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Equities/Macro/FX Market Update

Updated: Oct 13, 2018

Authors: Justin Lam Equities Analyst, Phoenix Li, Macro/FX Analyst, Chris Jin Co-VP Education/Research, Jason Sohal Co-VP Education/Research


Equities – Justin Lam


Summary


Both Canadian and U.S. equities ended lower on the week, despite the settlement of the United States-Mexico-Canada Agreement. The markets initially jumped up following the agreement of the revised NAFTA deal — the Dow hit an all-time high, driven by gains in major American exporters Boeing and Caterpillar — but the enthusiasm faded as concerns over trade with China intensified. Trading volume was elevated, and the CBOE Volatility Index (VIX) spiked to its highest level for the past three months.

Canadian stocks slump amid new trade deal


Source: CBOE

Canadian stocks declined in ten of the eleven major sectors of the S&P/TSX Composite Index. The info-tech sector led the slump this week, with the TSX Information Tech Capped Index (TTTK) falling by 5.49%. Blackberry (TSE: BB) was among the biggest movers in info-tech, dropping by 11.54%. Shopify (TSE: SHOP) also fell by 11.65% as concerns grew over Amazon’s announced Storefront service. Storefront is targeted at the same small businesses for which Shopify helps to create e-commerce platforms. Amazon had previously created a Shopify competitor called Webstore, but it was shut down in 2015. The financial sector also declined following Italian lawmaker Claudio Borghi’s anti-Euro comments. Borghi said that most of Italy’s problems would be resolved if it readopted a national currency, which triggered a broad-market sell off. Despite the turmoil, the new trade deal cleared the way for more rate hikes from the Bank of Canada, with several more predicted in the near future.


Big movers in Canadian markets


Shares of oil sands producer MEG Energy (TSE: MEG) surged 37% after Husky Energy (TSE: HSE) made a C$6.4 billion hostile bid. Husky Energy fell by 3.96% during the week, as several large shareholders of MEG predicted a bidding war and demanded a higher bid. Meanwhile, Canada Goose (TSE: GOOS) faced a sharp drop of 13.19% over concerns of its high valuation. At C$60, GOOS trades at 85x trailing 12 months (TTM) earnings. This price represents a share valuation 85x greater than the company’s earnings per share over the previous 12 months, placing it among the most expensive stocks on the TSX. Marijuana stocks also fell after PepsiCo (NASDAQ: PEP) said it has no plans for any cannabis-based products. Canopy Growth (NYSE: CGC) ended the week 5.31% lower, and Aurora Cannabis fell by 5.64% before making a recovery at the end of the week.


American energy stocks bolstered by strong oil prices


In the U.S., large-cap indexes held up better to the overall decline compared to small-cap index and the NASDAQ Composite. Energy was among the top performing sectors of the week, in anticipation for the implementation of new sanctions on Iran in early November. The S&P 500 Energy Index (SPN) increased by 1.86%, as strong crude oil prices bolstered oil company profits. Equities in the financial sector also outperformed, with improvements to its bank lending margins. Long-term interest rates jumped up to their highest levels since 2011, as the yield of the benchmark 10-year Treasury note increased from 3.06% to 3.25%. Even in the face of rate hikes, the U.S. bull run seems undeterred.


Macro/Currency Analysis – Phoenix Li


The Current Economic Cycle


Without a doubt, global financial markets are dynamic and ever-changing. However, the current economic cycle we are in is quite special. Everything started with the 2008 financial crisis, which is the largest global financial crisis in the human history. With globalization causing the financial markets to be more in sync across borders, the contagion effects were exacerbated and the recovery prolonged. This economic recovery took the U.S. 10 years, and even longer for less mature or less diversified economies. With the recent rate hikes and unwinding of the balance sheet, the U.S. became the first country to declare an “end of cycle signal” since 2008. Despite these rate hikes, global interest rates have never been so low (still negative in Japan and Sweden). With the world’s economy more intertwined than ever, we find ourselves in uncharted territory. Many economists and strategists have been giving their forecasts on how and when this 10-year economic cycle is going to end, but surely no one knows the answer.


The USD Rally Versus Vulnerable Emerging Market Currencies


The USD, which is the world’s largest reserve currency has been a hot topic in forecasts and discussions on the street. I would like to take some time to offer my personal views on the USD. The purpose of this report is not to give readers investment advice. Rather, it draws a picture of the topics related to USD and provides a way of thinking on macro/FX analysis. All the arguments are open to discussion.


