|By Matein Khalid| While the S&P500 fell only 1.2% last week, things will get uglier in April and May. Fed chair Yellen is playing with fire in talking down US interest rates and inflation risk. The Volatility Index (VIX), Wall Street’s barometer of greed and fear, does not capture the rising global financial and political risks at only 15. Market breadth, sector divergence, smart money flows, sentiment, leadership, bank shares and negative distribution stink. Earnings will contract at least 8% as margins sag. The yen is at 108. Valuations are expensive at 17.4 times earnings that will contract, not grow in 1Q 2016. As M.C. Hammer once put it, can’t touch this!
Investors should expect volatility to rise in the second quarter as there is a disconnect between the strong US data momentum (457,000 new jobs in February and March 2016 alone with the PCE inflation gauge at 1.7%!) and Janet Yellen’s rhetoric. The financial markets have de-rated global growth projections, the reason Uncle Sam’s ten year note trades at a mere 1.70%. Yet the next twist in US inflation and interest rates is higher, as regional Fed presidents Lacker, Williams and Bullard protested in their call for a April FOMC rate hike, a public rebuke to Dr. Yellen. This is bad news for global equities.
The Doha meeting between Saudi Arabia and Russia will decide if Brent crude falls back to $30 or resumes its epic short covering rally. The US Dollar Index is also at critical support levels at 94. This is the reason I have turned negative on the near term prospects of the Canadian dollar and Asian/Brazil currencies. Negative interest rates, a malaise in Abenomics and the yen shock have slammed Japanese equities by 15% for US dollar investors while Brazil and Canada, with their mining/energy tilt were the two stock markets and currencies to own since February 11.
Europe has been disaster in the past month, as the Euro has risen to 1.14 and inflation expectations have plummeted, leading to a bear market in European banks/insurers. A Black Death in global financial stocks, the largest sector in the world, is not exactly a positive omen for global equities. Nor is the softness in Chinese PMI and metrics of global trade.
This is only the surge in emerging Asia’s currencies and is unsustainable, a clear opportunity to make money by shorting the Thai baht, Malaysian ringgit, South Korean won, Japanese yen and Chinese yuan. I am more sanguine on the Indian rupee, which I would buy at 67 for a 64 target, as the Union Budget clearly gives Dr. Rajan space for monetary easing, though a rise in the CPI above 5% precluded a 50 basis point rate cut in April. Indian rate sensitive stocks remain stellar value buys even as Modi’s crackdown on tax evaders and offshore black money (Netaji McMansions in phoren lands, as the Panama Papers reveal, are not easily hidden!).
Strong economic data, the oil rally and monetary sweet nothings led to the 230 point rally in the S&P500 from its February 11 bottom. Yet I doubt if April will be so benign to American equities, as China, crude, credit, currency (dollar) and contagion (the five deadly ‘C’s!) that inflicted such havoc on global markets in January resurface again. I expect the dethroned King Dollar to rise as Wall Street prices in a June rate hike. The Philly Fed data argues that US manufacturing has bottomed while the consumer economy, 70% of GDP, is on a roll. The US consumer price index has begun to rise above 2% and wage growth is the next macro trend that will spook the bond market. The rebound in stock prices in March was driven by short covering, not real money and fresh positioning.
The second successive week of declines in US equities despite s snapback in crude oil puts the onus on first quarter corporate earnings/guidance. The threat of intervention by Japan’s Finance Minister has also hit the yen bulls at 108, which makes the Japanese stock market a value buy at TOPIX 1250 after its recent brutal correction. The easy money in Russia, Brazil, India and Philippines equities in 2016 is now over. Argentina’s $12 billion sovereign jumbo deal is a historic win for the center-right President Macri after decades of Peronist misrule. The peso devaluation, subsidy reform, the “holdout” legislation, a credible anti-inflation program. Like the Obamas, time to tango on the Rio Plata, though only at a 8% yield, por favor!
