Document Text Content
Global Cross Asset Strategy – Year Ahead
The Trump inflection
Investment Strategy
30 November 2016 Corrected
Key takeaways
• Market response to Trump is logical but moves have been frontloaded. We now see
USD & rates only modestly higher next year.
• We see higher growth and inflation, notably in Japan. We go long NKY, stay long EM
AXJ & selective yield in equity/ credit.
• Risk is an overshoot so we stay long USD/ short rates, adding a CNH put and short
10Y real rates. CNH a hedge vs trade risk.
Investment strategy
Global
James Barty >>
Investment Strategist
MLI (UK)
+44 20 7996 3291
james.barty@baml.com
See Team Page for Full List of Contributors
Trump extends some trends, starts others
In the three weeks since Donald Trump’s election victory global markets have seen some
dramatic moves. Som1e of those moves are extending trends that had already started –
higher yields, higher USD, rotation from long to short duration. Others are new – JPY
lower, NKY higher, EM lower. The key question is how much more they can go?
Growth/inflation higher in 17/18 - modest fiscal boost
Our economists think the fiscal impact of Trump will be modest at 0.5% on growth in
H2 next year. Fiscal stimulus elsewhere also to be modest but it is taking the pressure
off monetary policy. Growth was already improving so any fiscal stimulus helps. Our
economists have both growth and inflation higher into 2017 and 2018.
Inflection point in markets but much discounted already
Market moves at turning points are often violent. The task of investors is to work out
how much is already discounted. Our fixed income strategists have 10Y US yields at
2.65bp and bunds at 65bp at end 2017, also EUR/USD at 1.02 so moves look
frontloaded to us. That suggests their implications for other markets should fade.
Unauthorized redistribution of this report is prohibited. This report is intended for amanda.ens@baml.com
Evolution not revolution – long NKY, short 10Y real rates
If that is the case then we do not want to make wholesale changes to our strategy. We
make two key changes today, adding long NKY (Japan strategist targets 20k) and short
10Y real rates trades. The former is part of our strategy to be pro-growth and we think
it complements our long EM Asia trade being affected differently by USD strength.
The hunt for yield is dead, long live the hunt for yield
If yields only rise modestly next year then the hunt for yield will live on. We keep a yield
basket in European equities, AT1s and spread in Euro/US credit. We go outright long
European Healthcare by lifting our Food & Beverage short, which has dropped sharply.
Overshoot in rates, USD and trade key risks – add CNH put
The world would look very different if the US 10Y blew through 3% and the USD went
on a tear, so we stay long USD and short rates. We add a CNH put vs USD as a hedge
against an escalation of trade tensions under the new Trump administration.
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Refer to important disclosures on page 26 to 27. Analyst Certification on page 25. 11691609
Timestamp: 30 November 2016 12:00AM EST
Current trade recommendations
Table 1: Current cross asset trades
Asset Trade idea Strategist
Long European Quality Yield Screen (yield)
James Barty
Long SXDP Index
Ronan Carr
Equities
Long Nikkei
Shusuke Yamada
Long European index dividend futures
James Barty
Long MSCI Asia ex-Japan
Ajay Kapur
Long RTY short SPX 2y variance swap
Nitin Saksena
3000-2850 SX5E put spread Dec 16 expiry James Barty
Equity vol
Long NKY short SPX Dec 18 variance swap
Benjamin Bowler
Long SX5E short SPX Dec 18 variance spread
Abhinandan Deb
Eurostoxx 2y/3y put calendar
Abhinandan Deb
Short EUR/SEK
Kamal Sharma
Long USD/CNY call
Claudio Piron
FX
Short GBP/USD
Kamal Sharma
Long USD/AUD
Ian Gordon
Long RUB/ZAR
David Hauner
2s-5s-10s fly
Shyam S.Rajan
Fixed Income
Short US 10y real rates
Shyam S.Rajan
Paying 5y GBP real rate swap
Mark Capleton
Buy 30y US IG Industrial spreads
Hans Mikkelsen
Credit
Buy basket of Euro AT1s
Barnaby Martin
Long Xover short Main
Ioannis Angelakis
Source: BofA Merrill Lynch Global Research. For the full methodology and reference pricing please see Appendices. New trades in bold.
