As per an annual tradition, earlier today Goldman released two reports previewing what Goldman thinks will be the top 10 themes for the 2019, as well as its first release of "top trades" for the coming year.
While we will break out Goldman's top themes in a subsequent post, Goldman strategist Charles Himmelberg - picking up on his ominous report from last week which warned that a "stocks may be about to enter a sustained bear market" - warns that following October rout, many investors appear to be questioning whether risk assets will find their footing in 2019.
He cautions that the US economic outlook "appears to be turning increasingly less friendly" and notes that after more than eight years of growth the business cycle has matured; domestic activity looks quite likely to slow next year as the effect of 2017’s tax cuts wanes and tighter financial conditions begin to bite; and the Federal Reserve seems intent on steadily raising interest rates due to tight labor markets and growing inflation pressures.
Add to this list an ongoing (and possibly escalating) trade conflict between the US and China, the budget tensions in Italy, and fragile growth in a number of emerging market economies, and it is not hard to understand market concerns about a challenging investing climate over the next 12 months.
Yet despite the uncertainties, Goldman thinks it is "too soon to head for the risk bunker" adding that "while some incremental caution is likely warranted in 2019, our view is that portfolios should maintain a modestly pro-risk tilt, for a few reasons."
- First, Goldman economists expect global growth to hold up reasonably well, and for activity outside the US to accelerate moderately on a sequential basis. This mostly reflects a rebound in several medium-sized emerging markets which struggled this year—Turkey, Argentina, Russia, South Africa and Brazil—and roughly steady growth in the rest of the world.
- Second, Himmelberg predicts that activity in China is likely approaching levels that are intolerably low for the government, and there is a good chance that growth momentum may bottom over the next few months on the back of more determined policy support. The current five-year plan underlying much economic decision-making in China includes a goal to double real GDP between 2010 and 2020. Based on growth since 2010, reaching this target implies a growth “floor” for the next two years of about 6.1%. As of the most recent data, growth appears to have slipped slightly below that level: Goldman economists estimate that Q3 GDP grew at an annualized pace of 6.0%. And while Goldman does not expect large-scale stimulus that would send Chinese growth on a meaningfully higher trajectory, because policymakers will likely balance near-term activity with medium-run concerns related to pollution, financial sector reform, and other issues, it thinks growth objectives are sufficiently important that officials will take steps to prevent the economy from slowing any further. Therefore, Chinese growth—and the many assets affected by its slowing in 2018—may be bottoming.
- Third, Goldman does not think additional Fed tightening presents insurmountable risks to markets. While the bank expects two more rate increases in 2019 than currently discounted by markets, 11 of the 13 hikes expected from the Fed this cycle have already occurred or are priced in. Therefore, financial markets have arguably “paid the price” of Fed hiking to a significant degree: since the end of 2015, US Treasuries have delivered sizable negative excess returns, global equity multiples have declined, and the currencies of emerging market economies with the largest foreign capital needs (e.g., Turkey and Argentina) have already depreciated sharply. Moreover, US inflation remains moderate enough that the FOMC still has room to pause if financial conditions were to tighten too abruptly. So, while we expect the committee to keep moving, they will not be hiking with blinders on—signs of a hard landing for the economy coming from markets and/or the incoming data would likely result in a Fed pause.
With that in mind, here are the specific "top trades" wrapped within key thematic groups:
US: Late-Cycle Dynamics
- Long 5-year n US inflation swaps
- Enter 2s30s UST flattener
- Long agency MBS vs. IG credit
- Short IG idiosyncratic risk funded with AAA CMBX
China: Growth Bottoming Out Soon
- Long AUD & NZD vs. EUR
- Long CLP funded out of CNY
- Long S&P GSCI Industrial Metals Index
EM: Pick Up Excess Risk Premium, Have Hedges
- Long MSCI EM hedged with MSCI EAFE
- Receive a basket of high-yielders 5-year swaps (ZAR, MXN, COP) vs. 10-year swaps in low-yielders (PLN, HUF, THB, KRW)
- Long IDR 10-year bonds
- Short KRW vs top-6 currencies in GS trade-weighted basket
Brexit: Deal Dividend
- Pay 2y1y SONIA versus receive 2y1y EONIA
Central Banks: Data Driving Divergence
- Short EUR/SEK
- Short USD/CAD
- Long PHP vs. top-7 currencies in GS trade-weighted basket
- Long SGD/THB
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Below we lay out the specific details on each of these trades, as laid out by the bank:
US: Late-Cycle Dynamics
Long 5-year US inflation swaps; target: 2.35%, stop loss: 2.00%.
