In addition to its three previously announced so far “Top Trades” for 2014 (see here, here and here), just over an hour ago Goldman revealed its fourth top recommendation to clients. To wit: Goldman is selling China equities (via the HSCWI Index), while buying copper (via Dec 2014 futs), or at least advising its flow clients to do the opposite while admitting that “for the long China equity/short commodity pair trade to “work” best, these two assets, which are usually positively correlated, will have to move in opposite directions.” For that and many other reasons why betting on a divergence of two very closely correlating assets will lead to suffering, read on. Finally – do as Goldman says, or as it does? That is the eternal question, one whose answer is a tad more problematic since the author in this case is not Tom Stolper but Noah Weisberger.
From Goldman Sachs
Top Trade Recommendation #4: Long China equities/Short Copper
• We introduce our 4th Top Trade Recommendation for 2014:
• Long China equities via the HSCEI Index vs. a short copper position via Dec 2014 LME futures.
• We set an initial target of +c.25% on the combined position, and a stop loss of –c.13% on the combined position.
• This trade highlights several important features in our 2014 set of market views:
• the expected 2014 acceleration in global growth,
• the desire to own equity risk,
• the importance of EM differentiation,
• the positive market implications of China growth stability,
• and commodity price downside generated by seemingly abundant supplies.
1. Market round up
In Friday’s short US market session, the S&P 500 broke thru the 1810 level, only to retreat into the (early) close and finish down a fraction on the day. European equities were mixed, with the DAX up a touch, but most other markets down. And the USD continues to strengthen, particularly relative to EM currencies.
Overnight, HSBC PMI in China was a touch stronger than expected and the official PMI print was unchanged from the previous month. In Australia, building approvals were much stronger than expected in October and remain the one bright spot in the non-mining economy; however, the recovery in the housing investment sector remains insufficient to offset our forecast for contraction in the mining investment sector. As such we continue to expect economic growth to slow to 2.0% in 2014 and for the RBA to ease interest rates 25 bp by March. Today, the final print of the November PMI for the Euro Area is released too. In the US, we expect the ISM index to be slightly higher than markets expect (we forecast 55.5 vs. consensus at 55).
This week, there are seven MPC meetings: Euro Area, UK, Canada, Australia, Norway, Mexico, and Poland. In each case we and consensus expect no major announcements and the central banks to stick to the current monetary policy stance. On Friday, the Nonfarm Payrolls for November is going to be closely followed. We are expecting employment gains to be a touch below consensus (GS +175k, consensus +183k, last +204k).
2. Top Trade Recommendation Number 4: Long China equities/Short Copper
In today’s Global Markets Daily, we introduce our 4th Top Trade Recommendation for 2014: Long China equities via the HSCEI Index vs. a short copper position via Dec 2014 LME futures. Given that the volatilities of these two assets are similar, we recommend implementing this trade with equally sized positions in the two assets, with an initial target of +c.25% on the combined position, and a stop loss of –c.13% on the combined position.
Our China Equity Strategy team has a year-end target of 13600 for the HSCEI (+c.19% from current levels), and our Commodity Strategy team has an end-2014 copper price forecast of $6,200/mt (-c.13% from current levels, with the Dec 2014 LME future a bit above spot, suggesting some positive carry from a short position here too), making our combined target of +25% a bit more modest than the two separate forecasts would suggest.
This trade highlights several important features in our 2014 set of market views: the expected 2014 acceleration in global growth, the desire to own equity risk, the importance of EM differentiation, the positive market implications of China growth stability, and commodity price downside generated by seemingly abundant supplies.
This long equity/short commodity trade is a way of isolating exposure to China equity risk via a long HSCEI position, which we think is underpriced by the market given our views of stable growth and ongoing rebalancing there, while the copper short hedges out exposure to China’s economic growth, which we think will be stable but not stellar. Short copper, which is typically highly correlated to China growth outcomes and China equities too, has the added advantage of being an asset that we think will likely be facing headwinds of its own over the course of the year, with the short position potentially adding to the positions’ expected returns, and not just a hedge against unanticipated outcomes.
