Monthly Chartbookfiles.ctctcdn.com/3bf703a6001/24b6d79b-3eb2-4753-8a73-ab... · 2015. 11. 8. · Beijing continues to support the Chinese yuan, rather than unleashing a disinflationary

Monthly ChartbookNOVEMBER 2015

This week’s EVA Chartbook explores the outlook for US interest rates in light of some signs that global economic and financial risks are receding… for now. While China’s summer flu was enough to scare the Federal Reserve into delaying its September rate hike, a restored sense of calm in global markets has prompted the Fed to signal that an interest rate hike this December is now a “live possibility.”

Three things have become clearer in the past two months: (1) China’s economy is slowing, but not collapsing, (2) Beijing continues to support the Chinese yuan, rather than unleashing a disinflationary shock on the rest of the world, and (3) the market turmoil we saw in August was more of a panic attack than a legitimate crisis.

With six weeks left before the Fed’s December policy meeting, it is still WAY too early to say what Ms. Yellen and her colleagues will do. At this point, the outcome largely depends on the incoming stream of US economic data and whether global financial markets can come to terms with the rising probability of a rate hike without melting down as we saw in August. In an age of computerized trading and over-risked investors, the answer to that question is not entirely clear.

If nothing else, the shift in expectations is likely to stir up some serious volatility as 2015 draws to a close.

Fears of an Asian Contagion Subside… For NowBY WORTH WRAY

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M O N T H LY C H A R T B O O K / N O V E M B E R 6 , 2015

• According to a Bloomberg News Survey in early August (top chart), the vast majority of Wall Street economists expected the Fed to hike interest rates at its September 2015 policy meeting.

• Those expectations fell dramatically by the end of August… despite the fact that the tightening US labor market and stable inflation expectations satisfied the Fed’s previously stated conditions for a rate hike.

• What happened?

Source: Bloomberg News SurveysNote: The August 7-12 Survey had 62 respondents. The August 27-31 survey had 54. Percentages may not add up to 100 due to rounding.

BY WORTH WRAY

A September Fed Hike Looked Like a Sure Thing…

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• China’s CNY “devaluation” on August 10, 2015 confused investors around the world. • Some said that Beijing was reforming its currency-fixing regime to become more market oriented in order to earn a place in the

IMF’s Special Drawing Rights (SDR) basket of reserve currencies. They argued that Beijing had little interest in depreciating the currency.

• Others said that the Chinese Communist Party’s failure to prevent its equity market from collapsing was proof that Beijing was losing control of its economy and would soon join the global currency war. They argued that Beijing was positioning for a bigger depreciation, which smacked of desperation. For better or worse, this view initially seemed to resonate with more investors.

*Note: China’s currency, the renminbi (RMB), includes both the onshore yuan (CNY) and offshore yuan (CNH). While the CNH (which underpins Hong Kong’s “dim sum” bond market) floats freely, Beijing has traditionally kept a firm grip on the USD/CNY exchange rate by forcing the markets to trade within a narrow band around a midpoint set arbitrarily each day by the People’s Bank of China. For all practical purposes, this protocol has kept the Chinese government in control of the CNY exchange rate. All that began to change on August 10, 2015 when Beijing abruptly devalued the currency and introduced a new market-driven protocol for guiding the exchange rate over time. While daily moves in the USD/CNY exchange rate are still limited to 2% in either direction, the central bank now sets each day’s midpoint in line with the previous day’s closing price… which is to say that the currency can now rise or fall over time as 2% daily market moves accumulate. For now Beijing is intervening in the open market, but there is no guarantee it will continue. Please check out my August note (“What Happens When a Dragon Flaps it’s Wings?”) if you are interested in learning more.

Source: Evergreen GaveKal, Bloomberg

BY WORTH WRAY

… Until the People’s Bank of China Unanchored the RMB* M O N T H LY C H A R T B O O K / N O V E M B E R 6 , 2015

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CHINESE YUAN PER US DOLLAR

http://www.evergreengavekal.com/evergreen-virtual-advisor-7/


• Although China’s economy has been slowing dramatically in recent years (white line), global investors did not seem very concerned until the stock market (green line) began to collapse.

