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Risk Off For A While
More Central Bank Intervention Needed

6 September 2019
 
US Recession Fears Aggravated By Rising Political Risks. US economic indicators point to an economy that is slowing affected by waning global demand but still operating near full employment (unemployment rate at 3.7% end July 2019). Despite the 2yr/10yr yield curve inversion, we hesitate to conclude that a recession in the USA is imminent in the next 12-18 months. Recessions occur when the Fed raises interest rates rather than cuts them. Moreover, the yield curve is inverting due to disinflationary pressures globally (namely in the EU) causing medium term bonds to seek lower levels as the ECB signals a resumption of quantitative easing and further cuts in its policy rates (which are already negative). No doubt Trump’s latest decision to raise tariffs from 25% to 30% on US$250bn worth of Chinese imports is expected to cause more anxiousness. Businesses will be forced to re-evaluate their capex plans considering the new tariffs will impact a wider cross-section of firms across industries. Not surprisingly, Fed Chair Jerome Powell remarked at the Jackson Hole Economic Policy Symposium that the Fed will ease rates in an attempt to stave of ‘threats to growth’ and deflect disinflationary pressures threatening the economy.
 
 
Equities not just yet. Despite expectations of more rate cuts from central banks globally, we encourage investors to re-evaluate investing in equities despite the recent sell off, especially as forward P/E ratios remain above the 10-year mean. The ongoing US-China trade dispute has weighed down on investor sentiment as both parties have escalated the issue by applying tariffs on their respective imports with rising fervency. China’s recent decision to apply a 5% tariff on imports of US crude oil, implies that US exports of as much as 250,000 barrels per day into China will have to be sourced elsewhere. This could push the US economy from a slowdown into a recession considering the global demand for oil is already weak. As for the Chinese economy itself, the fact that retaliations have become increasingly bitter after 17 months has already affected business confidence. This suggests the need for more aggressive rate cuts and RRR cuts leading to an even weaker RMB (possibly beyond USD1:RMB7).
 
 
More Stimulus Coming For the Philippines. Budget delays in 2019 coupled by the lagged impact of the BSP’s 175bps hike last year have caused the investment cycle to slow (system wide loan growth of only +10% yoy vs +14% yoy in 2018). As a result, we have downgraded our 2019 real GDP forecast from +6.2% yoy to +5.8% yoy. Come 2020 the situation will be reversed. The BSP has indicated it will continue to lower the policy rate (at least another 25bps by yearend) and reduce the reserve requirement levels just to reinvigorate money supply growth. This is possible as inflation will remain subdued at only +3.0% in 2020 given that the price of oil is expected to remain stable at under USD$70/barrel and we expect at least another -3% yoy contraction in the price of rice. Moreover, we expect the government to meet its fiscal deficit target of 3.2% of GDP. In absolute terms, the 2020 fiscal budget of Php4.1trn is +12% yoy higher and equivalent to 19.4% of GDP.
 
 
Changes in the POGO structure could undermine growth. The biggest risk to stronger domestic economic growth in 2020 is the possible changes in the arrangements currently afforded POGO operators. China has made its intentions clear that it is cracking down on gambling activities by its citizens offshore. Any reduction in the presence of POGOs in the Philippines will have a negative impact on growth temporarily considering they accounted for 10% of pre-sales for most developers in the last 3 years. At the end of 1H2019, we estimate that POGOs occupied close to 1M sqm of commercial/office space. The BPO sector could absorb the areas occupied by POGOS but they require only 400K sqm of additional office space every year.
 
 
Stick To Safety Haven Assets. The local bond index has outperformed the PSEi by a multiple of 3x (18.1% vs 6.9% year to date) and we expect this will be the case for the remainder of 2019. The Asia Pacific Region (which now trades at its 10yr PER average) will de-rate given that the risk to a further depreciation in the RMB remains high. China knows it can be patient regarding the trade war. President Trump only has until November 2020 (next US presidential election) to find a solution. As the trade conflict escalates we favor traditional safety haven assets USD and Gold. President Trump is pragmatic. A compromise deal is more than likely prior to the elections. But prior to reaching this inflection point, we expect the conflict to escalate further which will undermine any rally in global equities. Global growth is expected to slow more than initially expected (consensus estimates have reduced China’s 2020 GDP estimate from 6.2% to 5.8%) and disinflationary pressures are gaining more momentum (South Korea’s CPI fell to zero in August for first time ever). Interest rates will have to fall more than expected again to support growth, rendering longer duration corporate bonds and high dividend paying stocks ideal safe havens to weather the uncertainty in markets.
 