Currencies – Is the Canadian dollar finally overvalued?
I recommended buying the Canadian dollar at 1.46 since the loonie was grossly undervalued after eighteen months of consistent selling in the global currency markets. In fact, this column had recommended buying the US dollar against Canada way back in spring 2014 at 1.06 on the eve of the oil crash. I now believe the Canadian dollar is overvalued relative to West Texas crude at 1.29. Why?
One, the speculative short position as the loonie bottomed in late January at 1.46 is now virtually wiped out. This is the reason the Canadian dollar surged so dramatically in the past eight weeks, though the 40% rally in West Texas crude and positioning for Justin Trudeau’s pro-growth Ottawa budget provided ample fundamental ballast to the rally. However, at 1.29, the Canadian dollar has “overshot” its fundamentals, now that its entire losses since October 2014/January 2015 have been recovered.
Two, the Canadian dollar’s correlations to West Texas crude have only risen since the 2014 oil crash began, a testament to its role as Planet Forex’s most liquid G-10 petrocurrency. However, Saudi Arabia linked any output cuts to Iran, which refuses to even negotiate an output freeze now that US sanctions are lifted. This limits the upside in West Texas crude – and the loonie.
Three, Ottawa’s fiscally expansionary Federal budget (deficit spending is not a dirty word for the Liberals and M Trudeau) and an uptick in domestic growth data relative to consensus justified the epic move in the Canadian dollar. Yet these macro factors are fully priced in the Canadian dollar at 1.29 – 1.30. The Bank of Canada now fears loonie appreciation from current levels as it will hit manufactured exports. In any case, the Bank of Canada has warned that the condo building binge in Vancouver and Toronto is a speculative bubble, that Canadian housing is overvalued by 30% and consumer debt a time bomb. The Canadian government estimates Trudeau’s rise in Federal spending will boost growth 0.5% in fiscal 2017 and fiscal 2018.
Yet wage growth is still mediocre and the economic malaise in Alberta, Manitoba Saskatchewan and the mining enclaves of British Colombia has now begun. The fall in the Canadian dollar will give a boost to manufacturing, as will US auto component/timber demand. Still, epic household debt is a sword of Damocles on Canadian consumer confidence and spending. This means the Bank of Canada will fear additional loonie strength.
Four, Canada’s core inflation rate is now 2%, thanks to the pass through impact of the free fall in the Canadian dollar since 2014. This will not lead to any central bank rate hike in 2016 as the Bank of Canada is far too worried about the contraction in Alberta/mining states. However, as the Bank of Canada pauses while the FOMC raises interest rates this summer, US/Canada interest rate spreads argue the loonie depreciates to 1.36. No free fall but no more rocket bull run either.
Five, despite Dr. Yellen’s dovish warnings, February and March payrolls saw the creation of 457,000 new American jobs, a symbol of accelerating growth momentum in the US economy. The Euro’s current rally is unsustainable given dismal EU growth rates, banking woes, geopolitical risks (migrants, Greece, Ukraine, terrorism), deflation and Brexit risk. While Mario Draghi ruled out more deposit rate cuts, 80 billion Euros in bond purchases and credit easing in the corporate bond markets is hardly a steroid shot for Euro bulls. Brexit could be a political and economic disaster for the EU and will trigger hot money outflows from the Old World this summer, as will the grim reality of negative interest rates. I believe the Euro is once again a short at 1.15. Hence my strategy call to take profits to my fellow loonie bulls.
My strategy call to accumulate the Russian rouble at 78 was, in retrospect, a winner. At 67, the Russian rouble now trades at a four month high against the US dollar, thanks to the oil price spike and King Dollar’s pause once the Yellen Fed dissed its own phony dotplot! Yet I can see the rouble depreciate to 72 this summer if Saudi Arabia refuses to cut output at Doha on April 17th and global risk assets are spooked by either Brexit or the Republican convention circus.