We think the US inflation premium is attractive across the curve, particularly given last month’s underperformance (Exhibit 1). In our view, this underperformance reflects concerns over potential overtightening by the Fed (we disagree with this view), weaker and volatile oil prices, and a recent string of misses in core inflation readings. On the last point, our economists have noted cyclical upside risks to these readings, given tight labor markets. Additionally, we think two factors strengthen the case for getting long US inflation: 1) our commodities strategists’ view that crude is oversold, and should rebound by year-end (Exhibit 2), 2) our US economists’ view that the trade war will likely escalate, causing the upcoming rounds of tariffs to find their way into inflation readings faster than prior rounds.
Enter 2s30s UST flattener; target: 25bp (1Q2019), stop loss: 60bp.
We think the front end of the US Treasury yield curve is currently underpricing future Fed hikes, and expect further flattening of the 2s30s US Treasury yield curve in the next few months (Exhibit 3). In our view, the risk that the Fed gets derailed from its intended path over the next 2-3 hikes is low. The trade carries negatively, but ex-ante carry at this stage of the cycle typically tends to be a contrarian indicator of performance as markets have typically underestimated the extent of a Fed tightening cycle (Exhibit 4). We see two risks to this trade. First, yields may turn much more sensitive to elevated supply levels, keeping the 5s30s portion of the curve steeper than usual. Second, a sizable exogenous shock to US economic momentum in the next few months could cause the front end of the curve to rally.
Long agency MBS vs. IG credit (rates-hedged); target: 4%, stop loss: -3%.
We recommend getting long 4.5% coupon 30-year conventional pass-throughs hedged with 2-year and 10-year Treasuries (at ratios of 1.0 and 0.25 respectively) vs. the IG corporate bond index (also rates-hedged); at a 2x to 1 notional ratio. The trade is carry positive and reflects two key ingredients. The first is the prospect of slower US growth, which typically allows Agency MBS to outperform IG credit (Exhibit 5). Second is our expectation of a relatively narrow range of outcomes for the Fed, and thus low interest rate volatility; a tailwind for agency MBS excess returns. As shown by Exhibit 6, agency MBS excess returns tend to be positive when interest rates are range-bound, a pattern that reflects the negative convexity of mortgages. We acknowledge that supply/demand technicals will likely remain challenging for the Agency MBS market, as the Federal Reserve’s portfolio holdings continue to run off. But we expect macro fundamentals will likely dominate supply/demand technicals as drivers of relative performance
Short IG idiosyncratic risk funded with AAA CMBX; target: +3%, stop loss: -2%.
We recommend getting short the 3-7% CDX IG series 31 tranche, partly funded with a long position in the AAA CMBX series 11 index, with a 1 to 3.5x notional ratio. The trade is roughly vol-neutral but carry negative (Exhibit 7 for recent performance). In our view, elevated idiosyncratic risk in the low end of the CDX IG quality spectrum will likely cause junior tranches to underperform, while low recession risk should keep spreads on the AAA CMBX index well-behaved. While recent weeks have seen a sharp repricing of idiosyncratic risk in the IG market, the strong exposure of the widest names in the CDX IG index towards sectors facing cyclical and policy challenges such as Autos, as well as structural and late-cycle margin headwinds such as Consumer and Food & Beverage, leaves risk skewed to the downside. As for the long leg of the trade, AAA CMBX, we acknowledge that valuations in the CRE market remain stretched relative to historical norms as well as relative to the residential market. But unlike the low end of the IG quality spectrum, where structural and late-cycle headwinds challenges will constrain the ability to deleverage, there have been tangible signs of adjustment over the past few years, via lower LTVs and tighter lending standards (Exhibit 8).
