BloombergTV Daybreak: Talking Points January 16, 2018

The Tri Polar World’s synchronized global growth recovery has been fully embraced by investors with both interest rates & stocks rising around the globe.

Rising Rates serve to confirm the global growth scenario & are BULLISH for stocks as they point to higher EPS and may start to lead investors out of FI and into equity, especially among the retail investor base.

A major risk is a sudden rate SPIKE, due to an inflation outbreak or perhaps a Central Bank policy mistake – unlikely but one may want to hedge that risk.

What sector represents the BEST equity hedge against a sharp rate rise? BANKS.

10 yr. UST rates have backed up roughly 50 bps in the past 3-4 months and banks (XLF) have rallied roughly 12% vs. 9% for the SPY.

Q4 Bank earnings are muddy given the new tax regime but the focus should be on 2018 where bank sector EPS are forecast to rise 21%, well above the 13% expected for the market as a whole.

BANKS also represent that rare breed: a 2-way player.

On offense, banks provide exposure to the growing economy via greater demand for credit, fewer bad debts  & better NIM while also benefiting from reduced regulation.

On defense banks provide a hedge against rising rates.

BANKS may also provide leadership. Looking at the top 4 US sectors in terms of expected 2018 EPS growth, energy leads followed by financials, materials and Industrials.

Note all 4 sectors are cyclical, value plays. TECH 2018 EPS growth is forecast to be ONLY market growth or 13%, suggesting a possible rotation from growth to value and from Tech to Banks which could also serve to elongate the bull market.

European Banks (EUFN) also look attractive. While XLF now trades at roughly 1.4-1.5 x P/BV. Europe’s banks trade at close to a 30% discount at roughly 1-1.1x P/BV with roughly the same ROE. 

10 yr. German Bund rates have backed up roughly 30 bps in the past month and EUFN is up 7%; it looks to be breaking out of a multi year range.

One ODDITY of the current market environment is the juxtaposition of the highest short-term rates in several years with a USD that is at its weakest point in the past 3 years.

I believe there are four factors undermining the USD at this point.

First, global investors are massively long US financial assets with the SPY up 370% since the March 2009 lows vs. 170% for Europe and a 120% for Japan (all in USD).

Second, while the Fed has been the leader of the great CB unwind the rest of the world looks like it wants to join in and so the gap between US monetary policy and ROW is narrowing.

Third, the US is running large deficits in both its trade account and its budget account with the latter now being forecast to rise to close to 5% by 2020 thanks to the tax cuts just passed.

That leads us to politics and here the US does not look good at all – from a looming Govt shutdown to an erratic White House to the Mueller investigation and on to the mid term elections this Fall, it makes perfect sense for offshore owners of US assets to think about lightening up.

This is especially true when neither the Euro, nor the Yen nor the RMB is fighting appreciation. Europe has a 3% current accout surplus and shows no sign of a Euro around 1.20 having any impact on trade. The Yen is one of the most undervalued currencies with fair value around 90-93 vs. the current 110. Finally the RMB, which is hovering around a two year high, welcomes strength as it helps reduce inflationary and hence rate pressures internally while a stronger RMB just may protect China from Pres. Trump’s trade salvos.

If the dollar is set to weaken further this will have large implications for Asset Allocation in the year ahead. More on that front in my next piece.