Global Strategy Flash Weekly Cross Asset Views Deutsche Bank Markets Research
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Global Strategy Flash Weekly Cross Asset Views Deutsche Bank Markets Research
Deutsche Bank Markets Research Global Australia Canada United States Cross-Discipline Date 18 November 2014 Dominic Konstam Global Strategy Flash Research Analyst (+1) 212 250-9753 [email protected] Weekly Cross Asset Views Joseph LaVorgna Trade recommendations US Treasury futures: We are bearish on FV and longer calendar rolls. USD: Buy contingent 6M3Y OTM payers subject to knock-out criteria. USD: Buy contingent 1Y3Y OTM payers subject to knock-out criteria. U.S. Economics We expect a one-tenth decline in headline CPI in October, in effect lowering the year-on-year growth to 1.5% based on further decline in energy prices. However, we expect services inflation to accelerate in the near term as the unemployment rate approaches the NAIRU. U.S. Rates We remain broadly neutral on the market at current levels. Nonetheless we see a number of themes that are more likely to produce a re-test of recent lows in yield than they are to produce a breakout to higher levels. Japan Rates We see the risk of a repeat strong performance of the incumbent government in the next elections, which could trigger a further rise in equities and USD/JPY and put upward pressure on JGB rates. Agencies Modestly bullish on long-end spreads. Good value in 2-year agencies, expecting 1.04% 12M total return with unchanged yields. Chief US Economist (+1) 212 250-7329 [email protected] Makoto Yamashita, CMA Strategist (+81) 3 5156-6622 [email protected] Francis Yared Strategist (+44) 020 754-54017 [email protected] Steve Abrahams Research Analyst (+1) 212 250-3125 [email protected] David Bianco Strategist (+1 ) 212 250-8169 [email protected] U.S. Credit The low point in HY defaults in this credit cycle is likely already behind us. Mortgages We remain overweight MBS against rates on expectations of a flatter curve, good carry and demand outpacing supply. U.S. Equities The dollar’s broadening strength vs. EUR, GBP, Yen, and the rapidity of oil’s price plunge has put our previous S&P 4Q EPS estimate of $30.50 out of reach. We now expect $30 for 4Q and ~$117.50 for full-year 2014 ________________________________________________________________________________________________________________ Deutsche Bank Securities Inc. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014. 18 November 2014 Global Strategy Flash: Weekly Cross Asset Views U.S. Economics The latest inflation readings are especially important given that the FOMC acknowledged recent declines in market-based measures of inflation expectations in the October meeting statement. In our view, above-trend growth will continue to put downward pressure on the unemployment rate and eventually upward pressure on inflation, in particular for service sector prices. Since the latter are the dominant driver of measures of core consumer inflation at around 75%, the trend in service prices will ultimately dictate the broader trend in core inflation. This may be one reason why the October meeting statement indicated that the Fed continues to see the likelihood of inflation running persistently below 2% as having diminished somewhat since earlier in the year. Goods disinflation is abating, while service prices are on the rise. The current 12-month rate of change in the consumer price index (CPI) is 1.7%—the same rate as the core CPI. Energy prices will likely continue to weigh on headline CPI in the near term and we expect a one-tenth decline in October, which would have the effect of lowering the year-over-year growth rate of headline CPI inflation to 1.5%. However, core prices are expected to rise +0.2%, raising the year-over-year growth rate a tenth to 1.8%. It is core inflation that matters most for monetary policymakers, given the inherent volatility in food and energy prices. Moreover, it is the core personal consumption expenditures (PCE) deflator that policymakers are watching most closely. Core CPI goods prices have been declining year-over-year since April 2013, and this has weighed on overall core inflation. However, core service prices have shown no such weakness—they have consistently been growing at well above 2% for the past three years. The weakness in goods prices has been the direct result of a significant deceleration in non-petroleum import prices— particularly imports from China. Essentially, the slowdown in global growth outside of the US lowered the demand, and therefore, the price of globally traded goods. While modest disinflation in the goods sector may continue in the near term, this is not the case for services, where the price of labor is the dominant input into the production