China: Growth Bottoming Out
Long AUD & NZD vs. EUR; target: 106, stop loss: 97.
We recommend getting long AUD and NZD vs. EUR, indexed to 100 with a total return target of 106 and stop loss at 97 (Exhibit 9). Despite strong domestic fundamentals, AUD has weakened in lockstep with other EM assets this year against a backdrop of China slowdown concerns (Exhibit 10). NZD has faced similar headwinds, as well as additional jitters around political tensions and a more dovish perception of the central bank. Now, with China growth bottoming out and domestic inflationary forces starting to build, we think there is room for a rebound. We recommend funding the trade out of EUR, where a confluence of political risks and growth concerns is likely to cap performance over the next few months and carry is attractive.
Long CLP vs CNY; target: 108, stop loss: 96.
We recommend getting long the CLP funded out of the CNY, with a total return target of 108 and a stop of 96. We expect the CLP will likely outperform, for several reasons (Exhibit 11). First, in contrast to most EM economies, domestic growth and inflation pressures in Chile have inflected meaningfully upwards and are supporting a young, carry-rebuilding hiking cycle (Exhibit 12). Second, unlike other Latin American economies, the current administration’s market-friendly stance should keep uncertainty around investment and policy in Chile in check. Third, the trade provides exposure to copper prices, where our commodities team sees upside on both the 3- and 12-month horizons. Fourth, the CLP has priced in a significant deceleration in Chinese growth, and we expect the pace of deceleration to abate going into 2019. Fifth, the CLP is less exposed than other currencies, such as the KRW, to a weakening of the CNY. This should allow the trade to outperform if growth stabilizes in China but the CNY weakens further. Finally, funding the CLP with CNY provides a hedge against an escalation of trade tensions between the US and China. We would emphasize that this trade is about spot moves, not carry. While carry may gradually improve as the hiking cycle in Chile wears on, the trade implies a cost of carry of about 0.5% over a 6-month horizon.
Long S&P GSCI Industrial Metals Index®; target: 1400, stop loss: 1100.
Industrial metals declined sharply this year on trade fears, China concerns, and a stronger US Dollar. Contrary to the unfriendly macro environment, the micro fundamentals have been supportive (Exhibit 13). Inventories of copper, aluminum, zinc and nickel have all been falling, indicating that demand has been outpacing supply. While our economists expect continued year-over-year deceleration in China growth and trade disputes may be difficult to resolve in the near term, the market has largely priced in these headwinds, in our view. On the other hand, downward pressure on exports and consumption is likely to lead to more infrastructure investment in China, disproportionally benefiting industrial metals (Exhibit 14).
EM: Pick Up Excess Risk Premium, Have Hedges
Long MSCI EM hedged with MSCI EAFE (1 vs. 1.25); target: 105.5, stop loss: 96.5.
We recommend getting long EM equities hedged with non-US DM equities (MSCI EAFE) on a volatility-adjusted basis (1x long EM vs. 1.25x short EAFE) (Exhibit 15). EM equities have been hit harder than global peers this year primarily due to weaker growth outcomes than expected upon entering 2018; and we expect this to reverse next year (Exhibit 16). Specifically, we expect the sequential growth data in China to bottom out in coming months, and that the market will price this in sooner rather than later, particularly as policymakers have begun to show greater willingness to stimulate growth domestically.