Themes
Long Cyclicality
• Long Asia EM – recovering growth, earnings revisions and cheap valuation.
• Long Nikkei – growth picking up, JPY soft, 20k target.
Long Yield
• Long European dividend yield stocks – 5% yield, big pick up over IG credit.
• Long Dec 18 SX5E dividend future – implies 4% drop from 2016, we see 4% rise.
• Long basket of AT1s – high yield, equity cushion to rise.
• Long XOver short Main – investors’ reach for yield to push them towards Crossover.
• Long basket of 30Y US industrial IG spreads – further spread compression.
Hedge the Fed/Trump
• 2-5-10 fly – 5Y part of the curve looks most vulnerable to Fed hiking.
• Short 10Y real yields – inflation breakevens have adjusted real rates have not.
• Long USD – long via USD/GBP and USD/AUD, we think policy divergence will drive
USD stronger if the Fed tightens as our economists expect.
• Long USD/CNH 7.6 6 month call – hedge against trade tensions
Hedge the Rest
• We are long SX5E, NKY and RTY vs SPX variance. Carry positive, convex in a sell-off.
• Long Dec 17/18 SX5E put spread. Long 3000-2850 Dec 16 put spread.
Alpha Trades
• Long European Pharma. Sector discounting no pipeline, valuation back to cheapest
since 2011. Solid yield too.
• Paying 5y UK real rates at -254bp. Implied inflation/rates inconsistent.
• Long RUB/ZAR (positive on oil, cautious on S African politics).
• Short EUR/SEK, strong Swedish growth, limiting room for Riksbank easing.
2 Global Cross Asset Strategy – Year Ahead | 30 November 2016
The Trump inflection
Changes today: Add NKY long, 10Y real rate short and CNH put, close forward
Kospi vol and Food & Beverage short. We are not making mass changes today. While
some of our trades have worked better than others post-election we are broadly happy
with the balance. We still want exposure to growth and to own yield where we can but
also want to protect ourselves from a further surge in the USD and rates.
We diversify our equity long in EM and European yield with a long Nikkei position.
It is not the best entry point but we suspect it has further to run on a one year horizon.
A stronger USD is good for Japanese equities where it is not for EM, so they
complement one another. We add a short US 10Y real rate trade too to protect
against rising US yields, as breakevens have already moved significantly. We close our
Kospi vol trade (changed view from strategists) and drop the short Food leg of our
Pharma/Food trade, reflecting the sharp sell-off in the long duration sectors of late.
Summary: Still be long growth and yield but hedge with USD and Rates
Year aheads are notoriously tricky to write and almost always wrong. Anyone who
wanted to correctly predict the outcomes and how markets would react to them in 2016
did not need so much as crystal ball as a time machine. As investors and strategists we
have to make calculations as to the most likely outcomes, where is the best upside to
play them and how best to hedge the risks around them.
Donald Trump’s election is in our view an inflection point for global markets,
starting new trends in some asset classes and extending trends in others. It does
not completely change the world though, as the disinflationary and weak growth
pressures that have plagued the world since the GFC are structural rather than cyclical.
But the shift to fiscal and populism is likely to boost growth and inflation, so it does
change the picture to a significant degree. If we are to call it an earthquake it is perhaps
a five rather than a nine on the Richter scale.
We have to adjust our way of thinking though. The rise in rates and higher USD that
we had hedged against now look like they are going to go further. That is going to
hurt longer duration assets. So we continue to run our long USD positions and add to
our short rate positions (via 10Y real rates). There is risk around trade and geopolitics,
which has to make us more nervous of our EM positions. So we diversify our risks by
pairing our long EM position with a long Japan position and add a CNH put.
But the world is not completely changing. Even in the new order we only forecast 10Y
Treasuries at 2.65% and Bund yields at 65bp end 2017. So the hunt for yield will not
disappear completely. We still want to own yield, but as we have said of late it cannot
be yield for yield’s sake. Yield in equity markets has been safest in the shortest duration
buckets, such as Banks and Cyclicals since the summer. We changed our yield basket last
month is this direction so we keep it. We stay long AT1’s and in credit we keep our
spread trades both in Europe and the US.
