Following yesterday's completely non-arbitrary release by Jan Hatzius of his about face economic upgrade at precisely 4 minutes ahead of the Fed data dump, Goldman has released the first 5 trades of its top 2011 trades. Hopefully these trades will perform far better than the basket of 2010 trades which left Goldman clients flat at best (especially the FX component which was a total disaster and which Thomas Stolper apologized for yesterday). On the basis of its suddenly rosy outlook for the economy (as always, Goldman by definition is buying whetever a client is selling and vice verse) here are the first five trades that Goldman believes will be the best money makets for the next year.
From Francesco U. Garzarelli et al
Our Top Trades for 2011
These market themes run through the first five of our recommended 2011 Top Trades. They have a clear procyclical tilt. But unlike 2010 we have looked for exposure in the developed world (US banks, high-yield bonds and Japanese equities), particularly places where tightening in response to better growth is least likely, alongside positioning for some of the pressures for normalisation and policy response (commodities and $/CNY).
1. Short $/CNY via 2yr NDFs, currently at about 6.4060, target of 5.9, expected potential return 6%
The trade and current account positions in the US and China remain at the core of the global imbalances debate. We remain of the view that the $/CNY exchange has an important role to play in the rebalancing process, and expect the recent trend of gradual CNY appreciation to continue for several reasons (mentioned below). Persistent FX reserve accumulation to prevent appreciation is an unsustainable policy in the long run. Rising external political pressure on the CNY from the US and other countries, as well as the threat of escalating trade tensions, expose China’s dependence on exports. More gradual CNY appreciation would help alleviate these tensions. Rising inflationary pressure has led to policy tightening in China already and more is in the pipeline. The Chinese authorities are pursuing a long-term goal of rebalancing the economy towards more domestic demand, which would also be consistent with a stronger CNY. To the extent that the Chinese authorities manage the CNY on a trade-weighted basket, broader USD weakness would translate into additional $/CNY downside pressure.
We also prefer going short $/CNY via long-dated forwards to benefit potentially from market expectations for further trend appreciation beyond the next 12 months. 2yr NDFs (expiry 4/12/2012) currently price about 2% annualised, compared with our expectations of 6% over the next 12 months. Should markets start to price in a similar speed of appreciation as we forecast, 2yr NDFs could start pricing a level of 5.90, which would translate into an expected potential return of about 6%.
2. Long US large-cap Commercial Banks (BKX), at 44.76, target of 57, expected potential return +25%
The improvement in the US economic outlook in 2011 and 2012 is one of the most important shifts in our global macro view. The combination of incrementally more growth acceleration, with still accommodative policy is a very friendly one for equities, underscored by the US Portfolio Strategy team’s 1,450 target for the SPX in 12 months’ time. Not only are top line GDP growth expectations more robust, but a faster-than-previously-expected repair of the US consumer balance sheet has also led to a more robust view of real consumer spending growth and domestic demand more broadly. We believe being long US banks via the BKX index (there is also an ETF, the KBE, for those so inclined) is an attractive way to gain exposure to a more constructive domestic US story.
After performing in line with the overall US equity market index for much of the past two years, the BKX has significantly lagged through most of the ‘QE2’ rally. On price action alone, the BKX stands apart from other potential implementations of our stronger US domestic demand view, such as consumer discretionary stocks, which outperformed the overall market in 2010. Our 57 target for the BKX suggests about 25% upside and would only bring the banks back to the levels of April earlier this year. Of course, the price action reflects in part sector-specific headwinds that cropped up repeatedly in 2010. But, apart from pricing at a significant discount, the macro backdrop looks increasingly favourable. First, a more robust real GDP growth profile and, critically, stronger consumer spending ought to help spur loan growth—year-on-year loan growth should turn positive early next year and grow steadily through 2012—as Richard Ramsden and the US banks team have recently highlighted. And the large cap banking sector is particularly geared towards consumer activity, with relatively less exposure to construction and commercial real estate activity. Second, the decline in the unemployment rate should lead to further declines in credit losses. And, third, although the front end of the yield curve will likely remain anchored for some time, we expect 10-year yields to gradually drift higher, with a steeper yield curve also benefiting these stocks.
The possibility of additional ‘headline risk’ is a clear challenge for this sector even if the macro outlook turns out to be correct. But many of these concerns are likely already priced-in to a degree and the sector does not seemto be ‘over-owned’ here. We believe it is reasonable to question if banks can generate the return on equity that they did in the recent past and if multiples can revert towards historical levels given the new regulatory backdrop. But we think a more robust US economic outlook should still provide support for earnings and book growth, even if the market pays a bit ‘less’ for these shifts than it has in the recent past.
3. Long US High Yield (Selling protection on the CDX HY index), at a current spread of 528, target of 450, expected potential return of 8%-9%
We recommend going long the high yield corporate bond market by selling protection on the CDX HY index. We expect this strategy to benefit from the following three factors.
First, our top-down view on HY defaults has improved substantially as the US growth data have come in better than we expected and the risks of a double-dip recession have fallen accordingly. Moody’s data show that the 12- month trailing average has already declined to 3.7% in October from 13.4% a year earlier, while recovery rates have climbed to 60% from around 30%. We expect high yield default rates to continue declining in 2011 and we expect recovery rates to remain high.
Second, bottom-up fundamentals have improved. High yield firms are delevering, and Debt/EbITDA ratios have declined to 3.2x for double-B and 5x for single-B rated firms, vs. 3.35x and 5.4x a year ago, respectively. Shortterm liquidity positions have also improved. Many high yield companies have taken advantage of the current lowyield environment to re-finance near-term maturities. The amount of debt maturing in the next two years is currently around $100bn, vs. $200-300bn in a normal year. This reduces the chances of a liquidity crisis across high yield firms.