• While the Chinese Communist Party’s failed attempts to stem the tide did not inspire confidence, it’s important to point out that China’s stock market is a lousy indicator for the state of the country’s economy. Percentage wise, the Shanghai Stock Exchange rose almost as much from 2005 to 2007 than it did from 1990 to 2005 during some of the stronger years of China’s economic “miracle”.

BY WORTH WRAY

Investors Began to Panic as if China Were Collapsing

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CHINESE STOCKS VS. CHINESE GDP GROWTH


• Faced with seemingly-imminent risk of a China hard-landing, emerging market currencies (white line) and commodity prices (gray line) continued to tumble while the dollar (green line) rallied on improving US economic data.

• The very real prospect of a rising US dollar and a falling Chinese yuan led a number of investors to believe that the global economy was on the edge of a crisis comparable to 1997’s Asian Contagion. For the record, I still think these are enormous risks over the medium term, but many investors got ahead of themselves in August.

BY WORTH WRAY

Fears of Simultaneous Fed Hike & China Hard LandingWeighed on Commodities & Emerging Markets

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US DOLLAR, COMMODITIES, & EM CURRENCIES


• Amid the confusion, investors overreacted to widespread worries of a global crisis. As falling Chinese stocks continued to drive fears of an imminent hard-landing in the world’s second largest economy, major equity indices around the world followed suit.

• As the US volatility index saw its largest week-over-week spike on record, the S&P 500 abruptly sold off more than 11%.• Even AAA Corporate bond spreads rose dramatically, reflecting a tightening in financial conditions and suggesting the

equity sell-off could continue.

BY WORTH WRAY

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M O N T H LY C H A R T B O O K / N O V M B E R 6 , 2015

AMERICAN VS. CHINESE STOCKS

It Didn’t Take Long for Global Stability Fearsto Trigger a Sharp Sell-Off in US Financial Markets

US EQUITY VOLATILITY INDEX AAA CORPORATE BOND SPREADS

• These cartoons say it all…

BY WORTH WRAY

For a Moment, It Felt Like the US Stock Market Might Collapse

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Steve Liesman’s August 28, 2015 CNBC Interview with Vice Chair Stanley Fischer. (Video, Transcript)

• On whether September was still the appropriate time to hike interest rates: “The change in circumstances which began with the Chinese devaluation is still relatively new and we are still watching how it unfolds.”

• On whether financial market volatility would influence the Fed’s decision: “If you don’t understand the market volatility and I’m sure we don’t fully understand it now… it does affect the timing of a decision you might want to make.”

BY WORTH WRAY

Vice Chair Stanley Fischer Told Us the Fed was Worried about the “Chinese Devaluation” & Subsequent Market Volatility

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http://video.cnbc.com/gallery/?video=3000412562

http://www.cnbc.com/2015/08/28/cnbc-exclusive-cnbc-transcript-federal-reserve-vice-chairman-stanley-fischer-speaks-with-cnbcs-steve-liesman-on-cnbcs-squawk-alley-today.html

• In its June 2015 policy statement, the FOMC clearly indicated that it would be “appropriate to raise the target range for the federal funds rate when it has seen (1) further improvement in the labor market and (2) is reasonably confident that inflation will move back to its 2% objective over the medium term.”

• But in September – although the FOMC acknowledged that those conditions had been basically met – the Fed decided to delay further policy tightening due to “global economic & financial developments.” According to Gluskin Sheff Chief Economist, David Rosenberg, such concerns have not factored so heavily into a Fed rate decision since the Asian Financial Crisis in 1997.

• As you can see in the chart to the right, China has been top of mind in recent Fed meetings. As I explained in a recent EVA Exchange, these concerns likely had more to do with the explosion in US equity volatility and subsequent tightening in US financial conditions than a genuine concern for global economic stability.

•

BY WORTH WRAY

Then the Fed Changed Course, Saying It Was Monitoring Developments Abroad

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http://files.ctctcdn.com/3bf703a6001/32cfe6be-cb05-4cf7-b34f-15e6c3a2794e.pdf

• While many investors continue to worry that a weaker Chinese yuan (CNY) could unleash a painful disinflationary shock on the rest of the world, Beijing has intervened in the open market rather than allowing the currency to weaken against the US dollar. While the yuan’s increasingly market-oriented structure certainly complicates the Fed’s decision-making process, Ms. Yellen and her colleagues on the Federal Open Market Committee have the unenviable task of balancing the risk of a Chinese currency shock against the equally distressing risk of over-stimulating the US economy and US financial markets.