AND we remind investors of something we said at the start of 2016, be prepared
to trade the ranges in markets. If there was one lesson of the last year it was that.
When assets get very loved and overbought, sell them, when it is the opposite you have
to buy them. Think of buying EM and commodities in February. Think of selling
defensive equities and bonds and buying banks post-Brexit. None of us will get that
right all of the time, but the Warren Buffet maxim “be greedy when others are fearful
and fearful when others are greedy” is particularly useful in current markets.
Finally, as cross asset investors think about what can go wrong with your positions
and find asymmetric hedges for them if you can. That should be the edge you have at
looking across the range of asset classes compared to single asset class investors.
We would like to thank our BofAML colleagues who have supported our product this
year by providing many such ideas and trust they will continue to do so through 2017.
Global Cross Asset Strategy – Year Ahead | 30 November 2016 3
X Asset Strategy: Long growth, short bonds, long USD but
the hunt for yield lives on
Clearly markets are different and will continue to be so under President elect Trump
BUT not everything will change. The disinflationary forces triggered by the GFC have
not gone away but the decision to focus on fiscal stimulus, not just in the US but also
Japan and to a lesser extent the UK, is a welcome shift taking some of the burden away
from monetary policy. It means rates should be higher for any given amount of growth.
But higher does not mean a return to pre GFC levels of rates, which we need to bear in
mind when setting our strategy. Indeed, our strategists 10Y forecasts are US 2.65%,
Euro 0.65% and Japan 0% for end 2017.
Similarly on trade, for all the rhetoric of the President-elect again we do not think he
wants to trigger trade wars that would damage US growth. That means we should not
necessarily drop our pro-EM bias.
So we think of it as an evolution rather than a revolution in the way our strategy is
structured. We wanted to be exposed to growth, we tweak that by adding a NKY long to
replace our US energy long. We continue to have yield in the portfolio where we can find
it, which is through a mixture of equities and credit (AT1’s, European yield basket, Xover
v Main and US long date industrial spreads).
Even more than before we want to be protected against a stronger USD and higher
rates, hence the addition of the 10Y real yield trade, and trade tensions which we have
tried to cover through our CNH put.
Nov 8 th accelerates some trends, starts other
Before the US election we said that the tectonic plates were starting to shift, with bond
yields having troughed and starting to head higher. We thought there were signs too
that global growth might be shifting up a gear. So we wanted to have defensive
positions in bond markets, be long the USD and be long growth where we could. The
election of Donald Trump has arguably turned this gradual shifting of plates into a full
blown earthquake for global financial markets.
The key questions for investors as we look ahead to 2017 are how big an earthquake
and how much the moves that have happened since November 8 th are likely to be
extended into next year vs how much we have frontloaded them already in 2016.
Chart 1: USD/JPY has surged post-Trump
Chart 2: As have bond yields
125
2.5
120
115
JPY/USD
2.3
2.1
10y UST yield
110
1.9
105
1.7
100
1.5
95
1.3
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Mar-16
Apr-16
May-16
Jun-16
Jul-16
Aug-16
Sep-16
Oct-16
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Mar-16
Apr-16
May-16
Jun-16
Jul-16
Aug-16
Sep-16
Oct-16
Source: Bloomberg
Source: Bloomberg
4 Global Cross Asset Strategy – Year Ahead | 30 November 2016
Chart 3: EM debt and equity have been hit
Chart 4: While Banks versus Staples has gone ballistic
950
900
850
800
750
700
650
Oct-15
Nov-15
Dec-15
MSCI EM
Wisdom Tree EM Local Debt Fund
(RHS)
Jan-16
Feb-16
Mar-16
Apr-16
May-16
Jun-16
Jul-16
Aug-16
Sep-16
Oct-16
40
39
38
37
36
35
34
33
32
0.43
0.41
0.39
0.37
0.35
0.33
0.31
0.29
0.27
0.25
Oct-15
Nov-15
Dec-15
Jan-16
S&P 500 Banks relative to Food & Bev
Feb-16
Mar-16
Apr-16
May-16
Jun-16
Jul-16
Aug-16
Sep-16
Oct-16
Source: Bloomberg
Source: Bloomberg
The moves since Nov 8 th have certainly been violent in certain asset classes. USD/JPY
stands out, but the sell-off in US treasuries has been very marked, the hit to EM fixed
income equally big, while in equity markets the outperformance of the Russell, the surge
in the US banks and the sell-off in long duration equities has been remarkable.
