Following that disaster that was Goldman’s Top trades for 2016, when the bank promptly closed out virtually all of its best ideas at a loss within weeks of publication, there is little point to discuss the signal-to-noise ratio of the annual spectacle that is Goldman’s top strategists sitting down and deciding what trades to lure their best clients into (whether or not their reincarnated prop desks also take the other side of these trades will be revealed in due course).
So without commenting on whether one should listen to Goldman recos or do the opposite (a 50/50 split here may be best), here are the bank’s Top Trade ideas across various asset classes – they include a bunch of DM and EM short USD crosses, several rate reflation trades, a preference for HY over IG and the top of the CLO and CMBX stack, a preference for IG over MBS, emerging market junk bonds, and Pacific rim outright equity longs:
- Long CAD and AUD vs USD with equal weights
- Long a roughly vol-weighted basket of MXN, ZAR, and INR vs USD
- Long CNY and Long 3Y CGBs combined
- Long SGD vs TWD
- Long 3y1y forward US real yields
- Long (1.65:1) vol-weighted 1y forward 5s30s steepeners
- Long 2s30s Gilt curve steepeners
- Long 10y10y-2y2y HICP curve flatteners
- Long High Yield vs. Investment Grade in the USD cash market (1 to 1.15 notional)
- Long USD Investment Grade bonds vs. agency MBS
- Long EUR AT1 vs. High Yield bonds
- Long US AAA CLOs vs. AAA CMBX index
EM (Local Rates, Credit, and Equities)
- Long 6-year (R186) SAGBs, USD-hedged
- Long BRL DI Jan-2022 receivers
- Long INR 5Y bonds
- Long 2s10s IRS steepeners in EM LY (CZK, KRW and THB)
- Long EM HY credit
- Long EM bank stocks vs EM consumer staples
- Long Korea (and KRW) vs Taiwan (and TWD) equities
We find it curious that despite Goldman’s sudden conviction that stocks are set to soar in 2021 and 2022, hitting up to 4,600 in two years, there is no trade reco to buy US equities. We wonder how long it will take before Goldman – or rather its clients – are stopped out of all these trades.
Below we excerpt some details from Goldman’s justification for each trade:
1. Long CAD and AUD vs USD with equal weights; total return target of 105 and stop of 97.5. We continue to see risk/reward favoring Dollar shorts into 2021. Vaccine development appears to be making good progress, consistent with our base case of approval by year-end, and additional headway should further lift cyclical assets as markets price in stronger growth closer to our own expectations. The policy backdrop should also remain favorable for risky assets as central banks around the world keep rates on hold and continue QE programs, combined with likely additional fiscal stimulus in the US—albeit smaller than expected under a “blue wave” scenario. Moreover, our outlook should be supportive of commodities on boosts to demand and structural underinvestment (especially in non-energy commodity producing sectors), paving the way for a new bull cycle to emerge in 2021. Specifically, we expect oil and copper prices to perform well—particularly the latter in the near term—which should, respectively, benefit CAD and AUD the most in G10 (Exhibit 1). The biggest risk to this trade is that broader and deeper lockdowns may temper optimism about the cyclical recovery. But given our baseline forecasts and our belief that markets have yet to fully price in our constructive outlook, we reiterate our open trade recommendation to short the Dollar against an equally-weighted basket of CAD and AUD.
2. Long a roughly vol-weighted basket of MXN, ZAR, and INR vs USD; total return target of 108 and stop of 96. In mid-2020, with EM high-yielding currencies underperforming, we argued that, in order for EM high-yielders to take leadership in a Dollar down move, we would need to see (i) a continued recovery in global growth and risk sentiment, (ii) some normalization of global trade policy (and US-China trade tensions), and (iii) further evidence of credible coronavirus management in highly affected EMs. Now, with our economic forecasts pointing to an above-consensus global growth recovery by end-2021, an ongoing rally in risk sentiment that is consistent with a constructive vaccine outlook, a US election result that could portend an eventual easing of US-China tensions, and a trend of confirmed coronavirus case counts that, in many EM high-yielders, has avoided extreme left tails, many of these drivers appear to be coming together, and have been reflected in encouraging price action through the US election (Exhibit 3). Moreover, EM high-yielding FX is one part of the EM asset complex where deep value still resides, suggesting more room to run from here (Exhibit 4). As a result, we recommend that investors stay long a basket of MXN, ZAR, and INR, with weights of 25%, 25% and 50% respectively, which we first initiated on October 9. MXN and ZAR each offer an attractive combination of high carry, undervaluation and high exposure to a cyclical upturn, while the lower-volatility INR, which leads all EM currencies in terms of carry-to-volatility, helps reduce some of the risk exposure of the expression as we head through a potentially bumpy Q4.