process. The unemployment rate has fallen significantly over the past year, declining 140 basis points (bps) to 5.8% at present, and is on track to fall within the Fed’s estimate of full employment by the second half of next year. The FOMC’s central tendency forecast pegs the non-accelerating inflation rate of unemployment (NAIRU) somewhere within the range of 5.2% to 5.5%. As shown in the accompanying chart, as the unemployment rate approaches (and then moves below) the NAIRU, both wage pressures and service prices tend to accelerate. While the increase in wages to this point in the business cycle has been relatively modest, a tightening labor market will put upward pressure on labor costs. In turn, service prices, which have been consistently running above 2%, are likely to accelerate. Given that services (75%) have roughly three times the weight in measures of core inflation compared to goods (25%), it would take an unusually large decline in the latter to prevent core inflation from trending higher. This is highly unlikely given our above-trend growth forecast for the US economy. Page 2 Deutsche Bank Securities Inc. 18 November 2014 Global Strategy Flash: Weekly Cross Asset Views Core services inflation tends to accelerate as the economy reaches full employment Source: Deutsche Bank Joseph Lavorgna and Carl Riccadonna (+1) 212 250-7329/0186 [email protected],[email protected] Deutsche Bank Securities Inc. Page 3 18 November 2014 Global Strategy Flash: Weekly Cross Asset Views U.S. Rates While we are broadly neutral with most of our favored valuation metrics where they “should” be, we still think there are a variety of themes that are more likely to resolve toward a re-test of 2% in 10s rather than a break to higher yields over the next few months. We think changes in Treasury issuance, and the inclusion of Treasury supply formerly spoken for by Fed purchases in major indices, will produce index extension and force indexed investors to buy simply to remain at constant levels relative to benchmark. For example, we think real money needs to buy $225 billion in 10y equivalents just to maintain their current underweight position. On the real growth front, the issue hasn’t changed much during 2014 in that GDP remains disappointing (2-3 percent tendency) with an overreliance on labor input rather than productivity. Low productivity makes profits vulnerable to negative price shocks as well as a negative demand shock. Inflation of course remains undesirably low or falling across major industrialized economies. Ironically, the tendency of headline inflation to “cause” or lead core inflation could create a natural brake to not only inflation but also rate hikes. If expectations of higher rates strengthen the dollar, the stronger dollar puts downward pressure on commodities and most notably energy, falling food and energy put downward pressure on headline inflation that “leaks” into core, then in the end the tightening cycle could be far shorter than historical experience. We think the ECB was able to agree that balance sheet growth is desirable, but we remain skeptical that it is unanimous on how to bring that about. We remain concerned that markets will force the issue if the ECB does not clarify how it will grow its balance sheet in the reasonably near future. Trade Recommendations Buy $100mn 6M3Y 25bp OTM payers (1.78% strike) subject to KO if 3s > ATMF (1.53%) in the first 3M, offer 8c, a 77% discount to vanilla at 35c. Buy $100mn 1Y3Y 25bp OTM payers (2.16% strike) subject to KO if 3s > ATMF (1.91%) in the first 6M, offer 22c, a 67% discount to vanilla at 68c. December Treasury futures roll recommendations Contract Recommendation Rationale TU Relatively neutral Relative value FV Short the calendar Relative value TY Short the calendar The 2.25s of 7/2021 CTD is rich US Short the calendar The 10s-US-30s spread looks tight WN Short the calendar Relative value Source: Deutsche Bank Dominic Konstam and team (+1) 212 250-9763 [email protected] Page 4 Deutsche Bank Securities Inc. 18 November 2014 Global Strategy Flash: Weekly Cross Asset Views Japan Rates Yen bond market tested a rebound led by the superlong sector as the BoJ boosted its purchases of JGBs with residual maturities of over 25y by JPY40bn to JPY160bn. The trend of yen depreciation and a rise in stocks continues, but the market was led by supply/demand. The BoJ appears to be mechanically adjusting the amount of its purchases to extend the average maturity of purchases to 7-10 years. Domestic investors seem to be bullish despite the weak 20y auction on Tuesday. The Abe administration declared its intent to postpone the consumption tax hike scheduled for October 2015 and then dissolve the lower house for a general election before the end of this year in the hope of reaffirming