Moments ago, just two days after it was closed out of its Top Trade for 2015 (“to be short EUR/$ via a 1.00 – 0.95 put spread (initially struck at 1.20-1.15 with spot at 1.25), which expires out of the money incurring a loss of premium”), Goldman released its first Top 6 Trades for 2016. For those who can’t wait to take the other side of Goldman’s clients, and thus the same side of Goldman’s prop desk, here they are.
Top Trade #1: Long USD vs short EUR and JPY
Go long USD against an equally-weighted basket of EUR and JPY at 100, with a spot target of 110 and a stop loss of 95. Annual carry is positive at around 1%.
The divergence between the Fed and both the ECB and BoJ will continue to be one of the more durable themes of 2016, in our view. In the US, we believe ongoing improvement in the labour market and resilience in domestic demand will ultimately drive a Fed tightening cycle that is more hawkish than the market is currently discounting. And in Europe and Japan, the fragility of their economic recoveries and lower starting point for inflation mean that the policy stance will remain dovish and will lean against the Fed. Currencies are particularly sensitive to this divergence pressure and, despite the strength we have seen so far, we believe the USD has more room to appreciate vs the EUR and JPY.
Top Trade #2: Long US 10-year ‘Breakeven’ Inflation
Stay long 10-year US break-even inflation (USGGBE10 Index), opened on 10 November 2015 at 1.60%, with an initial target of 2.0% and a stop on a close below 1.40%.
In the US, core CPI inflation is running just below 2%, and the more sticky service price components of the index are trending upwards, contributing more than 200bp to the headline reading. Yet, since the oil price crash in mid-2014, inflation expectations priced by the market have declined all the way out to 10-years. Currently, the inflation swap market prices that headline CPI will not reach 2% (the Fed’s inflation objective) until around 2020. Moreover, the option market assigns a 40% probability to CPI averaging less than 1% over the next 5 years. We think this represents an opportunity to take the other side of too pessimistic expectations by being long 10-year TIPS and short nominal Treasury bonds. Our view is predicated on the idea that continued above-trend growth will lead to a further build-up of wage and price pressures. In our central outlook, the drag to headline inflation from the energy complex should gradually reverse in the coming months.
Top Trade #3: Long MXN and RUB (equally weighted) versus short ZAR and CLP (equally weighted).
Go long an equally-weighted basket of MXN and RUB versus short an equallyweighted basket of ZAR and CLP, with an entry level of 100, total return target of 110 and stops at 95. The expected return, including carry, is around 10%.
This EM relative value trade speaks to a number of our key themes in EM in 2016. It positions for (i) currencies where external balances have adjusted in recent years (RUB) versus those where more progress is required (ZAR); (ii) currencies (MXN and, again, RUB) that are exposed to crude oil where we see limited further downside under our central forecasts versus commodities tied to capital expenditure, such as industrial metals, where we see further downside (CLP, ZAR); and (iii) the short side is relatively more exposed to a slowing in China and the risk of a CNY depreciation. We expect a 10% total return including carry (about 1% on a 12-month basis).
Top Trade #4: Long EM ‘External Demand’ vs. Banks stocks
Go long a basket of 48 non-commodity exporters (GSEMEXTD Index) and short a basket of 50 EM banks stocks (GSEMBNKS Index). We will monitor this trade as the ratio between the two indices, currently at 1.12, with a target of +15% (1.30) and a stop loss of -7% (1.04).
We expect the EM growth engine to remain challenged heading into 2016, facing the headwinds of sustained low commodity prices, a bumpy downshift in China’s growth engine and stretched leverage ratios across the EM complex. We find that equities tend to be the most sensitive asset class to shifts in growth, and suggest adopting long/short exposure tying into diverging growth trajectories.
Specifically, we recommend buying a basket of non-commodity EM exporter stocks and selling a basket of the largest EM bank stocks. This trade reflects an improving external (DM) environment, helped by weaker EM currencies, versus slowing credit growth across EM as US interest rates rise. At the margin, this trade would benefit from left-tail risks in China (either growth or a currency devaluation) given a greater weighting of China equity in the short leg (22% among ‘Banks’ vs. 6% in ‘External Demand’), although the beta of the long/short pair to China risk is quite low. We will monitor the trade through the ratio of the Bloomberg baskets: GSEMEXTD <INDEX> vs. GSEMBNKS <INDEX>.
Top Trade #5: Tighter Spread between Italy and Germany Long Rates
Go long 5-year, 5-year forward Italian sovereign yields vs short 5-year 5-year forward German yields, with an entry level of 160bp, target of 100bp and stop loss of 190bp.