3. Long CNY and Long 3Y CGBs combined; total return target of 107.5 and stop of 97. Even after the strong rally, we remain bullish on the CNY given China’s strong economic recovery (following successful virus control), wide rate differentials and undervaluation. We think US President-elect Biden is likely to adopt a more traditional and multilateral approach to global trade with less recourse to tariffs, which should also be supportive for the CNY. CGB yields (around 2.5-3.0%) offer a significant yield pick-up to DM yields (WGBI index yield is around 45bp), and we think China’s fixed income market will benefit from secular inflows on a multi-year basis (Exhibit 5), particularly as CGBs are a very under-owned asset by both DM and EM investors, as well as by central banks. We forecast USD/CNY at 6.30 on a 12M view, while on valuations, our GS DEER/FEER models (using a 60:40 ratio) put the fair value of USD/CNY at around 6.00. There are good reasons to express this simply via short USD/CNH, since there is only a modest yield pick-up from going further out on the curve versus the 12M FX implied yield. However, as we have discussed previously, the declining correlation between CNY and CGB returns suggests that combining exposures offers better volatility-adjusted carry relative to either simple FX forward positions or owning long-end bonds on their own. Meanwhile, despite our expectations for higher UST yields by end-2021, we expect the PBoC to keep monetary policy unchanged in 2021; and a year-over-year decline in bond supply, and substantial foreign inflows, should drive CGBs’ outperformance vs US bonds. As such, we maintain our recommendation to go long 3Y CGBs on an FX-unhedged basis (entry at 2.83% and USD/CNY at 6.83 (indexed at 100), with a revised total return target of 107.5 and stop-loss of 97).
4. Long SGD vs TWD; total return target of 104.5 and stop of 97. Taiwan’s economy has been outperforming the region both in coronavirus control and economic activity. While consumption was hit hard in the first half, like elsewhere, the extent was relatively limited compared with other economies in the region. USD/TWD NDF points have declined further into very negative territory from hedging flows to sell USD/TWD forward (for details on Taiwanese life insurance flows, please see: TWD hedging demand). This means that being short TWD offers very attractive carry. Given our bearish USD view, we prefer to express this via NJA crosses and considered the carry-to-vol and risk profile of all NJA pairs (vs. TWD). We note that the SGD/TWD cross offers reasonably attractive carry-to-vol versus peers, but most importantly is fairly risk-neutral (Exhibit 7). In other words, the drivers of spot USD/SGD and USD/TWD are broadly similar, which allows the trade to harvest the carry without being too reliant on the broader risk direction. Meanwhile, Singapore’s economic activity should continue to recover in line with easing containment policy and the MAS should keep policy steady in 2021. We think the SGD will likely stay close to the mid-point of the SGD NEER policy band, but should trade more frequently in the upper half (than in the lower half), as SG government bond yields remain attractive vs. DM markets. As such we recently recommended going long SGD vs. TWD (entry at 20.95 (index at 100) with a total return target of 104.5 and stop-loss of 97).
5. Long 3y1y forward US real yields; target of -1.65% and stop of -1%. While we expect a steady reflationary theme to gain traction in rates markets from 2Q 2021, barring a spike in the second quarter, spot inflation readings in the US are likely to remain below the Fed’s 2% target over the next two years (see here). Over the past 25 years, core inflation has not consistently exceeded the Fed’s 2% target until after the employment gap has closed—our economists do not expect a return to full employment until mid-2024. Given this, and the Fed’s current forward guidance, our economists do not expect liftoff until early-2025. The combination of the Fed keeping the (nominal) policy rate on hold until inflation hits 2% and is “on track to moderately exceed 2% for some time” suggests that the period before liftoff should see significantly negative short-term real rates—probably lower than -2%, given that core CPI is likely to be higher than core PCE (the Fed’s inflation metric). As of now, the rates market is fully pricing the first 25bp hike by early 2024, about 1 year earlier than we think the inflation trajectory will allow. Additionally, the inflation market is pricing for CPI to only just return to 2% by the point where liftoff is priced (core PCE, the Fed’s targeted measure, is still likely to be somewhat below 2% given the CPI/PCE wedge). This pricing appears inconsistent with Fed guidance—either liftoff will occur later than currently priced and/or markets need to price a stronger inflation outcome to maintain consistency with current guidance. Therefore, we think risk/reward favors being long forward real yields—we believe 3y1y real yields offer the best risk/reward in a range of scenarios (Exhibit 9), though buying 5y TIPS should also work (the latter expression is also exposed to front-end inflation, however). The main risk to this trade comes from markets assuming the Fed would abandon its current guidance and/or an inability to achieve its inflation objective.