 
Contributor:
 

Carlos A. Jalandoni
VP, AMTC Head of Research
BPI Asset Management & Trust Corporation
cajalandoni@bpi.com.ph
 

 
US Treasuries Near Upper Limit
Further Fed Action Will Supress Rally
29 Aug 2019
 
With the 10yr US treasury now at 1.45%, (down 180 bps since 4Q2018, and at a level not seen since 4Q2016) many ponder whether it will breach the 5-year low of 1.31% on the back of lower than expected in global growth. Much will depend on the resiliency of the US domestic economy, in particular US consumption. Thus far, US consumers have managed to benefit from global disinflationary pressures and withstand the negative ramifications of the escalating US-China Trade war. As of the end of July, the unemployment rate was steady at 3.7% and average hourly earnings rose 3.2% year-on- year (yoy) on the back of 164,000 growth in nonfarm payroll employment. These are hardly signs of economic weakness.
 
 
But minutes from the 30-31 July FOMC meeting show Fed concerns about ‘low inflation, risk management and decelerating economic growth.’ There are also other signs of further economic weakness, as sales of recreational vehicles (RV) have come in below 2018 levels during each month of 2019, falling by as much as 20% yoy. In the last three recessions, sales in this auto category have fallen just prior to the recession occurring (see graph below). Similarly, sales of luxury homes (priced $1.5mn or higher) have fallen 5% in the second quarter alone. Existing-home sales only expanded 0.6% yoy in 2Q19 despite home price appreciations slowing considerably and 30-yr mortgage rates falling from 5% (Nov 2018) to 3.75% (August 2019).
 
 
All told, whilst we are still firm believers that a full blown US recession is unlikely in the near term, the 10yr US Treasury will most likely reach the 5-year low of 1.31% shortly. Whether it will breach this level will also depend on how proactive the Fed will be in cutting the policy rates to try and stave off a much deeper correction in growth. Encouragingly, the Fed has been transparent on the need to ease rates in order to support growth and mitigate global risks. We believe that this support for the domestic economy will boost investor sentiment such that the 10yr US Treasury will struggle to breach 1.31%; and that it is more than likely overbought at that level.
 
 
 
Contributor:
 
 
Carlos A. Jalandoni
VP, AMTC Head of Research
BPI Asset Management & Trust Corporation
cajalandoni@bpi.com.ph

 
The Return to Lower Rates
Here comes the global 'soft landing'
21 May 2019
 
Ever since the Fed reverted to a more dovish stance as early as November 2018, markets have been cognizant of the prospect of a more pronounced slowdown in economic growth globally (see Fig. 1). The bellwether 10-year US Treasury yield failed to rise above 3.2% (hit a low of 2.34%) after it became evident that all was not well with the global economy. The concern was fueled by mixed economic data coming from the US with housing starts at 3-year lows (+11.2% yy Dec2018) and delinquent auto loans at 7mn (end 4Q2018). This was despite the fact that the unemployment rate has fallen to 3.6% and hourly earnings rose 3.2% yy in April 2019.
 
 
In line with consensus we remain convinced that instead of a full-fledged recession, the US economy will post sluggish economic growth that will recover 18-24 months later (see Fig. 2). From our point of view, the Fed’s decision to pause and adopt a more dovish stance was rooted in economic issues that were external more than domestic. Moreover, the Fed’s more dovish guidance regarding interest rates marked a turning point in economic policy with both fiscal and monetary policies now converging to try and salvage any semblance of economic growth globally.
 
 
The ECB recently cut its 2019 GDP forecast from +1.7% to +1.1% (see Fig. 3). What Mario Draghi called a ‘sizable moderation in economic expansion that will extend into the current year’, puts into focus whether Germany will follow suit and raise fiscal stimulus after the May EU elections. The result of the May EU elections will not only determine Mario Draghi’s replacement but also indicate whether a more significant fiscal stimulus is forthcoming in the 2020 EU budget. Currently, the expectation is the Eurozone budget deficit will widen to -1.1% in 2019 from -0.6% in 2018. However, more fiscal stimulus is needed since this latest budget expansion will only add 0.3% to GDP growth this year. Much will really depend on the state of the German economy which continues to weaken as suggested by the April manufacturing PMI which stood at 44.5 due to industrial orders falling -4.2% mm in February (contracting 7 months out of the last 9 months) and falling exports due to weaker global demand.
 