Stock Pick – Biogen is a global neurology disease colossus!
If there was a recurrent theme in American equities in 2015-16, it was a swift, outsize return in hated, underperforming sectors. Oil, gold and mining shares prove this point since late January 2016. The biotech sector has been gutted on Wall Street since last summer, having lost almost 40% from its highs on fears that the Clinton White House would crack down on drug pricing and stunt the industry’s profit machine. The 2012 – 2015 biotech bull market had made this sector a fabulous winner, as I had pointed out a dozen times in successive strategy columns on Gilead, Biogen, Celgene, Regeneron, Roche and Amgen. The sheer scale of the biotech selloff has derated the industry’s valuation metrics and growth expectations, now trading at their lowest levels since 1995.
Since I believe Hilary Clinton is destined to be the 45th President of the United States in November as Donald Trump’s monstrous ego destroys the Republican Party, I concede that a political assault on aggressive drug pricing will feature in Uncle (or more accurately, Aunty!) Sam’s agenda in 2017, the 5 point valuation multiple derating on biotechs is entirely rational.
Yet the biotech sector now trades at a 25% discount to the broad market even though it can well deliver 15% EPS growth in the next decade. Valuation is never an infallible timing sector in a notoriously high beta sector and I would still avoid biotech where revenue growth is hostage to aggressive, exorbitant price increases in a handful of life and death drugs. I must disclose a non-financial soft spot for immune – oncology shares since I believe these companies could well deliver a cure for humankind’s ancient enemy – cancer. While I am skeptical about a S&P500 index that has soared 230 points since its February 2016 bottom, I believe compelling value now exists in some of the sector’s blue chips.
Biogen (symbol BIIB) is one of the world’s most innovative biotech companies and its shares have plummeted from a 52 week high of $400 to $265 now. Biogen is the world’s de facto “multiple sclerosis” monopoly, with a 40% market share in a $20 billion global market for MS therapies. Wall Street believes MS growth will decelerate due to fewer untreated patients and competitive therapies. True, MS therapies are no less than 80% of Biogen sales and undervalues its pipeline of future neurodegenerative disease therapies notably Alzheimer’s and Parkinsons disease/spinal muscular atrophy. At $265, Wall Street assigns zero value to the Biogen’s drug development pipeline. Wall Street is wrong, though I concede pricing pressure will hit Biogen’s existing MS drugs but three FDA approvals could create new multi-billion dollar growth markets. Alzheimers disease is the ultimate killer app in biotech and Biogen’s therapy could well be the compound that wins the prize. Biogen has $6 billion in cash, a billion dollar hemophilia franchise, a lucrative agreement with Roche on the oncology drug Rituxan and innovative intellectual property in gene therapy. Drug pricing politics has led to only 4% price increase for Tecfidera and Avonex. I expect the buy/sell range on Biogen is 230/380 in 2016.
The Wall Street biotech grapevine contends that Medivation (symbol MDVN) is in play as a takeover candidate, with Gilead, Sanofi and Amgen reputed to be among the suitors. While Medivation management has not shown any public desire to do a deal, the biotech bloodbath has made it a far cheaper acquisition candidate. The company has hired Wall Street merger & acquisition defense specialists as strategic advisors, notably J.P. Morgan. There are few more juicy takeover targets on NASDAQ than midcap biotechs. Medivation shares surged 20% on takeover speculation last week.
There is no doubt that merger mania will be a major theme on Wall Street in 2016 as megacap biotechs are cash rich and looking at deals to boost revenue/pipeline growth since small cap biotechs have fallen 35 – 45% from their highs. There is at least $180 billion in deal firepower for biotech M&A next year and small cap, early stage biotech relative valuations are, to channel Colonel Sanders of KFC, finger lickin’ good. Look for earnings positive companies with potential blockbuster drugs in prostrate cancer, leukemia or gene therapy in FDA Phase Three trials.