Third, given our forward view on defaults, the current level of HY spreads implies a credit premium that is still elevated relative to its historical level. We therefore think spread levels on the CDX HY15 are likely to tighten around 75bp from their current level of 525bp. In addition to this general spread tightening, a long position in HY15 will benefit from about 65bp of roll-down. Assuming an average DV01 of around 3.5 over the next year, this implies investors can earn 490bp of mark-to-market gains in addition to 525bp of ‘carry’. Against this we think 150bp of default loss is a conservative assumption. We would therefore expect the trade to earn around 8-9%.
4. Long Nikkei 225 (NKY), at 9,988, target 12,000, expected potential return +20%
For much of the latter part of this year the Japanese equity market index (Nikkei 225) has underperformed major developed markets such as the US, UK and Euroland, to say nothing of emerging markets, a pattern that has been fairly typical over the last several years. But despite this lack of ‘alpha’ from Japanese equities, significant ‘beta’ to the global industrial cycle, which may now be accelerating as per our Global Leading Indicator (GLI), does exist.
The combination of a beta to a reaccelerating global cycle, real GDP growth in line with trend and easy policy on many fronts—policy rates on hold, additional BoJ asset purchases worth 5 tn Yen, and a potential cut in the corporate tax—makes for a friendly macro backdrop for equities. The contrast in policy stance to many other parts of the world is especially worth highlighting: while we expect tightening in much of the EM world, and also in Euroland and the UK next year, we expect further easing in Japan. In addition, a more constructive outlook for consumer and investment spending in the US should benefit Japanese exporters directly and indirectly by
helping to support short-dated bond yields in the US and, by extension, putting some downward pressure on the Yen, with our forecast calling for Y90/USD in 12-month’s time In addition to the favourable macro environment, Japanese equities currently trade below book value (P/B 0.9X), and despite our forecast that corporate profits will approach 2007 highs and listed firms possess record levels of cash on their balance sheets, most equity investors remain lightly positioned in the market.
A few words on implementation and risks. The choice of the Nikkei 225 index rather than the Topix index is deliberate—the Nikkei 225 index has more weight in the globally exposed and cyclically sensitive sectors, such as industrials and tech. Our target of 12,000 implies around +20% upside relative to current levels, although we are mindful that Japanese equities have already started outperforming other markets in the last few weeks. Another proximate risk is that the weakness in activity in Q4—payback from the earlier strength from government stimulus measures—weighs on the market, before the more equity-friendly macro outlook for the year ahead comes into focus. However, in terms of the market’s path, our strategists expect that—similar to 2010—Japan’s positive returns may be ‘front-loaded’ in early 2011, since policy tightening in Asia ex-Japan and sovereign-related uncertainties in Europe may add to the relative attractiveness of Japanese equities near-term. See Japan: Portfolio Strategy: A Bullish Start to the Year of the Rabbit, also published today, for further details.
5. Long a Basket of Crude, Copper, Cotton/Soybeans and Platinum (‘CCCP’), indexed at 100, expected potential return 28% [luckily Goldman is not selling gold to clients]
After a decade of high commodity prices, the key markets that remain structurally supply-constrained are crude Oil, Copper, Cotton/Soybeans and Platinum. Owing to the narrow geographic distribution of supply in these markets, they continue to face significant political and geological constraints on the free flow of capital, labour and technology, which in turn constrain supply growth regardless of price or expected return. It is no coincidence that these supply-constrained commodity markets are also the same commodity markets that China is extremely short, as their ability to invest in these industries is severely restricted relative to other commodity markets, which further underscores the structural nature of these supply constraints.
Accordingly, we believe that these commodities are best positioned to capture the theme of ‘resource realignment’, which is the need to redirect resources that are in limited supply away from the developed markets and towards the emerging markets. This redirection or rationing of limited supplies can only come about through higher prices. And with US growth likely to be on more solid footing, this dynamic will likely become more pronounced in 2011 when US demand recovers towards pre-crisis levels and bumps up against a China that is now consuming 23% more oil, 63% more copper, 18% more cotton and soybeans and 29% more platinum than it did in 2007.
More specifically, given that Oil is still leveraged to the US, it is the one commodity that lagged the rest of the complex in 2010, leaving it in a more early cycle phase with drawing inventories, which creates significant upside as the growth prospects for the US improve. Our 12-month target is $105/bbl versus a current Dec-11 value of $84/bbl.
In contrast, Copper is more late cycle given its leverage to China and the much lower inventory cover, which suggests it will be more volatile with the potential for significant upside price spikes during 2011. Our 12-month target is $11,000/mt versus a current Dec-11 value of 8202/mt.
Cotton and Soybeans will face an ‘acreage battle’ in 2011, with corn as limited acreage will need to accommodate strong emerging market demand for cotton and soybeans at the same time as the US demands 41% of its corn crop for biofuel purposes. Our 12-month targets on Cotton and Soybeans are $1.25/lb and $14.00/bu respectively, with current Dec-11 and Nov-11 values of
$0.87/lb and $11.65/bu respectively.
Finally, Platinum is both one of the most supplyconstrained commodity and the commodity that China is the most short. These shortages will only become more acute in 2011 as the auto industry recovery gains momentum. Our 12-month target is $2000/toz versus a current value of $1644/toz. Due to liquidity reasons we recommend using a GSCI-type rolling front month index.
We recommend implementing this trade with a basket comprised of: Dec-11 WTI (weight 40%), Dec-11 LME Copper (20%), Nov-11 CBOT soybeans (10%), Dec-11 NYB cotton (10%) and a GSCI-type rolling front month platinum index (20%). Our 12-month expected potential return is 28%.