Some of these moves, such as stronger USD, higher yields, banks vs staples were
extensions of moves that had already begun. Others, such as Russell vs S&P, JPY, Nikkei,
were the start of new moves where 8 Nov marked a key turning point.
The moves that had already started are now getting quite stretched with US 10Y yields
up 5 standard deviations from the July low, with US Banks up by a similar amount vs
Staples. The USD/JPY move though is more like a 2 SD move, with the NKY similar (if
we exclude the 7% drop on US election day).
Peak liquidity, deflation, inequality and globalisation – watch for Peak Trump
So what does a Trump presidency mean for the world? Michael Hartnett, our Chief
Investment Strategist sums it up nicely with four of his seven peaks. Peak liquidity –
the era of excess liquidity is over; Peak inequality – with fiscal stimulus to address
inequality; Peak globalisation- free movement of trade, labour and capital ending, FX
wars starting; and Peak deflation – the secular low point in bond yields now behind us.
We would add a peak to that which investors need to bear in mind – Peak Trump. What
we mean by that is at what point do the policy changes of the Trump presidency get
fully discounted in markets. We have moved pretty quickly to do that but we suspect
there is more to go, even if the quick returns have probably already been made.
If we think about these peak questions, the two that stand out to use as obvious and not
really open to challenge are Peak liquidity and Peak deflation. The Fed left its peak
liquidity position behind ages ago, the BOJ has moved to yield rather than liquidity
targeting, the BOE may extend its current programme of QE one more time but then is
probably done and even the ECB is talking about tapering, even if they are unlikely to do
it in December. The Peak deflation theme follows on from this with the secular low in
bond yields surely behind us if the central banks are stepping away from flooding the
world with ever more liquidity.
Peak liquidity/deflation means higher yields – inflation expectations adjusting
The question then is how much yields will likely rise from here. Much of course depends
on how quickly inflation picks up. Markets have already moved to price in a significant
pick-up in expected inflation as the two charts below show. To our mind breakeven
inflation rates had been too low for too long, which is one reason we wanted to be
defensive in bond markets. It would seem to us that inflation expectations are now up
with events. US headline CPI at 2.5% is consistent with the Fed modestly overshooting
Global Cross Asset Strategy – Year Ahead | 30 November 2016 5
its 2% core PCE target. Our economists think that the Fed may well aim a little high in
the short term on inflation to ensure they have sufficient room to ease in the event of a
downturn. However, it is unlikely that the Fed would tolerate a sustained overshoot of
their inflation objective. That is particularly the case if the Fed under President Trump is
made more hawkish as our economists think it probably will be (see Liquid Insight:
Trump’s stamp on the FOMC).
Chart 5: US 5Y5Y forward inflation back towards 2.5%
3.3
3.1
2.9
2.7
2.5
2.3
2.1
1.9
US 5y5y fwd inflation swap
1.7
Chart 6: Euro 5Y5Y forward inflation up to 1.6%
2.8
2.6
2.4
2.2
2
1.8
1.6
EUR 5y5y fwd inflation swap
1.4
1.2
Source: Bloomberg
Source: Bloomberg
Equally, our economists in Europe are sceptical on the ECB’s ability to get inflation to
rise significantly from current levels. Optically there is scope for European breakevens
to head higher if the ECB were to be successful but investors are likely to want to see
some evidence of rising inflation first before they price that in. We will return to this
below. For now we agree with our fixed income strategists that the rise in inflation
expectations is probably sufficient and that any rise in yields from here has to be one of
higher real yields.