• As you can see in the chart to the right, US equity volatility has fallen back to normal levels… further signaling an “all clear” to the Fed.

BY WORTH WRAY

Since Then…


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CHINA’S YUAN HAS BEEN REMARKABLY STABLE US EQUITY VOLATILITY HAS RECEDED

• The People’s Bank of China has cut its benchmark interest rate (green line) six times in the past year and three times since the equity bubble began to burst in June. That 1.65% decline in interest rates is driving a re-acceleration in year-over-year total social financing (white line) – the broadest official measure of Chinese credit growth.

• While China’s growing debt burden will likely continue to drag on economic growth over the long-run, it is supporting economic activity for the time being.

BY WORTH WRAY

China’s Central Bank Continues to Cut Interest Rates


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PBOC BENCHMARK INTEREST RATE & TOTAL SOCIAL FINANCING GROWTH

• While a number of China skeptics point to sharp declines in the Li Keqiang Index* – a popular index which was once a useful proxy for Chinese GDP growth – such measures do not tell us anything about the service sector which now accounts for roughly half of China’s economy.

• The 6.9% official year-over-year real GDP figure likely overstates Chinese growth, but the economy is not collapsing. The truth is somewhere in between. Recent Purchasing Managers Index (PMI) data confirms this idea. As you can see in the chart on the right, manufacturing activity is slightly contracting at 49.8 and non-manufacturing activity (largely dominated by services) is modestly expanding at 53.1.

*Note: The “Li Keqiang Index” is based on Premier Li Keqiang’s preferred economic indicators back in 2010: rail cargo volumes, electricity consumption, and bank loans. It provides an alternative view on the strength of China’s industrial growth, which is becoming less useful as China shifts toward a post-industrial growth model.

BY WORTH WRAY

China is Slowing, But Not Collapsing


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OFFICIAL GDP GROWTH VS. THE LI KEQIANG INDEX PURCHASING MANAGERS INDICES

• China’s equity market has risen almost 20% from its August trough as lower borrowing costs spur margin trading and improving economic data restores Chinese investors’ faith in Beijing.

• It may take a while for foreign investors to return to China’s domestic stock market, but rising share prices are reinforcing the upswing in global sentiment for now.

BY WORTH WRAY

China’s Stock Market is Recovering


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SHANGHAI COMPOSITE INDEX & TOTAL MARGIN DEBT

• The S&P 500 has come screaming back since mid-September and is now trading back near its all-time high. • AAA corporate bond spreads* have narrowed back to mid-August levels, reflecting a recovery in bond prices and an

easing in borrowing costs.• Considering Ms. Yellen’s comments in her September press conference that the drop in equity prices and a widening

in risk spreads had “tightened overall financial conditions to some extent,” the reversal in US financial markets is yet another “all clear” for Fed voters to consider.

*Note: The difference between AAA corporate bond yields and 10 year US Treasuries

BY WORTH WRAY

With “Global Economic & Financial” Turmoil Settling, US Financial Markets Have Bounced Back


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S&P 500 INDEX & AAA CORPORATE BOND SPREADS*

• With global concerns out of the way (at least for now), the Fed’s decision to hike or delay hiking interest rates now comes down to the incoming economic data in the United States.

• As you can see in the chart to the left, the US labor market is now at or near the Fed’s target “full employment” level with the U3 unemployment rate (white line) at 5.1%. Both jobless claims (green line on the left chart) and ISM non-manufacturing employment (white line on the right chart) suggest that strong job gains are likely continue rolling in over the next few months. This morning’s stronger-than-expected non-farm payrolls report is a big step in that direction.

BY WORTH WRAY

All Eyes on the US Economy…


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WILL THE LABOR MARKET KEEP TIGHTENING? SIGNS OF STRONG JOB GAINS AHEAD?

• While the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) measurements continue to show inflation running well below the Fed’s 2% long-term target, the Fed believes weak inflation readings are the product of short-term drags from a strong US dollar and weak commodity prices. That is to say that the Fed expects inflation will rise back to its target whenever the US dollar falls and commodity prices recover.