China also has its own economic challenges in 2019, which explains why it has joined the stimulus bandwagon. China’s economic growth rate is expected to slow to 6%-6.5% in 2019 (vs +6.5% 2018) on the back of ongoing trade tensions with the US and continued efforts to deleverage its state owned enterprises (SOEs) (see Fig. 4). Recent efforts to reallocate credit away from SOEs to the private sector by easing banks’ capital constraints, boosting loanable funds via RRR cuts, and lowering funding costs should be positive for growth. On the fiscal side, the budget deficit was expanded marginally from -2.6% (2018) to -2.8% (2019) which should pave the way for an additional tax cut equivalent to USD194bn (+18%yy). So far, these measures have had a positive impact highlighted by China’s industrial production growing +8.5% yy in March 2019 (well above expectations) and property sales growing +1.8%yy (versus -3.6% yy decline in Jan/Feb 2019). As a result, China’s 1Q19 GDP growth stabilized at +6.4% yy, well ahead of market expectations.
 
 
The dominant currency will be the USD in 2019 as a result of Europe and Japan suffering from slower economic growth (see Fig. 5). Aside from the positive carry, the lack of monetary/fiscal options in both Europe and Japan (both the BOJ and the ECB are still maintaining negative policy rates) only strengthens the relative position of the USD. Moreover, weaker global trade borne out of a weaker global economy is expected to have a bigger concern for EM currencies than any potential uplift from lower rates overall globally. This is clearly the case for the PHP which is expected to weaken approximately 3.0%-3.5% per annum to Php53.50 (2019) as guided by the BSP due to the government’s intent to run a widening budget deficit and current account deficit in order to support growth.
 
 
We maintain a favorable outlook for Philippine issued bonds— either local government securities or corporate bond—in lieu of inflation falling faster than expected and the Fed’s more dovish tone (see Fig. 6). The expected reduction in the budget deficit because of the delay in the budget process reduces the net government financing needs by Php200bn – Php350bn. This suggests that the succeeding government issuances (domestic) may only be used to rollover the maturing debts in 2019. We believe the front end of the yield curve will offer more value going forward as we anticipate yield reduction in line with expectations that the Fed will cut rates in 2020 in response to a slowing domestic economy.
 
 
There are questions about the ability of the BSP to lower the policy rate (and ease the liquidity situation locally) given that the price of oil has recently reached USD$75/barrel (a 5-month high). Oil spiked again after the United States said that they were ending all exemptions for buyers of Iranian oil (OPEC’s 3rd largest producer). We believe these investor concerns will soon pass as the Philippine economy is well placed to see both declining inflation (headline inflation has fallen for the 6th straight month to 3.0% in April) and improved liquidity conditions. We expect a cut in the reserve requirement rate as early as the May 09 BSP Monetary Board meeting (see Fig. 7). Even if the price of oil rises to USD$75/barrel (vs our initial estimate of USD$67.5/barrel), our calculation shows that headline inflation will only rise to +3.0% yy—still well within the 2-4% range set by the BSP.
 
 
The PSEI has struggled to break out of the 7,753 – 8,032 range due to foreign investor concerns about the impact of slowing global growth in EM. These concerns will be temporary and, strategically, the outlook for the PSEI remains constructive. PSEI companies are expected to post strong earnings growth of +12.9% yy in 2019 (vs +9.9% yy in 2018) led by rate cyclicals (the financial and property sectors) who are seen to benefit from lower interest rate expectations. But the tactical outlook for the PSEI remains volatile for the remainder of 2019 as foreign outflows equivalent to USD240m are expected to be reallocated by foreign investors away from the Philippines to China. Recall that MSCI will raise the percentage assigned to China A shares in its Global Emerging Market Index from 5% to 20% by the end of the year. We advise investors to be opportunistic accumulating only when the PSEI is trading below its long term average of 17xPER (or 7,800 based on +12% yoy eps growth). The recent rally spurred by the surprise credit rating upgrade of the Philippines by S&P to BBB+ will eventually succumb to concerns about the higher allocation afforded China in the MSCI EM Index.
 