6. Long (1.65:1) vol-weighted 1y forward 5s30s steepeners; target of 72bp and stop of 20bp. With divided government the most likely election outcome in the US, anticipation of an expansionary fiscal policy is no longer a prime driver of reflationary pricing. Rather, this would depend on public health news, both on the trajectory of coronavirus infections and vaccine availability. While the high efficacy reported on the Pfizer vaccine appears to have spurred yield curve steepening (excessively so in the near term, in our view), forward yield curves remain too flat—the 1y forward 5s30s swap curve is about 15bp flatter than the spot curve, and our YE2021 forecasts imply a further 15bp steepening of this curve from current levels. Part of the reason for the flatness of the forward curves is the recent cheapening in the belly of the curve. While we had argued for belly cheapening in the event of a “blue wave” and a widely available vaccine, we do not believe the vaccine news on its own justifies the Fed repricing driving the selloff in the belly. Rather, we expect the reflation theme to play out slightly differently in the latter case over the next year—a delayed steepening with a smaller belly selloff. Indeed, we would be inclined to fade the weakness in the 5-7y part of the curve by overweighting the long end of the steepener. One way to do this is to use volatility weighting—this would account for market perceptions of how “free” the belly is relative to the long end, given the differences in the Fed regime in this cycle. The trade carries very well, roughly 2bp/month and, in our view, with favorable risk/reward—the range of 5y yields for plausible shifts in Fed liftoff pricing is small (Exhibit 11). The risk to this trade comes from tail scenarios: (i) much stronger economic performance than even our above-consensus economic projections, which would lead markets to price aggressive Fed normalization, or (ii) a large exogenous negative shock to the economy, which would flatten the yield curve given the Fed’s reluctance to relax the zero lower bound.
7. Long 2s30s Gilt curve steepeners; target of 1.15% and stop of 0.85%. We think both domestic and global factors point to UK curve steepening. First, we expect the cyclical boost associated with an early vaccine will lead to higher yields across major markets. Second, we have an optimistic view that the UK and the EU will strike a (thin) free trade deal in coming weeks, reducing tail risks into year-end. And third, although the cyclical outlook remains challenged, we think that for now the BoE is unlikely to add more stimulus through QE given the recent addition of £150bn in extra purchases throughout 2021. We expect that these factors will lead to long-end rates selling off in the UK and steepening in the 2s30s curve (Exhibit 13). We think that the long end of the UK curve will be increasingly cyclical, consistent with comments from BoE Governor Bailey that balance sheet policy should itself respond more to cyclical variation in the economy—in this way, the long end should sell off into a cyclical recovery. And although we do not expect the BoE to cut rates into negative territory, we think this possibility will keep front-end rates well-anchored, with the probability of negative rates only materially reduced by a strong cyclical recovery, which itself should imply higher long-end yields.
8. Long 10y10y-2y2y HICP curve flatteners; target of 0.55 and stop of 0.85. As virus containment measures have escalated in Europe, the HICP curve has steepened modestly. We think that eventual cyclical recovery will see front-end inflation rise, resulting in a flattening of the inflation curve (Exhibit 14). 2y2y HICP is around 85bp currently, and has room to reprice closer to its 2019 average of 1%. Although we expect underlying inflation dynamics to remain subdued, this repricing should be aided by a recovery in headline inflation as temporary effects abate, such as the cut in German VAT. At the long end, we think there is limited room for inflation forwards to reprice higher—with 10y10y trading near 1.60%, it has returned close to pre-COVID levels. Although the ECB may attempt to bolster long-term inflation expectations as a part of its strategy review, we think that the inflation expectations process in Europe is more adaptive and so will first require evidence of rising spot inflation before a long-end move is realized.
