The US Dollar Index’s fall from grace from 102.60 in January to 93.50 now was due to myriad political, financial, data driven and positioning factors. One, President Trump has been enabled to boost US GDP growth to the 3% level he promised in his campaign. First quarter US GDP growth was a dismal 1.4% even as European growth/PMI have surged. This led to a surge in the Euro above 1.17 on all-time highs in German IFO Institute business sentiment from a 1.05 low in January.
Two, the election of President Macro in in France and the defeat of the National Front has slashed political risk in Europe while Kremlingate and the Mueller investigations of the Trump clan has raised political risk in Washington. Trump has been unable to offer a credible tax reform or fiscal stimulus plan to a Congress over which has forfeited leadership. If relative political risk shapes currency trends, the Euro/dollar was the winner of 2017, up 10% in its first seven months.
Three, Fed chair Janet Yellen turned dovish in her Congressional testimony while ECB President Mario Draghi spoke about the “end of deflation” at the Sintra, Portugal monetary conference and hinted at a taper in his Frankfurt press conference. Predictably, the yield on the 10 year German Bund almost doubled to 0.56 basis points, ballast for the spectacular Euro rally in the past two months.
Four, the financial markets were positioned long US dollars for the “Trump reflation trade” after the election. Once Trump failed to kick start his legislative agenda, and got ensnared in Russiagate, Planet Forex dethroned King Dollar. This led to the Euro as the best performing G-10 currency after the Swedish kroner. Global growth data gathered momentum even while US growth data lost momentum.
Five, Morgan Stanley estimates financial/banking deregulation has created an extra $100 billion in excess capital on Wall Street that was exported abroad once Trump did not expand the productive frontiers of the US economy. This meant a softer US dollar.
Six, US Dollar Index began its historic surge in April 2014, when it was 78 and rose almost 30% in the next thirty months. This period also coincided with a historic plunge in crude oil prices and a collapse in many emerging market currencies. The false breakout of the US Dollar Index in January was a powerful bearish, trends reversal signal.
The July FOMC was dovish because it did not reiterate Janet Yellen’s earlier assertion that the fall in core inflation below 2% will be “transitory”. The Federal Reserve expects to shrink its $4.5 trillion balance sheet “relatively soon” (the September FOMC?) but only after it evaluates how the economy evolves.
The US dollar sagged after the July FOMC, primarily against the Japanese yen and the Canadian dollar. I remember being in France in August 2008 when the Euro was 1.60 and “le tout Paris” thought “le buck” was merde Little did we know that Lehman Brothers would bite the dust a month later and trigger the end of the 2001 – 2008 US dollar bear market. For me, the trade of the decade was to short sterling even though cable’s post Thatcher high was 2.11 in November 2007. Sterling’s brutal fall to 1.35 in the next year bigger than the devaluations of 1992 under John Major or 1968 under Harold Wilson. I knew all the talk about the US dollar losing its reserve currency status due to Bush, the Iraq war, $148 Brent crude or the death of Mickey Mouse was nonsense.
Despite the safe haven dollar panic bid after Lehman’s failure, the next US dollar bull market did not begin until April 2014 and the Yellen Fed did not hike rates until December 2015. Is the third post Bretton Wood US dollar bull market now over? No. The U.S. central bank will reduce its balance sheet by at least $180 billion by next summer. This will happen while the ECB balance sheet continues to expand by at least another 400 billion Euros. The Fed Funds rate will be 1.50 in July 2018. The ECB deposit rate will be minus 40 basis points. Macron’s Reaganomics will trigger strikes in Paris this fall. Italian politics is a time bomb. The Euro rally will not last. This is a correction in the US dollar bull market, not its death rattle.
Stock Pick – Bank of America shares will outperform the US stock market in 2018
Bank of America, the second largest US money center bank after J.P. Morgan, rose from 14 to almost 26 in the last twelve months, powered by a steeper US Treasury yield curve, record $17 billion profits in 2016, epic cost control, the Fed stress test capital returns windfall and the peak in its 2008 crisis related $70 billion litigation expenses. Bank of America is also the most interest rate sensitive among America’s Big Three banks, thanks to its trillion dollar retail deposit base in California and the fall in the ten year US Treasury note yield from $2.40 to 2.24% on disappointments over Trump’s legislative policy agenda, Janet Yellen’s dovish Congressional testimony and the decline in inflation expectations has led to profit taking in its shares, now trading at 24.
As the Federal Reserve shrinks (normalization in Fedspeak!) its $4.5 trillion balance sheet and the Trump White House rolls back Dodd Frank and even appoints ex Goldman Sachs President as the next Fed chairman, I expect Bank of America shares to continue their bull run, even rising to $28 a share in the next twelve months. There is no real risk of a US recession, though Trump’s 3% GDP growth promise is now a pipe dream. US housing is on a roll and mortgage put back losses will decline. The biggest threat to the bank is a U-turn in financial regulation or an unanticipated rise in credit risk. A stock market sell off could create an ideal entry point to buy the shares at 22 or 10 times forward earnings.
Bank of America’s second quarter 2017 earnings reinforce the trends that have boosted the bank’s operating leverage to the highest among its US money center peers. Revenue growth was a stellar 23 billion, well above the $21.78 billion sell side analyst consensus estimate at a time when the bank has slashed $20 billion in operating expenses. Earnings per share were 46 cents, above the $0.43 EPS Street consensus. Investment banking fee income growth was 8.9% though trading income declined, thanks to historic lows in volatility across asset classes.
The bank’s net interest income and net interest margins disappointed relative to expectations. The decline in net interest margins (NIM) offset the rise in earning assets and float benefits. The 5 basis point decline in net interest rate margins to 2.34% was due to lower trading carry, ineffective hedges, the sale of the British credit card portfolio and sluggish North American consumer banking loan yields.