The case for USD assets (bonds or equities) remains uncertain largely due to US economic data giving mixed signals. Those with bearish tendencies point to declining new home sales which fell (-6.9% yy) at the end of 1Q19 despite mortgage rates falling from 2018 highs and house price inflation slowing. On the other hand, those that are more optimistic highlight real GDP rising +3.2% yy at the end of 1Q19, surpassing consensus estimates of +2.3%yy. Stronger growth was led by real inventories which increased for the 3rd quarter in a row and net trade contributing +1.0 ppt to 1Q19 GDP. Whilst the futures market is pricing in a 53% probability of a rate cut by end-Jan 2020, this runs counter to the Fed’s dot plot which suggests a rate increase come 2020. So despite the fact that short VIX positioning for the S&P has hit its previous all-time low (see Fig. 8), we stop short of taking more US equity risk for fear of extended valuations.
 
 
Contributor:

Carlos A. Jalandoni
VP, AMTC Head of Research
BPI Asset Management & Trust Corporation
cajalandoni@bpi.com.ph

 
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Embrace The Volatility
Best To Be Diversified In International Equities
21 November 2018
 
Local investors felt the benefit of shifting from a purely peso investment portfolio to a multi-currency portfolio after the peso depreciated 5.3% year-to-date (see Fig. 1). To make matters worse, we expect the peso to depreciate at least 3.0% per annum as the economy experiences the twin deficit problem — a rising current account deficit and an expanding budget deficit. Despite the recent heightened volatility (the VIX hit a high of 37 year-to-date), we still believe US equities offer more upside potential tactically relative to their global peers given the strength of the underlying economy. However, we encourage investors looking for international equity exposure to avoid pure plays and instead opt for a more diversified global equity portfolio. The S&P 500’s current valuation is stretched, trading at a 5% premium to its 10-year forward-PER average (17.7x) which will render it vulnerable to profit taking and more volatility in the foreseeable future.
 
Figure 1. USDPHP exchange rate
 
The US economy is surging. The US economy is expected to grow 2.5% in 2019, slower than 2018’s 2.9% growth. However, this is coming off a high base marked by S&P 500 corporate earnings expanding 16% yy in 2018 (excluding tax benefits). Based on 82% of the S&P 500’s market capitalization that have reported 3Q18 earnings year-to-date, 73% of companies have surpassed bottom-line estimates by an average of 6.4%. Moreover, the labour market is expected to remain tight (if not tighten further) given that the economy continues to add 213K jobs per month (see Fig.2). The average unemployment rate in the last three months stood at 3.8%, a rate not seen since 1999/2000. Similarly, average hourly earnings growth rose to 3.1% yy and the labor force participation rate inched higher to 62.9% in October (vs. 62.7% in September).
 
Figure 2. US GDP vs US Non-farm payroll
 
Be wary of rising bond yields. The rise in volatility in the S&P 500 is attributable to the Federal Reserve’s (Fed) indication to raise the Fed funds rate above what it deems the neutral rate (2.75%-3.00%). This effectively implies up to four (4) more 25bps rate hikes from the FOMC in the next 12 months, followed by a pause (see Fig. 3). Rising bond yields until recently signaled increasing confidence from the Fed that the economic recovery has finally gained momentum. But after the Fed raised its benchmark rate for the 8th time (since 2015) last September 2018, investors have become warier of further rate hikes. In fact, many see further rate increases as a step closer to slower economic growth and possibly a recession. There is no doubt that President Trump will be under greater scrutiny after the Democrats regained control of Congress, rendering Washington less able to pass legislation. However, we don’t see a divided Washington deterring the Fed from its current tightening path, which implies that we could still expect more volatility for the S&P 500.
 
Figure 3. US Treasury Yield Curve
 
The case for EM rises with lower oil prices. The price of oil has fallen by as much as 20% from four-year highs after the Trump administration’s recent decision to issue waivers to eight countries (including China, South Korea, India, Japan) allowing continued purchases of Iranian oil for a six-month period (see Fig. 4). Lower oil prices will continue to give relief to EM Asia currencies as the market discounts the potential improvement in their respective balance of trade. All told, the combination of compelling valuation (EM Asia now trading at 10.4x forward-PER or 11% discount from its 10-year mean), a resurgent local currency, and resilient earnings growth picture in 2019 (11.8% eps yy 2019 vs 14.3% yy eps 2018) should prove too much to resist for investors who are currently heavily underweight Asia.
 