9. Long High Yield vs. Investment Grade in the USD cash market (1 to 1.15 notional ratio); target of 2% and stop of -2%. We recommend going long the iBoxx High Yield Liquid index vs. its Investment Grade peer, both rates-hedged, at a 1 to 1.15 notional ratio. We expect two drivers will likely fuel further spread compression across the rating spectrum. The first is strong search-for-yield motives, given the anchored and low level of yields across the broader fixed income complex, as well as the prospect of declining volatility, now that investors have more clarity on both the election outcome and the vaccine timeline. The second is our expectation that the record-high level of liquidity on corporate balance sheets, coupled with easy funding conditions and rebounding growth in 2021, will fuel a benign default backdrop in the US High Yield market. We continue to forecast the 12-month trailing default rate in the US High Yield market will decline to its long-run average of 4% by year-end 2021, from 8.5% currently, with risks skewed to the lower side.
As shown in Exhibit 15, the rating compression theme has been visible in macro synthetic indices, with CDX High Yield significantly outperforming CDX Investment Grade. By contrast, there has been little differentiation between the two rating buckets in the bond market. In our view, this pattern reflects lingering technical pressure from new issue volumes in the High Yield bond market. Unlike the Investment Grade market, where activity declined to normal levels by the end of September, High Yield new issue volumes have only started to normalize recently; a trend we think will gain momentum over the next few quarters.
10. Long USD Investment Grade bonds vs. agency MBS; target of 1.5% and stop of -1.5%. We recommend going long the iBoxx Investment Grade Liquid index vs. conventional 2.5% coupon 30-year agency mortgage backed securities, both rates-hedged, at a 1:1 notional ratio. As shown in Exhibit 16, the trade generates a positive carry, given wider investment grade bond spreads relative to agency MBS, and is net “long beta”. Three ingredients underpin this trade recommendation. First is our pro-cyclical view and our expectation that investment grade bond spreads have room to modestly tighten in 2021. After solidly outperforming in the second quarter, investment grade bonds have since been moving sideways vs. agency MBS (Exhibit 17). Although this trend could extend over the short term if the market shifts its focus to the gap between vaccine approval and “herd immunity”, we think the implicit policy support for investment grade bonds will likely mitigate this risk. Second, we expect refinance risk for MBS to remain elevated through 2021 even if benchmark Treasury yields rise. High refinance rates should provide a drag on mortgage returns given that the 2.5% coupon bond trades at a substantial premium to par. Third, we think the investment grade bond market scores better in terms of supply technicals. As we recently discussed, we expect new issue volumes in the investment grade bond market will materially slow down in 2021, after a record-breaking 2020. We forecast gross issuance volumes of $1.3 trillion in 2021 vs. 1.8 trillion year-to-date. By contrast, we continue to think low mortgage rates will allow the 2020 mortgage originations boom to extend and forecast $2.9 trillion in gross mortgage originations in 2021. On our estimates, over 60% of outstanding 30-year conventional mortgage borrowers will still have a 50bp or larger incentive to refinance by the start of 2021, even assuming that the proposed adverse market refinance fee is implemented. We would hedge the 2.5% coupon MBS using 2-year and 10-year Treasury instruments with respective hedge ratios of 0.05 and 0.60.
11. Long EUR AT1 vs. High Yield bonds; target of 2% and stop of -2%. We recommend going long the iBoxx EUR Contingent Convertible Liquid Developed Market AT1 Index vs. the iBoxx EUR Liquid High Yield Index at a 1 to 1 notional ratio. We had been recommending this trade (since May) at a 1 to 1.25x notional ratio, but are now lowering the hedge ratio to 1. We continue to like AT1 bonds over their HY-rated peers for two reasons. First and foremost, we view the relative valuation of AT1s as attractive. As shown in Exhibit 18, the AT1 index has remained meaningfully wide to the EUR HY index (in spread terms) since the global acceleration of the coronavirus in mid-March. While the current spread differential is well below the local peak of 327bp in mid-May (leaving the extreme volatility of March and April aside), it is nonetheless still elevated compared with the pre-pandemic levels. From November 2019 to February 2020, the AT1 index traded, on average, just 40bp wide to the EUR HY market (again, Exhibit 18). Given the persistent uncertainty in the ongoing Brexit negotiations, we believe the large weight of the AT1 index towards UK-based issuers has likely been an overhang on its relative performance (Exhibit 19). That said, this should ultimately prove transitory as our European economists expect a deal to be reached soon. Second, we view this trade as a hedge against a potential downward repricing of growth expectations in the Euro area. Such an outcome would likely weigh more heavily on the EUR High Yield universe as opposed to the region’s largest banks, which remain well capitalized and benefit from policy support for lending via the TLTRO programs. A key risk to this trade, however, would be an expansion of ECB corporate bond purchases (via the PEPP and CSPP) to include High Yield bonds.