its mandate. This expectation has already triggered a significant rally in equities and further depreciation of the yen. The general consensus is that Prime Minister Shinzo Abe will remain in office with the ruling Liberal Democratic Party (LDP) maintaining a clear majority. JGBs might ordinarily be sold off on economically positive news and concerns over a weakening yen and a worsening fiscal outlook, but few market participants expect interest rates to rise significantly while the BOJ remains such a big buyer of bonds. That said, if the LDP is able to match its 2012 election showing, the implied endorsement of the Abe government's course of action could trigger further rises in equities and USD/JPY. Few observers expect a repeat of the LDP's 2012 landslide victory at this juncture, but we are reluctant to rule out another very strong performance given that opposition parties are now much less popular than they were two years ago. Makoto Yamashita (+81) 35156 6622 [email protected] Agencies Given the uncertainty regarding the futures of Fannie and Freddie, we are slightly bullish on long-end spreads. Our best guess is that the two housing GSEs will muddle along in their current form while continuing to benefit from the implicit government backing in exchange for remitting quarterly dividends to U.S. Treasury. While opposing camps on the reform issue both agree that conservatorship is not the permanent solution, neither side is incentivized enough to push for things to move along faster. An orderly wind-down of the GSEs by the government should be positive for spreads. Currently, 85% of FNMA and FHLMC long-term debt mature before 2020, which we believe will be the earliest reasonable termination date for any potential GSE bill to be enacted. With under $100 billion outstanding that matures after 2020, and even less after factoring in callables which may be redeemed early, the remaining amount should be manageable for the government to take steps to preserve their credit ratings. We see good value for investors in the two-year sector. Spread volatility is lowest in this part of the curve, and the breakeven spread-to-spread volatility ratio remains more attractive relative to other sectors and its own history. The rolldown is also quite substantial: on an unchanged yield curve investors can expect a total return of 1.04% in one year’s time. The Federal Home Loan Banks priced $3 billion new two-year Global on Friday. Demand for this note was especially strong from central banks, which bought 31% compared to their past average of 21% for new issue 2yr Globals. The new issue brings YTD FHLBanks Global issuance to $13.5 billion, a 12.5% Deutsche Bank Securities Inc. Page 5 18 November 2014 Global Strategy Flash: Weekly Cross Asset Views increase from last year and the highest since 2011. FHLBanks’ next and final issuance slot for 2014 is December 1. Steven Zeng (+1) 212 250 9373 [email protected] U.S. Credit Our current assessment of this most recent episode of spread widening is that we came close to crossing the line into the next credit cycle, but probably have not actually done so. With corporate balance sheets already carrying a significant weight of leverage, and many indicators of aggressive issuance reaching their 2007-cycle peaks, we are probably closer to the next credit cycle than consensus continues to believe. Credit quality metrics are probably 7080% on their way to reaching their limit, and what stands between us and the next default cycle is (1) an external shock of a somewhat higher intensity than what we experienced in October; and (2) a shift in monetary policy. Thus, as we move into early 2015 and approach a point of a liftoff in the fed funds rate, these preconditions for the next credit cycle will continue to evolve and take us closer to the point where it turns. The shock we have experienced so far in the last few months, coupled with pressures on the fundamentals of the weakest energy issuers we discussed last week, is probably sufficient to conclude that the low point in defaults in this credit cycle is already behind us. Having seen default rates bottoming at 1.7% on the issuer basis and 1.9% in face amounts earlier this year, we are likely to see them trending towards 3.5% in 2015. Part of this gradual increase would be attributable to low-quality energy names, whereas other candidates could come from other somewhat stressed sectors such as media, gaming, and retail. Overall, this base-case is still compatible with a view that the current credit cycle could go on for a little longer, perhaps the next year or so, before it finally reaches its tipping point. Historical evidence provides us with additional comfort to say so, as each of the past three credit cycles saw a modest increase in defaults to 