BCA: Risk/Reward Tradeoff Still Remains to the Downside

Since early 2015, the USD/CNY exchange rate has been an excellent leading indicator of global equity performance. A stable/appreciating renminbi has been positive for stocks, and vice versa. In fact, the August 11 devaluation forewarned the late-August plunge in the MSCI All-Country World Index (ACWI). Looking closer at the correlation is revealing: the PBOC front-run the Fed that was slated to raise rates in September, but the FOMC backpedaled, erring on the side of caution, owing to rising global financial stress. Nevertheless, the data-dependent Fed acted on December 16 and soon after that the Chinese allowed their currency to drift lower anew. January was a brutal month for global equity returns, as the fresh renminbi drop rekindled anxiety over the Chinese/emerging markets (EM) slowdown, and reignited fears of competitive devaluations across the EM.

If the Fed pauses as we expect in March, but proceeds with a second hike in June, assuming wage pressures intensify given the firming labor market, it is highly likely that the PBOC will have to act and further depreciate the yuan. This tit-for-tat strategy breeds uncertainty and heightened volatility and will continue to cap any global equity upside as it creates a self-limiting aspect to any rally attempts. The risk/reward tradeoff remains to the downside.

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Ultimately, a rising exchange rate absorbs the deflationary shock and up to now the US dollar (and US economy) has been the sole absorber of the global deflationary impulse. Thus, from a deflationary prism, it makes sense for the PBOC to redistribute intensifying deflationary pressures to other regions by allowing the currency to depreciate. Importantly, spiking junk bond yields reflect the US economy’s deflation absorbing attribute and recent US recession angst: Typically when the US junk bond spread surges above 200bps on a year-over-year basis, a US recession ensues. While there are only three business cycles covered, due to limited junk bond spread data, and a couple of false positives, the US recession threat remains acute, sustaining downward pressure not only on the US, but also global equities (top panel).

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Nevertheless, there is a ray of hope at least for a tactical/relief global equity market rally, especially if the dogmatic Fed backs off its tightening bias even temporarily. The leading ISM new orders-to-inventories (NOI) ratio has vaulted to 1.14 and pulled up the overall ISM manufacturing out of its recent lull (bottom panel).

Bottom Line: While we are seeking to participate modestly in this broad market rally attempt via the global industrials upgrade to neutral, a capital preservation mindset is still warranted. We are not ready to alter our overall preference for global defensives over global deep cyclical equities that has staying power.

For more details, please read the latest Global Alpha Sector Strategy report titled “A House of Cards?” at gss.bcaresearch.com.

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