull consolidation after sharp sell-off).

Screen Shot 02-23-15 at 12.50 AM

(Source: FXCM)

The ECB bond buying program: Ambitious plan, disappointing results?

We are aware now that the ECB has announced a round of measures in order to counter the deflationary cycle (inflation rate of -0.6% in January) and of course support investment and consumption, the two key contributors of the 19-nation economy. The last one was of course the January announcement of additional purchases (combined monthly asset purchases of 60bn Euros from March to September 2016). This programs involves private assets such as covered bonds (safe form of debt issued by banks), ABS and public debt (bonds of national government and European institutions). However, unlike the Fed, the ECB will have to seek them in the secondary market; in other words, find the banks that will sell them these bonds. And Draghi’s (and Co.) problem here is that the ECB may face unwilling sellers. As some of you know, banks’ treasury desks usually buy short-term bonds and use government debt as a liquidity buffer: regulators require banks to hold high-quality liquid assets – HQLAs – against future cash outflows in periods of market stress. As some of you may know, most bonds issued by banks are excluded as they may prove illiquid during a financial crisis; however, the eligibility requirements imposed on government bonds look loose. Therefore, this implies that that government bonds currently represent a considerable portion of bank assets.

In the European Union, there are two new ratios:

  • Liquidity Coverage Ratio LCR, requiring banks to hold a stock of liquid assets for an amount covering the net liquidity outflows which might be experienced, under stressed condition, over the following 30 days,
  • Net Stable Funding Ratio (NFSR), which requires that the amount of available stable funding (i.e. portion of capital and liabilities expected to be reliable over a one-year time horizon) should be at least equal to the required amount of stable funding or the matching assets (i.e. illiquid assets which cannot be easily turned into cash over the following 12 months).

These two ratios were enacted through a Capital Requirements Directive (CDR4) and Regulation (CRR) issued in June 2013. Based on the Basel 3 documents, liquid assets in the LCR should mainly consists of:

  • Cash
  • Central bank reserves (including required reserves)
  • Marketable securities representing claims on or guaranteed by sovereign, central banks, PSEs, BIS, IMF, the ECB and European Community, or multilateral development banks
  • Bonds issued by non-financial firms and covered bonds with a rating at least equal to AA, subject to a 15% haircut and a 40% concentration limit

The two questions now that comes to my mind are:

  1. Who will sell those bonds to the ECB?
  2. Suppose the ECB offers good prices (i.e. good realized PnL for bond trading desks), what will traders do with this new cash with a deposit rate now at -0.2%?

Disappointing ECB could lead to Euro strength…

To conclude, I think there is potential risk that the ECB disappoints the market in March based on their purchases as the central bank won’t find the liquidity in the market. In my opinion, this scenario could play in favor of the single currency. My point is that we may see a bull consolidation before reaching the parity level that everyone seems to be talking about. The next couple of resistances to watch on the topside would be at 1.1530 and 1.1680.