The silver lining in the bank’s results was the 45% growth in merger and acquisition fees (true, BankAm does not exactly dominate the global M&A league tables) but debt and equity capital markets underwriting revenue growth was mediocre.
It is now probable that Bank of America will deliver $1.80 EPS growth in 2017 and meet $2.15 EPS estimates in 2018. This means the bank now trades at 11.2 forward earnings, 1.3 times forward tangible book value and a 2% dividend yield. These are relatively modest valuation metrics for a bank with a $2 trillion balance sheet, 17000 wealth advisors (thanks to the shotgun marriage with Merrill Lynch’s thundering herds in the autumn of 2008!) and a continuing fall in credit costs and non-performing loans. The bank’s fully loaded Basel Three common equity Tier One ratio is 11.5% with a SLR ratio of 7%.
Chairman/CEO Brian Moynihan has led Bank of America through its worst protracted crisis since it was founded a century ago by an Italian immigrant financier in San Francisco. His $18.5 million stock compensation for 2016 is tied to the attainment of a 0.8% return on asset ROA) and a 8.5% annual rise in tangible book value targets. This means the CEO’s interests are aligned with shareholders on a scale I rarely see in international banking. The easy money in BankAm has been made but the banking colossus of Charlotte is still a must own for money despite the mixed second quarter!
Citicorp’s’ first investor day since 2008 confirmed my conviction that the most globalized US money center bank will also offer the highest EPS growth rate among its peers in the next three years. Even though Citi doubled its dividend, it still trades at a mere one times tangible book value and will return $20 billion in share buyback next year. No wonder Citi shares were such a winner since I recommended them as a must own at 45 last October.
Macro Ideas – Ten macro reasons to buy Brazil shares
“Brazil is a country of tomorrow and always will be” General Charles de Gaulle dissed Latin America’s largest economy with Gallic disdain. Quelle horreur! Yet I have been fascinated by the magical land of samba, carnival, Pele, Gisele, Roberto Carlos and the Bovespa since my first visit in 1992 – blame it on Rio! The last two years were a political and economic nightmare for Brazil. President Dilma Rousseff was impeached and ousted after the Lavo Jato scandal implicated the entire political and business elite. Brazil endured its worst economic recession since the Great Depression. Standard & Poor’s slashed Brazil’s sovereign debt rating to BB, de facto junk bond levels. Even President Michel Temer, Dilma’s reformist successor, was implicated in a scandal and accused of offering hush money to a witness in a corruption probe. Latin America’s economic colossus seems yet another sad Third World banana republic, with its kleptocratic Senators, its bribery prone billionaires, its disgraced financiers, a country of tomorrow that will never come.
However, as an emerging market’s investor, I live life in the world of the second derivative, the deltas that define my calculus of risk and return. So, I do not shun Brazil’s financial woes, I embrace them by buying the iShares Brazil Capped ETF, the world’s largest Brazil country index fund, listed in the New York Stock Exchange under the symbol EWZ. Why?
One, “the big money is made when things go from Godawful to just plain awful” applies to Brazil in the summer of 2017. When the Temer scandal broke, the Brazil exchange traded fund sank 17% in a single session. I could smell blood in my Bloomberg screen. Mathematicians calculated this was a six sigma, one in a billion-year event. I thought no way. Temer refused to resign since he retained the support of a critical mass in Congress, the Sao Paulo business elite and the military. It was time to buy Brazil.
Two, Brazil’s rock star former President Luiz Inácio Lula da Silva, who symbolized Latin America’s socialist tilt in 2002, was just convicted of corruption and money laundering and sentenced to 10 years in jail. This makes it impossible for Lula to challenge Temer’s pro-market reforms or lead the Workers Party to win the 2018 general election. The political risk premium in Brazilian assets just shrank big time.
Three, Brazil has the world’s highest inflation adjusted interest rates at least 5%. So it does not surprise me that a fall in inflation has enabled the central bank in Brasilia to slash the Selic benchmark policy interest rate from 13.75% to 10.25% as I write. In fact, the Brazil Central Bank (BCB) has anchored inflation expectations by actually lowering its inflation targets. This is a Hellelujah moment for monetary policy in Brasilia and the Selic could well fall to 8% by year end 2017.
Four, Brazil’s Senate just approved a new labour bill that will help address the chronic budget deficit and reduce the risk of another sovereign debt downgrade.
Five, Temer has rightly staked his regime’s legitimacy on pension fund reform, which will both reduce country risk as well as increase the domestic fund allocation shift to corporate debt and equities, classic risk assets.
Six, Brazil is the emerging markets Cinderella and has lagged the 25% surge in the Morgan Stanley emerging market index in 2017. Valuations on the Bovespa are modest at 13 times forward earnings at a time when EPS growth can well rise by 20% next year.
Seven, Brazil boasts one of the largest mutual funds industries I have ever seen in the emerging markets, with $1.2 trillion in assets under management invested largely in Federal and bank debt. Yet pension fund reform will ignite a secular bull run in corporate debt and equities, the reason I love Banco Bradesco shares.
Eight, Brazil’s GDP could well rise from 0.3% in 2017 to 2% in 2018. The merest hint of green shoots could mean Bovespa 80,000 if the macro stars, dear Brutus, are aligned. Brazil’s judicial system has also launched a crackdown on political corruption.
Nine, Trump’s political woes in Washington has led to a softer US dollar and lower US Treasury bond yields, nirvana for Brazil’s external debt and the Brazilian Real.
Ten, the rise in iron ore (Vale is up 30%), sugar, crude oil (Petrobras, Energia de Brasil) and even coffee is hugely Brazil bullish, as is no China hard landing. Obrigado, Comrade Xi!