3. Stable China may be good enough, EM differentiation to continue
Core to our 2014 views is that global real GDP growth will accelerate a touch, from 2.9% in 2013 to 3.6% in 2014. Nearly all of that pick-up is coming from DM economies, with our views there most clearly above consensus. EM economic growth, on the whole, is expected to be stable, with growth in China forecast at 7.8%, up only a tenth of a point from 2013. Our China Economists have argued that external acceleration will help to mitigate ongoing domestic rebalancing. And on top of that, the set of reforms announced earlier this month have the potential to keep China on a steady path forward, toward a further strengthening of their underlying economic fundamentals.
While acceleration and stellar China growth per se, is not at the heart of our forecasts, external strength and stability at home ought to be enough to boost risk sentiment in China, particularly after several years of poor performance from Chinese equity indices. Chinese equities are about flat, year to date, have underperformed for much of the last several years, are well below pre-crisis highs (though those levels may be unattainable in the near term), and are also still below post-crisis, mid-2010 highs. Our Asian Equity Strategy team, which has an Overweight recommendation in the HSCEI, sees scope for multiple expansion in China and 10% EPS growth there. Importantly, China equity exposure seems to be fairly light in the data we monitor (Asian-focused funds are still significantly underweight China), which further suggests to us that very little “China upside” has been priced.
Underscoring the importance of EM differentiation, a core market view, this top trade recommendation is motivated by China risk optimism relative to a more downbeat view as priced by markets. But this is not a broader EM growth story. As such, implementation is very specific too. In the past, we have argued that a wide swath of assets – equity sectors, commodities, and commodity producing EM equity indices – all have outsized exposure to China growth. However, China equity risk, not growth, is the view we are expressing. Hence, our choice of trade implementation is long China equities directly, via the HSCEI index.
4. Commodity downside risks grow
One asset that has, historically, been correlated to China growth is copper. A short copper position paired with long China equities, is one way of focusing our trade on the “risk” aspect of the equity market, while hedging out the growth aspect. Moreover, despite its usual positive correlation with China equities, we expect copper prices to face pressure this year, forecasting a decline in price to $6200/mt from about $7070/mt currently, owing primarily to abundant supply and a lack accelerating demand, even as we expect risk sentiment to boost China equities themselves.
Expectations of copper price headwinds also underscore the headwinds that we think commodity producers may be facing in the coming year. Sectors like metals and mining and energy, and equity indices with outsized commodity exposure like Brazil, and even Canada are also likely to face headwinds too. Commodity-intensive equities may benefit somewhat from a broad improvement in equity sentiment; outperformance of commodity-linked cyclical assets is less likely given the headwinds for commodities themselves.
5. Some risks to the top trade recommendation
We are cognizant of several risks to this Top Trade recommendation. First, and foremost, for the long China equity/short commodity pair trade to “work” best, these two assets, which are usually positively correlated, will have to move in opposite directions. These two assets have, since late October, already started to move apart. And the assumption from here is that “mean reversion” will be supplanted by fundamental forces pushing in opposite directions– a preference for China equity risk, amid supply-side driven downside commodity pressures, will continue to prevail.
Should China growth prove more robust than we anticipate, it is possible that both copper and China equities will respond, pushing both higher. If so, trade performance will depend on the relative size of those moves higher, and returns will likely be more attenuated than current expectations. Another possible effect of stronger-than-anticipated China growth could be further a tightening of financial conditions there, which could be an incremental headwind to the equity leg of the trade. This possible configuration of macro shocks is, in some ways, the worst possible outcome for this particular trade recommendation, with better growth outcomes supporting copper, tightening financial conditions, and damaging equities.
Finally, we are also concerned that part of the China risk optimism that we anticipate is predicated on the proposed reform agenda helping to stabilize the anticipated path forward from here. While, ultimately, the success of these reforms will only be proven in the course of the next several years, near-term sentiment could be damaged if there is any backing away from the proposed set of reforms, or if those proposals generate political or public dissatisfaction.
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