Given the late-cycle nature of the US economy and equity valuation ratios that remain high relative to long-term levels, we prefer a relative equity expression over outright longs; and we note that the current growth worries, which have been more US and DM focused (rather than incrementally EM focused), have been better captured in long/short equity trades. Furthermore, on a sector-neutral basis, we find that EM equities trade towards the lower end of their 10-year valuation range relative to MSCI EAFE, which suggests the bar for positive surprise is quite low. For example, MSCI EM bottomed relative to MSCI EAFE on October 11 but the most recent absolute trough was October 29; we suspect the relative outperformance trend to be longer-lasting than the upward trend in equities outright.
Receive a basket of high-yielders 5-year swaps (ZAR, MXN, COP) vs. 10-year swaps in low-yielders (PLN, HUF, THB, KRW); target: 4.3, stop loss: 5.25.
In our view, the risk premium embedded in the high-yielders’ local rates curves is elevated following this year’s repricing (Exhibit 17) . While this partly reflects idiosyncratic local risks and weak EM growth momentum, the bar for upside macro surprises seems low, especially taking into account that negative output gaps in South Africa and Colombia should limit inflation pressures, while policy rates in Mexico are already at high levels. By contrast, in the EM low-yielders (PLN, HUF, THB, and KRW) thinner value buffers, low policy rates and positive output gaps (in CEE) suggest less protection from the global rates repricing that we expect over the coming months (Exhibit 18). Choosing shorter tenors for the long leg (5-year) than for the short leg (10-year) improves the carry profile of the trade and allows for a positive 7bp carry per six months.
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Long IDR 10-year bonds; yield target: 7.4%, stop loss: 8.6%.
We expect the macro backdrop to be more conducive for IDR bonds in 2019 (Exhibit 19). The sell-off in IDR markets this year has been primarily driven by the combined effect of the sharp back-up in US rates and the 10% rally in DXY. We think this is unlikely to be repeated in 2019. For one, US Treasury yields are near their cycle peak (our 2019 year-end forecast for 10-year yields is 3.5%). Second, we expect the USD to depreciate by almost 6% vs. the DXY in 2019. Our fair value models that screen across EM rates curves indicate that IDR bonds are cheap, and Indo real yields are the highest in the region at 3.3% (1-year IGB at 7.0% vs. 1y inflation expectations of 3.7%) and real rates are now at the top end of their range over the past 10-years (Exhibit 20).
Short KRW vs. top-6 currencies in GS trade-weighted basket; target: 106, stop-loss: 97.
A short position in the KRW hedges a wide range of global portfolio risks and is exposed to a weaker domestic outlook (Exhibit 21). Economic growth should be marginally weaker in 2019, with our forecast for GDP at 2.5% vs 2.7% in 2018, primarily due to weaker exports on the tech-cycle slowdown and exposure to China. Notably, chip exports alone accounted for 94% of ytd headline exports growth in 2018 and we forecast that the chip cycle will slow from +50% yoy in 2017, to +30% in 2018 to -3% in 2019 (Exhibit 22). We expect the current account to slow from 4.1% of GDP in 2018 to 3.6% in 2019. Private consumption should moderate following a slowdown in job growth to the weakest level since the GFC, affected by structural factors as well as large policy shocks (a cumulative 30% minimum wage hike over 2018-2019). A short position in the KRW also hedges the risk of a further tech-led equity sell-off since the Won is one of the most equity-centric currencies. Lastly, widening rate differentials with the US could also prompt further portfolio outflows.
Brexit: Deal Dividend
Pay 2y1y SONIA vs. receive 2y1y EONIA; target: 145bp, stop loss: 75bp.
Brexit risks are weighing on UK yields. We expect that an eventual deal will allow UK rates to move higher on both a reduction of uncertainty and upcoming fiscal expansion (Exhibit 23). At the same time, risks to Euro area activity remain skewed to the downside. While our modal case is for one ECB hike in 2019, we think the probability of a dovish revision to the EUR rate path is relatively high (40%). With Italy risks unresolved, we think UK rates can decouple from EUR rates in the wake of a positive Brexit outcome (Exhibit 24). The main risk is the Brexit deal itself, which is a digital event and so presents jump risk in both directions.