• In spite of these transitory factors, inflation expectations (chart to the right) remain remarkably stable. • In the event that the labor market continues to tighten through December and inflation expectations remain relatively anchored,

and that global economic and financial turmoil does not flare up in the meantime, the Fed will have everything it needs to follow through with a hike.

BY WORTH WRAY

All Eyes on the US Economy…

Source: Evergreen GaveKal, Bloomberg Source: University of Michigan Surveys of Consumers; Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters

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PCE MEASURES REMAIN WELL BELOW TARGET SURVEY INFLATION EXPECTATIONS ARE STABLE

• Expectations in the federal funds futures market (left chart) have shifted dramatically since October 14 when the probability of a December Fed hike sat at just 26%. Today, the fed funds market is pricing in a strong probability of 72%. Just yesterday, it stood at 56%.

• Morgan Stanley’s Number of Months to 1st Rate Hike Index is telling a similar story (right chart) as the index has fallen to its lowest levels since the September Fed meeting.

BY WORTH WRAY

It’s Still Too Soon to Say What the Fed Will Actually Do, But A December Rate Hike is Becoming the “Base Case”


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DECEMBER HIKE ODDS ACCORDING TO FED FUNDS FUTURES MORGAN STANLEY’S # OF MONTHS TO 1ST RATE HIKE INDEX

• As you can see in the charts above, the trade weighted US dollar index (left chart) and the DXY Index (right chart) decisively broke out of their long-term downtrends earlier this year and have been in sideways consolidation patterns ever since. In the event that the Fed tightens (or a major foreign central bank like the European Central Bank or the Bank of Japan eases), the dollar could climb considerably.

• Any further appreciation in the US dollar could have ugly consequences for global growth as capital flees emerging markets (including China) and erodes demand for dollar-denominated commodities. From that perspective, a Fed hike may lead to QE4 more quickly than many investors expect, should a surging dollar trigger enough trouble at home and abroad.

BY WORTH WRAY

If a Hike Does Happen, Watch Out for An Epic Dollar Rally


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DECEMBER HIKE ODDS ACCORDING TO FED FUNDS FUTURES MORGAN STANLEY’S # OF MONTHS TO 1ST RATE HIKE INDEX

• As Jeff Dicks recently commented in our September EVA Chartbook (“Flash Crash 2.0”), the August 24 shock wasn’t the first time that a macro-economic shock has triggered a sharp break in sentiment and confused the high- frequency trading programs that have become so pervasive in today’s markets. It is certainly possible that we could see a similar event if the markets continue to price in a December hike… which could prevent the Fed from hiking interest rates at all.

• If relatively small surprises can have big consequences over time in our highly leveraged, highly interconnected, and increasingly automated global financial system, major shocks can change everything in a flash.

• As I explained in a recent note (“Rage Against the Machine”), temporary dislocations in intraday trading can hurt emotional or ill-prepared investors, but they can also present enormous opportunities for those who have a plan in advance.

BY WORTH WRAY

If Investors Expect a Hike When the Time Approaches, Watch Out for Another Tantrum


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http://files.ctctcdn.com/3bf703a6001/c67987af-7758-48a0-a03c-d24d6220ff0c.pdf

http://www.evergreengavekal.com/evergreen-virtual-advisor-8/

• With the S&P 500 trading back near its all-time highs, we believe that any rally from here is an opportunity to get defensive. • According to Evergreen’s favorite valuation metric – the price-to-sales ratio, which is currently sitting at 1.86 – the US stock

market is even more expensive than at its 2007 peak. At these valuations, history suggests that long-term returns will be weak at best. Given the uncomfortable odds of a 25%+ correction and possibility of sharp flash-crash-type dislocations, we would rather be opportunistic buyers at meaningfully lower prices.

BY WORTH WRAY

Any US Equity Rally from Here is An Opportunity to Get Defensive


S&P 500 PRICE & PRICE-TO-SALES RATIO

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In closing, it appears that a number of risks are rising as global sentiment improves and the US labor market continues to grind past the Fed’s full-employment target. While these trends may open the door for a Fed hike by December, it could also set the stage for the kind of shock that would force Ms. Yellen and her colleagues to delay well into 2016. At this point, the Fed is like a man crossing a rising river by feeling the stones underfoot and running the risk of slipping every time he takes a step.