12. Long US AAA CLOs vs. AAA CMBX index; target of 1% and stop of -1%. We recommend going long AAA US CLOs vs. CMBX 8 AAA, at a 1:1 notional ratio. Exhibit 20 shows that AAA CLO spreads have substantially lagged their CMBX AAA peers, offering positive carry. We have long favored AAA CLOs as a way to harvest risk premium in structured products. As we showed in previous research, AAA CLOs have historically delivered relatively superior risk-adjusted returns relative to similarly-rated structured products. We have also consistently pushed back against the negative narrative vis-à-vis the CLO market and the concern that CLOs represent a source of macro vulnerability. With the recovery likely to gain more momentum in 2021, we think the AAA CLO premium has room to further compress given abating default risk among leveraged loan issuers and improving rating migration trend. Conversely, while the CMBX 8 AAA index is highly unlikely to experience losses, we think valuations leave spreads with little room to move materially tighter from here.
Recent positive news flow on the medical front notwithstanding, the ongoing deterioration of the virus situation in the US and the gap between the vaccine approval and “herd immunity” could prevent AAA CLO spreads from compressing. Even so, we think the trade’s positive carry provides a decent cushion against this risk.
EM (Local Rates, Credit and Equities)
13. Long 6-year (R186) SAGBs, USD-hedged; yield target of 6% and stop of 7.75%. Following the March sell-off and April volatility, we have been recommending longs in SAGBs, first favouring the 10-year bond in the spring and then switching our preference towards the 6-year point of the SAGBs curve heading into the summer, to maximize carry relative to duration and issuance risk. Different measures of risk premia have ranked South African local fixed income at or close to the top of the EM HY local universe for quite some time and, while the country’s fiscal picture remains a source of concern for longer-term local asset returns, we would argue that yields on offer are still sufficient to compensate for the underlying risks. The SAGBs rally has of course compressed these risk premia, but on a relative basis, in a world that remains more starved of yield going into 2021 than initially anticipated, we still think that long SAGBs is an attractive trade. The combination of high carry and roll per unit of duration risk, the lighter foreign positioning (Exhibit 21), and the more direct exposure to dovish innovations on the inflation and monetary policy front in the coming months, still make us prefer the 6-year point of the curve, even though we see an attractive entry point also in long-end SAGBs beyond the 10-year benchmark. We close our previous recommendation for a potential 5.82% total return, and open a new trade recommendation to go long 6-year SAGBs, with a yield target of 6% and a stop of 7.75% (Exhibit 22). We open the recommendation in USD-hedged terms, but given the rising FX-hedging costs and our constructive view on the Rand (see above) we also see upside potential in FX-unhedged longs.
14. Long BRL DI Jan-2022 receivers; target of 2.7% and stop of 4%. Over the past year, as the Central Bank of Brazil pushed the Selic rate to historical lows in both nominal and real terms, local rate markets have continued to price a sharp reversal of the easing delivered. The steepness of the short end of the BRL curve can be justified by the large deviation of real rates from their historically high levels. But the uncertainty around the government’s fiscal stance and commitment to maintaining the spending ceiling, coupled with the acceleration in headline inflation, has caused local markets to price a sharp and protracted hiking cycle to kick off as early as in the next 2-3 months, despite still dovish forward guidance by the BCB (Exhibit 23). While there is a meaningful risk that further slippages on the reform agenda and a less responsible fiscal framework may continue to hurt the Real, feed into inflation expectations and eventually force the central bank to withdraw some of the easing delivered this year, the bar for the BCB to tighten more than currently priced remains pretty high, in our view. First, the recent inflation acceleration has been mostly driven by volatile and non-core components, with underlying inflation dynamics remaining relatively benign so far; second, despite the strong economic recovery of the last few months, Brazil’s output gap remains in deep negative territory, also due to the legacy of the last decade of underwhelming growth, further strengthening the case for policymakers to look through transitory inflation volatility; third, we recently argued that the high share of floaters and short-maturity securities in Brazil’s federal domestic debt makes a monetary tightening in response to fiscal slippages more challenging for the central bank, given the fast pass-through to debt servicing costs. Thus, while we remain cautious on the medium-to-long-term trajectory of the economy and fiscal balances, we continue to recommend fading the current hawkish market pricing, by staying in BRL DI Jan-2022 receivers, with a target of 2.7% and a stop of 4% (Exhibit 24). We originally initiated this trade on October 7 at a similar level of DI pricing and note that it carries positively by ~25bp/month.