Central Banks: Data Driving Divergence
Short EUR/SEK; target: 9.60, stop loss: 10.60.
We recommend getting short EUR/SEK with a target of 9.60, or spot return of roughly 6.5% (Exhibit 25). The economy in Sweden is operating well beyond potential, inflation is on target, and yet policy remains accommodative (Exhibit 26). To be fair, this has been the case for some time now, but we think “this time is different” as the Riksbank’s communication about normalization has become decidedly more concrete in recent months. Our analysis suggests policymakers in Sweden will ultimately need to tighten policy sooner and more aggressively than their counterparts at the ECB, and we expect this will include some SEK appreciation. While domestic policy should provide some protection, the main risk to this trade is a more marked deterioration in Euro area sentiment, which tends to weigh on SEK. This supplants our previous trade recommendation to go long an equally-weighted basket of SEK and NOK, which we close for a potential profit of 1.05%.
Short USD/CAD; target: 1.27, stop loss: 1.35.
We recommend getting short USD/CAD with a target of 1.27, or spot return of 4% (Exhibit 27). The US and Canada are at similar stages of the economic cycle, meaning the BoC is likely to remain hawkish in the near term and rates should converge to similar levels (Exhibit 28). Even though uncertainty lingers around the passage of USMCA, it should be less of a headwind to CAD than it had been prior to the deal announcement (due to lower tail risk), and our DC economists expect the agreement will eventually be approved. Our equity analysts also see scope for some improvement from current WCS spot levels—another recent headwind to CAD vs USD—on i) refineries coming back online from maintenance and ii) favorable seasonal production patterns. However, they expect the WTI-WCS spread to average $30 in 2019 (wider than consensus) as capacity constraints likely remain prominent, which could limit CAD outperformance in the medium term.
Long PHP vs. top-7 currencies in trade-weighted basket; target: 108, stop loss: 96.
We recommend going long the PHP versus the top-7 currencies in the GS trade-weighted basket (TWI), comprising CNY (27%), JPY (19%), USD (16%), EUR (13%), TWD (10%), KRW (9%) and THB (7%). The trade has a positive carry of 3.6% per annum (Exhibit 29). We think a combination of a hawkish BSP, lower inflation, higher real rates and the meaningful broader tightening in domestic financial conditions should turn the FX flow situation around and support PHP outperformance (Exhibit 30). And while the current account deficit will likely be pressured higher on public capex spending and rice imports, the tightening in financial conditions this year – as captured by higher rates, lower equities and wider CDS spreads, should slow domestic demand and import growth and eventually cap this deterioration in the current account.
Long SGD/THB; target: 25.50, stop loss: 23.00.
We expect the MAS to steepen its slope to 1.5% at its April monetary policy meeting and the SGD to stay at the strong end of the SGD NEER. We expect real GDP growth to decelerate to 2.9% yoy in 2019, from an estimated 3.5% in 2018, driven by a slowdown in net exports. However, inflation has picked up over the past few months due to energy prices. Our measures of the output gap and labour market indicators suggests the economy is now at, or slightly above potential, and the MAS expects wage growth to strengthen going forward. Above-trend growth and reduced slack in the economy suggests more durable inflationary pressures are forthcoming. Recent MAS commentary has been more hawkish, suggesting that, in their view, the slope of the appreciation band is still below neutral. As such, we expect the SGD to stay on the strong side of the SGD NEER (Exhibit 31).
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What is Goldman's track record on these top trades? It depends: last year, and the year before the bank hit its targets on roughly half of its trade recos. The year before that, however, Goldman became a laughing stock on Wall Street when it was stopped out on most of its trades within a few weeks of their publication. Therefore, it is difficult to gauge how this batch of top trades will perform, although if Goldman's recent attempt to push clients into crude is any indication, just as oil suffered a record plunge over the past 3 weeks, traders may be better advised to take the other side of the trades that Goldman recommends.