It is far too early to say what will happen, which is exactly why we – I’m speaking for all investors – need to take advantage of the current market calm to re-evaluate our portfolios. You’ve got to ask yourself, am I taking too much risk? Am I taking risk in the right places? How much can I afford to lose in a correction? Can I afford to miss out on a modest amount of upside in order to capitalize on deep discounts in the next crisis?

Fortunately, pockets of value have emerged – particularly in resource-related assets like Master Limited Partnerships – that allow us to build diversified portfolios capable of delivering higher cash flow and better long-term returns. While these assets could certainly fall further in the coming quarters, we believe they offer a superior risk-reward proposition relative to richly-valued markets like US equities. Aside from

BY WORTH WRAY

Conclusion

replacing part of our core equity exposure with these beaten-up assets, our team at Evergreen GaveKal continues to maintain a defensive posture with an underweight to the equity markets, a healthy allocation to US Treasuries, and the largest cash reserves in our firm’s history.

While we believe we are approaching a dangerous stage in the market cycle, we are excited for the opportunities that lie ahead for the patient few who refuse to get caught up in the market’s emotional roller coaster.

CHARTBOOK AUTHOR:

WORTH WRAYChief EconomistTo contact Worth, email: [email protected]

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Our Current Likes and Dislikes

This report is for informational purposes only and does not constitute a solicitation or an offer to buy or sell any securities mentioned herein. This material has been prepared or is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. All of the recommendations and assumptions included in this presentation are based upon current market conditions as of the date of this presentation and are subject to change. Past performance is no guarantee of future results. All investments involve risk including the loss of principal. All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Information contained in this report has been obtained from sources believed to be reliable, Evergreen Capital Management LLC makes no representation as to its accuracy or completeness, except with respect to the Disclosure Section of the report. Any opinions expressed herein reflect our judgment as of the date of the materials and are subject to change without notice. The securities discussed in this report may not be suitable for all investors and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Investors must make their own investment decisions based on their financial situations and investment objectives. The specific securities identified and described do not represent all of the securities purchased, held, or sold for advisory clients, and you should not assume that investments in the securities were or will be profitable. Exxon is used as an example to illustrate the discount of blue chip energy stocks. You should not assume that an investment in any of these securities was or will be profitable. ECM currently holds Exxon, and purchases it for client accounts, if ECM believes that it is a suitable investment for the clients considering various factors, including investment objective and risk tolerance.

• Real Estate Investment Trusts (REITs)*

• Small-cap value

• Mid-cap value

• Small-cap growth

• Mid-cap growth

• Floating-rate bank debt ( junk)

• Lower-rated junk bonds

• Emerging stock markets

*However, some small and mid-cap issues look attractive (and are becoming even more so)

• Most cyclical resource-based stocks

• Large-cap value

• Short-term investment grade corporate bonds

• High-quality preferred stocks yielding 6%

• Long-term investment grade corporate bonds

• Short yen ETF

• Emerging market bonds (local currency)

• Short euro ETF

• Bonds denominated in renminbi trading in Hong Kong (dim sum bonds)

WE’RE NEUTR AL ON

I M P O R TA N T D I S C LO S U R E S

No changes this week.

WE DON’ T LIKE• Large-cap growth (on a deeper pull back)

• International developed markets (on a deeper pull back)

• Canadian REITs

• Intermediate Treasure notes

• BB-rated corporate bonds (i.e., high-quality, high yield)

• Cash

• Publicly-traded pipeline partnerships yielding 7%-12% (MLPs)

• Intermediate-term investment grade corporate bonds, yielding approximately 4%

• Gold-mining stocks

• Gold

• Intermediate municipal bonds with strong credit ratings

• Long-term municipal bonds

• The Indian stock market

• Long-term Treasury bonds

• Blue chip oil stocks (on a pull-back after the recent rally)

• Canadian dollar-denominated bonds

• Emerging bond markets (dollar-based or hedged)

WE LIKE

Documents

Monthly Chartbookfiles.ctctcdn.com/3bf703a6001/24b6d79b-3eb2-4753-8a73-ab... · 2015. 11. 8. · Beijing continues to support the Chinese yuan, rather than unleashing a disinflationary