The ECB’s easy interest rate policy and its government bond purchase programme have contributed to a decline in long-dated yields across the EMU bloc and beyond. Yet, the term structure of intra-EMU sovereign spreads has remained quite steep. The difference between 5-year rates in Italy and those in Germany is 50bp. But the same differential widens to over 150bp 5 years into the future. We think that a combination of the extension of the ECB’s QE program into 2017 (removing around 20% of the Italian debt stock from public hands, and fostering an extension of its average life), stronger Italian GDP growth than seen over the past two years and a cut to the deposit rate further into negative territory will encourage a compression of forward Italy-Germany spreads at least to where they were around the announcement of QE in March. A possible shift in the target duration of national central bank purchases and/or a shift away from an ECB capital key allocation of bond purchases to market capitalization would clearly give the trade a bigger boost. In terms of the more closely watched 10-year Italy-Germany spread, our trade recommendation implies a move from the current 105bp to around 75bp. We would look to add Spain and Portugal to the long side of the trade recommendation once uncertainties regarding the respective political scenes have subsided in the New Year.
Top Trade #6: Long large-cap US Banks relative to the overall S&P500
Go long large-cap US Banks through the BKX Index relative to the S&P500, indexed at inception to 100, with a target at 110 and stop loss at 95.
US banks tend to be mildly pro-cyclical and also benefit from a rising longer-dated yield environment (we forecast a steeper US term structure than the forwards discount), as the Fed tightening will lead to a progressive upward revision of expectations on terminal rates, while the ECB and BoJ’s efforts to boost inflation should restore bond premium across major markets. US banks are still relatively well-priced, trading just above book value and with a P/E below that of the overall market, and at about median levels compared with its own past history. Moreover, they remain off their recent highs, unlike other possible implementations of the domestic growth theme in the US stock market.
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And here are the three main risks Goldman believes are associated with its top trades:
Three Main Risks: Bond Yields Up, China and Oil Down
As always, there are idiosyncratic risks surrounding our Top Trade recommendations. There are three ‘common’ or systemic risks to which our set of trades is most exposed:
Bond yields rising faster than we already anticipate: We are about to enter the first tightening cycle since 2004, following seven years of near-zero rates. At the micro level, the instruments through which the Fed intends to tighten policy (IOER, reverse repos, term deposit, run-down of the bond portfolio) and their interaction with regulatory constraints on financial intermediaries, are largely untested. At the macro level, the market-implied expectation of ‘terminal rates’ is unusually depressed (the forwards discount that US policy rates will be barely positive in 5 years’ time), and the term premium is close to zero.
Against this backdrop, the risk of negative shocks originating from the fixed income markets (ranging from liquidity dislocations to a rapid shift in duration risk) is hard to calibrate. We have confidence that the loopback effects for Fed policy (i.e., a shallower path for Fed Funds should financial conditions tighten excessively), against a global backdrop of low interest rates, would ultimately cap the increase in bond yields. But the path to the new equilibrium could be volatile. In terms of our recommended Top Trades, risk factor analysis suggests that our long US banks vs SPX, as well as long USD trade recommendations would stand to benefit from a rising USD yield environment, but historical comparisons may be less relevant given the exceptional starting conditions.
A further fall in commodity prices, in particular crude oil: Our Commodities team remains bearish on industrial metals, and has flagged a downside risks to their forecasts for crude oil in the near term given the high level of inventories. Should this risk materialize, this would drag headline inflation down, masking the acceleration in core CPI; hurt the RUB and MXN; amplify credit risk in US HY in other large oil producers; and, more broadly, increase risk premium across assets. Ultimately, one should not lose sight of the fact that lower energy prices represent, over the medium term, a transfer of savings towards advanced economies. The trades that are most directly exposed to a decline in crude oil are long US inflation and our EM FX basket.
A devaluation of the Chinese Yuan: The ongoing decline in industrial metals suggests that China’s ‘old economy’ remains in recession. Over the balance of 2016, a more pronounced and broader deceleration in China’s domestic demand than already embedded in our central forecasts could amplify pressures for a devaluation of the Chinese currency. After policy interventions, the offshore CNH is priced to weaken by a meagre 2.5-3.0% against the US Dollar over the coming 12 months. Should the Chinese authorities opt for a step adjustment in the currency’s peg to the Dollar, in order to regain room to cut domestic rates without losing reserves, deflationary pressures across the advanced economies could intensify. The goal posts for all Emerging Market FX crosses would also move, and another round of currency weakness ensue. To be clear, our central scenario envisages a fiscal expansion alongside structural reforms, and some monetary easing. We would see interventions on the currency as part of a redesign of the currency peg once the economy has stabilized. But this is admittedly one of the largest risks for asset markets over the year to come. Our EM FX basket trade is designed to hedge some degree of weakness in China and US rates increases, although in such an eventuality the broad EM complex would come under pressure and differentiation strategies are less reliable.
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With all that said, something tells us the best trades for 2016 will be to go short the Yuan, go short Oil, and short TSYs, while doing the opposite of the Top 6 trade recos. We will CIX this “basket” and revisit one year from now.