15. Long INR 5Y bonds; total local currency return target of 104.5 and stop of 97. We like positioning for further policy easing in India, both in terms of rate policy and liquidity measures. The new composition of the MPC is quite dovish and the RBI will likely cut policy rates once inflation recedes, which we think will happen by Q2 2021 (Exhibit 25). Inflation has been quite elevated over the past few months (6.7%) driven by food prices, due to supply chain disruption (as opposed to increased demand). The level of economic output is still well below trend since the lockdown was very stringent, while the size of fiscal stimulus was fairly limited versus the size of the economic hit. The MPC noted that it will “await the easing of inflationary pressures to use the space available for supporting growth further,” which we interpret as dovish. Meanwhile, the RBI recently also announced a slew of new liquidity measures to support the bond market, which included increasing the size of OMO purchases to INR200bn (from INR100bn previously), special OMO purchases of state development bonds, a INR1trn on-tap TLRTO facility of up to 3 years, and extension of the held-to-maturity (HTM) limits for banks to March 2022 from March 2021 previously. We favor the 5Y over the 2Y, because the 2/5Y spread is quite wide at almost 100bp, which offers an incentive to extend duration. However, we favor the 5Y over the 10Y because we see scope for US 10Y yields to rise, which may impact INR 10Y bond yields. Meanwhile, our GS quantamental valuation model also indicates that there is scope for INR 5Y bond yields to fall. We recommended going long INR 5Y bonds (entry 5.20% (indexed at 100), target 104.5, stop-loss 97).
16. Long 2s10s IRS steepeners in EM LY (CZK, KRW and THB); target of 0.75% and stop of 0.3%. Going into 2021, we expect core rate curves to steepen further, and this basket of EM LY rates has shown a reliable sensitivity to this, including over the last few months (and days). We have argued for steepeners in the EM LY local rates, in particular in CZK, KRW and THB and initiated a trade recommendation on September 9. First, we remain comfortable receiving front-end rates in these markets, as the bar for rate hikes remains particularly high. Second, further positive developments on an early Covid vaccine could easily translate into renewed impulse for cyclical assets, and despite the more contained betas, steepeners offer reliable exposure to cyclical assets coupled with a better carry profile relative to outright payers (Exhibit 27). Finally, the increased issuance pace in the coming quarters is also likely to continue to exert upward pressure on long-end rates, with the Czech budget balance expected to remain at a well-below average -4.3% in 2021 (IMF estimates), and Thailand and South Korea’s primary bond supply expected to remain as high in FY2021 as in FY2020, against a backdrop of only limited (or no) asset purchases by the respective central banks (see here and here). All in all, while the steepening bias in these curves may be somewhat more back-loaded and Covid vaccine-dependent, we reiterate our recommendation to stay in 2s10s IRS steepeners in CZK, KRW and THB, with a target of 0.75% and a stop of 0.3% (Exhibit 28).
17. Long EM HY credit; total return target of 5% and stop of -4%. We have been recommending going long EM HY credit through a broad basket of EM HY sovereigns since early in the autumn, aimed at tracking the HY part of the EMBI global diversified index (prior to this, we were recommending front-end bonds in a more select basket of HY sovereigns). EM HY credit offers both value and upside under our overall constructive stance on EM growth and cyclical risk, based, in turn, on our expectation for a vaccine approval around the turn of the year. More specifically, we find that while EM HY credit increases exposure to frontier EMs, which are more vulnerable to the global Covid-19 shock, these risks are in the price. For example, we have noted that with an average yield of ~7%, EM HY sovereign USD bonds compensate for the potential rise in expected investor losses following the Covid-19 shock. Moreover, while EM HY sovereign spreads have retraced from the wides this year, spreads remain wide relative to their history, also when compared to the spreads of EM IG sovereigns (Exhibit 30). With the trade already having moved sharply in the aftermath of the US election and the Pfizer vaccine news, we are extending the total return target to +9% (i.e., we see an additional +5% upside from current levels) and bringing up the stop to the previous open.