3-4% in 1988, 1996, and 2006, all happening before the turning points discussed in detail above. Oleg Melentyev and Daniel Sorid (+1) 212 250-6779/1407 [email protected], [email protected] Mortgages Revisiting relative value The dramatic moves in the rates market last month ultimately left us back where we started but not without first shaking up valuations in different parts of the mortgage market and leaving some relative value opportunities. The shift in the Fed from net buying to reinvestment and the redoubling of the BoJ QE offensive also brings new potential demand dynamics to the market. All of it comes back to core positioning, where most still stands but a couple of new things look worth adding. For more detail on these positions, please see ‘The Outlook in MBS and Securitized Products’ from November 12, 2014. Remain overweight MBS against rates on expectations of a flatter curve, good carry and demand outpacing supply Get long lower-coupon 15-year TBA against 30-year TBA on the strength of supply technicals, better hedge-adjusted carry and continued bank demand Page 6 Deutsche Bank Securities Inc. 18 November 2014 Global Strategy Flash: Weekly Cross Asset Views Hold higher coupon TBA 30-year 4.5%s and 5.0%s on hedge-adjusted carry, but be cautious about position exposure to special dollar rolls To reduce exposure to a break in special dollar roll, consider adding call protection in 4.5%s rather than 5.0%s as the former looks undervalued after October pay-up volatility, the latter slightly overvalued Consider holding the 4.5%s in structure as a front PAC for additional yield and more convex total returns, while the 5.0% appears better in pool form For extension or call protection stories look to 3.5%s where seasoning, loan balance and high-LTV stories all appear undervalued The MBS market lost its one guaranteed net buyer when the Fed officially ended QE3 at the October FOMC. However, the Fed bought only $5 billion net last month, against an early estimate of $16 billion of net supply. And still the basis ground tighter—suggesting continued support from private capital. Indeed, according to the latest Fed H.8 release, US banks alone in October added $14 billion. Our early estimate for November net supply is a surprisingly robust $20 billion, which would put us ahead of our $30 billion projection for all of the fourth quarter—though December production has run flat to negative in two of the last three years. There is potentially some risk of a net supply upside surprise, of course. As noted in ‘Short the prepayment option’ from The Outlook on October 22, the MBA reported a marked improvement in origination margins in the second quarter—and suggested the low margins of prior quarters may have reflected the costs of complying with new underwriting rules out of the CFPB. Those costs may now be behind us, possibly making it a bit easier for banks to lend. However, despite FHFA Chair Watt’s recent emphasis on improving access to credit, it seems that tangible progress still needs to be made before lenders’ fears of GSE put-backs are sufficiently assuaged to meaningfully reduce credit overlays. Just ask Ben Bernanke how hard it still is to get a mortgage. Winter seasonals and tight credit should keep demand ahead of supply through the next few months at least. Steve Abrahams and Ian Carow (+1) 212 250-3125/9370 [email protected], [email protected] U.S. Equities We cut our S&P 4Q EPS estimate from $30.50 to $30, 2014E EPS ~$117.50 The dollar’s broadening strength vs. EUR, GBP, Yen, and the rapidity of oil’s price plunge has put our previous S&P 4Q EPS estimate of $30.50 out of reach. We now expect $30 for 4Q and ~$117.50 for full-year 2014. We maintain our 2015E S&P EPS of $123, which is nearly 5% growth. Our 2015E EPS assumes a small rebound in oil prices to an $80-85/bbl average and that the climb in dollar slows, such that EUR/USD stays above 1.20 in 2015. We expect investors to pay above-average multiples for below-average EPS growth given persistently low interest rates. However, we think striking the right balance in this uncomfortable math brings more volatility in the coming months and year. David Bianco and Priya Hariani (+1) 212 250-8169/2766 [email protected], [email protected] Deutsche Bank Securities Inc. Page 7 18 November 2014 Global Strategy Flash: Weekly Cross Asset Views Appendix 1 Important Disclosures Additional information available upon request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Dominic Konstam Page 8 Deutsche Bank Securities Inc. 18 November 2014 Global Strategy Flash: Weekly Cross Asset Views (a) Regulatory Disclosures (b) 1. 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Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. 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