They think such a rise as a tightening of monetary conditions which may be self-limiting
in the short term, particularly as the fiscal boost in the US is likely to be back loaded in
terms of 2017. If rates move too quickly and the USD follows before the fiscal stimulus
kicks in they could actually dampen growth. Indeed, our US economists have shaved
their near term growth forecasts already to reflect the current moves. They do not
expect the fiscal stimulus to start to boost growth before the 3 rd quarter.
Fiscal + hawkish Trump Fed means we stay short 5Y US via 2-5-10 butterfly
Our fixed income team estimated how much fair values of the different parts of the
curve would have to move were the market to move into line with the dot plot. Updating
those estimates for the move since their publication we find 2Y rates can move another
11bp, 5Y 39bp and 10Y 33bp. They argue that given we are past the inflection point for
rates, with fiscal policy being eased and now with a more hawkish Fed under Trump
likely, the dot plot should form the floor not the ceiling for rate expectations. All of this
translates into a view that 10Y yields can push to 2.65% by the second half of 2017.
Given their views on the curve we continue to run the 2-5-10 butterfly. It has moved
from around -10bp to +10bp since the election, and our fixed income strategists have
moved their target to +20bp.
6 Global Cross Asset Strategy – Year Ahead | 30 November 2016
Chart 7: 5Y yields to continue to underperform
0.5
0.4
0.3
0.2
0.1
0
-0.1
2s-5s-10s US fly
-0.2
Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16
Source: Bloomberg
Chart 8: Real rates likely to feel the pressure going forward
3.5
3
2.5
2
10y US TIP yield
1.5
1
0.5
0
-0.5
-1
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Source: Bloomberg
Peak globalization/inequality means higher real rates – short 10Y US real rates
Our fixed income team make the point that globalization has been a driving force behind
lower real rates as it has been good for EM growth and reserves. Those reserves then
found their way back into the US holding real rates lower. They argue that as the global
savings glut unwinds real rates have room to re-price. Peak inequality also means an
unwind of globalization as politicians seek to protect workers from the depressing
effect on wages coming from overseas. Donald Trump has already said he intends to
charge China with being a currency manipulator. Whether he does or not and what
action he takes to accompany it remains to be seen, but artificially low currencies
generating high current account surpluses are unlikely to go down well with the new
administration. That lends weight to the fixed income team’s arguments.
Peak inequality may also mean less migration across the world – think Trump’s
arguments on illegal immigration from Mexico and Theresa May’s desire to limit
migration into the UK post Brexit. Less migration likely means more upward pressure on
wages, which is the inflation expectations side of the argument. But Michael Hartnett
also thinks it means more action on fiscal policy. The UK government have implemented
a £24bn infrastructure fund in the Autumn statement. Donald Trump wants to trigger up
to $1tn of infrastructure spending in the US in addition to the tax cuts.
The fiscal boost should push real rates higher (at least in the short term). Some Fed
members have acknowledged this suggesting that equilibrium interest rate might be
moved higher by fiscal stimulus. The rates team also rightly says while they want to be
bearish rates given the speed of the move so far it is also right not to be foolish. Given
how much inflation expectations have moved they think there is better risk reward in
real rates. They argue the 10Y real rate is the most vulnerable to further moves higher in
rates. Although they have already risen from around zero in the summer to ~50bp now
they think 10Y real rates can reach 1%. So we add that trade to our 2-5-10s position.
Implications for other asset classes: Stronger USD, weaker EM?
The forces impacting on markets from the Trump victory have not been confined to
rates markets, although it is probably fair to say that most (although certainly not all) of
the impact stems from the move in rates. Higher US rates have meant a stronger USD,
an outperformance of short duration over long duration equities, a hit to EM debt and all
forms of carry trades.
Global Cross Asset Strategy – Year Ahead | 30 November 2016 7
Chart 9: USD breaks to new highs
105
DXY Curncy
100
95
90
85
80
75
Chart 10: As Treasury yields open big gaps with Europe and Japan
2.7
2.5
2.3
2.1
1.9
1.7
1.5
US 10y yield
10y Bund yield (RHS)
10y JGB yield (RHS)
1
0.8
0.6