Source: Bloomberg

Since the beginning this year, DXY has jumped 8%, which values the price of USD against a basket of currencies with the highest weights on the Euro, Yen, and GBP.


Source: Bloomberg

The Bloomberg dashboard shows that among all the major currencies, none of the currencies increased its value against USD except for the Mexican Peso (it was oversold at the beginning of the year because of the NAFTA uncertainty).


Source: Bloomberg

Source: Bloomberg

Looking at emerging market currencies, they are much more vulnerable than developed market currencies. This broad USD appreciation has significant implications on the financial markets. Spot Gold prices were down around 10% YTD since the USD is the major measure for the price of gold. International fund flows indicate money is flying out of emerging markets, which leads to declines in the stock markets of those countries. For example, the HK stock market hit the domain of “bear market” territory according to technical analysis.

Source: Atlas

The strong USD also triggered a series of debt problems in some emerging market countries, namely Turkey and Argentina, which will be discussed in the following section. China and India announced new currency outflow regulations to stabilize its currency against the USD. International investors are raising concerns over sustainable economy development for the emerging markets. In theory, a cheaper emerging market currency is good for exports, because it makes the domestic products cheaper and more attractive. However, with Trump’s trade war uncertainty, the pessimism and “risk-off” sentiment over-weighs any growth potential and valuation discrepancy after the sell-off (US index level P/E ~ 22 versus emerging market P/E ~ 12). If you are a true believer of “mean-reversion” theory, it seems like a good opportunity to load up on some emerging market stocks.


Higher U.S. Treasury Yields and Its Implications


There are several factors that contributed to the strong USD. One of the most important and obvious one is yield discrepancy. Since the U.S. became the first country to start the hiking cycle, the interest rate discrepancy has expanded. Simply stated, investors earn more interest on their money if they hold USD instead of other currencies. A carry trade is a typical hedge fund’s favorite trade in such an environment where they can use exotic instruments to increase their USD exposure while reduce their exposure in other lower-yield currencies, or leverage USD exposure financed by short exposure in other currencies.

Source: Bloomberg

As a result, investors who use this strategy will earn returns from two sources, namely, the yield difference between USD and other currencies (vulnerable emerging market currencies are often the candidate) and the market sentiment that pushes USD higher (when many investors do the same trade, the demand of USD increases, so does the price). On the other hand, US 10-year treasury bill finally hit 3.2% (the reason I say “finally” is because many institutions on the street forecasted that number to be hit by the beginning of 2018). The number “3.2%” is not just a number. It has more meaningful implications toward both equity markets and the fixed income world. For equity markets, since we have increasing number of quantitative strategies, the input being used in various mathematical and statistical models will be updated by a higher benchmark yield. Using portfolio optimization asset allocation model as an example, the increased risk-free yield would shift more weight on fixed income products and less on equity markets (a higher required return on equity will be produced as a result, and it is not easy to meet based on the current hyper-valued NA equity markets). In other words, due to the higher yields, fixed income products become relatively more attractive, which draws money from equity markets. Then some people might ask “why are we still in a bull market in North America” Well, we have to take USD appreciation into consideration. I think higher U.S. yields indeed draw money from equity markets, but just in North America. So far, it has been drawing more money from emerging markets (they are most vulnerable). I think in the future months, one of the main drivers to end this NA bull market will be a so-called “liquidity crisis”, where I initially formed my thesis back in Nov. 2017 and discussed it with couple of people on the street. The core thinking of the thesis is that with increasing U.S. treasury yields, hyper-valued U.S. equity markets and “end-of-cycle” fear, investors will tend to “risk-off” and move their assets into safer alternatives (namely fixed income and safe heaven currencies). This will result in reduced demand for equities. When long-term buyers shift to long-term sellers, the market will turn from bull to bear. This is very likely to happen before the U.S. economic data starts deteriorating, because the current market has priced in enough upside to justify the potential economic growth and there is no way to keep the treasury yields low because of the historically high volume of treasury supply (985 billion deficits + feds unwinding its 2 trillion balance sheet).


In conclusion, almost all the assets in the world of investing are correlated to each other. USD and U.S. treasury bills are the two hot assets nowadays. Understanding those two assets is of vital importance to design trading strategies and make good returns in the current market conditions. If you make trades based on the analysis above, please always remember the old saying that “the market is always irrational”.



The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the authors, which do not necessarily correspond to the opinions of University of Waterloo Finance Association (“UWFA”). Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by UWFA. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made.

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