Figure 4. Historical Oil Prices
 
Improved EM prospects will favour EU equities. Reported earnings for 3Q18 have been underwhelming thus far, on track to report +8.4% yy for 2018 (vs. +12.2% yy for 2017) due to lower trade receipts. But consensus estimates place EU companies posting stronger EPS growth in 2019 to +10.0% yy (vs. +8.4% yy 2018) despite the weakness in 3Q18 (see Fig. 5). Any recovery in EM next year and any relief in the US-China trade war issue will be more beneficial to EU given that 30% of export receipts are derived from EM (vs. only 15% for the US). Moreover, with US real GDP growth rate expected to slow to +1.8%yy in 2020 (vs. +2.5% 2019), Fed tightening is expected to pause. This should help narrow the US/Bund interest rate differential across the yield curve, which currently is at levels not seen since the late 1980’s.
 
Figure 5. Stoxx Europe 600 Index
 
Improved economic prospects for EM in the next 12 months are deemed favourable for EM/EU equities alike. The culmination of lower oil prices, de-escalation of trade tensions between the US and China, and a possible extended pause in the Fed’s hiking activities are seen to weaken the USD and favour EM. We encourage investors to diversify into international equities through the BPI Global Equity Fund of Funds to reduce the volatility in their portfolios (see Fig. 6).
 
Figure 6. BPI Global Equity Fund-of-Funds
 
 
 
Contributor:

Carlos A. Jalandoni
VP, AMTC Head of Research
BPI Asset Management & Trust Corporation
cajalandoni@bpi.com.ph

 
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Next Fed Chair Is Big News There is only one safe choice
Selection for next Fed Chair is huge.
26 October 2017
 
Who will replace Federal Reserve Chairperson (Fed Chair) Janet Yellen will determine the course of markets for the rest of 2017. Yellen’s term as Fed Chair will end in January 2018; President Trump has indicated that he will announce a replacement as early as 2Nov2017. Global markets wait with bated anticipation if Yellen will be extended or be replaced by somebody hawkish—one who advocates a much faster upward trajectory for interest rates. A more hawkish Fed Chair would not only drive interest rates higher more quickly, but could also result in a much stronger USD. Recall that the PSEi declined 20% in the 2H2016 due to the renewed strength in the USD coming from the Trump reflation trade.

The short list. President Trump has four top candidates: Kevin Warsh, Jerome Powell, Janet Yellen and John Taylor. Among them, Taylor is the most hawkish, believing that interest rates today should be at 2.5%, twice the current level of 1.25%; while Yellen is the most dovish—advocating slower rate hikes. Meanwhile, Warsh’s lack of experience renders him less likely to assume the position. The current front-runner, Powell, is seen as a soft spoken centrist who represents continuity like Yellen.

Trump’s agenda matters. Investors have so far ignored the potential disruption a more hawkish Fed Chair would bring to markets; the S&P 500 (2,575.21) and Dow (23,328.63) eking out new highs last week highlighted this. This is not surprising: investors believe their agenda is in-line with Trump’s goals. As much as conservative Republicans want a change from Yellen, we believe the Trump Administration prefers a continuity of current monetary conditions as it is favorable to wealth creation. The combination of a weaker USD and low interest rates has also boosted US corporate profits (+12% YoY 2018), underpinning the recent rerating in US equities.

Yellen again. We believe it is in the best interest of the economy (and markets) that Yellen is reappointed. While the economy is clearly on the path to recovery, it remains fragile as highlighted by the stubbornly low inflation rate. This is crucial since the biggest criticism of Yellen’s dovish era is the risk of being behind the curve—or not having high enough interest rates—which could lead to runaway inflation. But this is more manageable compared to Taylor. The risk here is destabilizing the economic recovery by raising rates too quickly. Recent history has shown that it is always easier to slow an overheating economy than it is to reinvigorate a slowly growing one.
 
 
Contributor:

Carlos A. Jalandoni
VP, AMTC Head of Research
BPI Asset Management & Trust Corporation
cajalandoni@bpi.com.ph

 
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