18. Long EM bank stocks vs consumer staples; target of 120 and stop of 102. Banks emerged as one of the worst-performing sectors throughout the virus-related pain in Q1 and so far have only recovered a quarter of the value lost. The underperformance has been driven by multiple factors, including rising non-performing loans and, in some cases, asset purchase programmes and deep rate-cutting cycles, flattening curves and eroding net interest margins. We push back against the view that these headwinds will be sustained. The NPL cycle already appears to be significantly priced in across EM, with current valuations already accounting for a rise in bankruptcies. Early indications from some of the more beleaguered markets, such as India, are also showing that policy safeguards have led to more-resilient-than-expected bank balance sheets. The deterioration in net interest margins does pose a problem for banks in markets such as Korea, Taiwan and Poland in which banks’ profits are heavily tied to the yield curve, but we have found that the earnings cycle of banks in high-yielding countries such as Brazil, India and Mexico are inversely correlated with the level of interest rates and are less impacted by the slope of the yield curve. We suspect that this observation reflects a ‘volume over margin’ factor: that it is overall credit growth which drives the earnings cycles, as prohibitively high interest rates in these EMs have historically disincentivised borrowing. Central banks across EM have cut rates sharply since the start of the coronavirus crisis, and we would expect a credit growth rebound as activity recovers, with the potential for a vaccine serving as a major catalyst to unlock the current value in bank sectors. Our preferred countries for a positive banks expression are Brazil, Russia, India, Mexico and South Africa, where earnings appear more tied to credit growth than to net interest margins, and where a significant round of NPLs already appears to be factored into bank valuations. Structurally, we favor ‘growth’ sectors like Tech, and do not see an imminent catalyst for that sector to underperform. Consequently, we prefer to implement the positive banks view relative to consumer staples companies, which should provide a cleaner pro-cyclical expression. The original trade was initiated at 100 on August 12 with a 15% target and 8% stop in August, but given the sharp move higher in recent weeks around positive vaccine developments and the US election we have adjusted our target and stop higher with a new potential gain of 10.1% and potential loss of 6.4% from current levels.
19. Long Korea (and KRW) vs Taiwan (and TWD) equities; target of 112 and stop of 98. Heading into 2021, our macro forecasts points to an-above consensus recovery across most of EM, but less so in Mainland China, where the recovery has already been impressive. The equity markets in Taiwan (+18% YTD) and Korea (+13%) have been particularly resilient this year, benefiting from their proximity to Mainland China and from the combination of China’s strong policy response and successful domestic control of the virus. Both markets are closely tied to the global trade cycle (generally more geared to the DM growth cycle than the rest of EM), but Korea’s equity market composition tends to be more closely tied to the global industrial cycle, whereas exports from Taiwan are heavily tied to sectors that have acted more defensively throughout the sell-off (semiconductor companies account for 57% of MSCI Taiwan). Consequently, the relative performance over Korea vs. Taiwan resembles a more ‘deep-cyclical’ thematic, similar to broad MSCI EM Industrials vs. Consumer Staples (as shown in Exhibit 34 below). Unlike a number of our other EM recommendations, the relative nature (long/short) of this trade may be attractive for investors who are cautious on the overall direction of risk after the very strong moves in early November, but who still expect cyclical leadership to persist as global activity rebounds. At current levels, valuation remains supportive for this trade, as the relative price to book ratio of MSCI Korea (1.04x) vs. MSCI Taiwan (2.26x) is back towards its lowest level since 2001; and note that the trade also embeds a long KRW versus TWD position. The trade has already gained close to 3% since implementation, and given the positive vaccine developments and risk-on move surrounding the US election we adjust our target and stop to 112 and 98, from 110 and 93, or a potential gain of 9.1% and potential loss of 4.6% from current levels.