[Premium] Q2 Playbook (Part 1/4)

In order to fully understand what's happening at the asset class level, below is the International and FICC portion of the playbook we published for US subscribers. This is important context as we outline the four major themes we're seeing. At the bottom of the post, we'll get into Indian-specific information about these themes and how we can take advantage of them.

In the section below we'll discuss the major themes in the Fixed Income, Commodity, Currency, and International Equity space. Rather than break them down into sections, we're going to break it down by theme/discussion and match the charts up where they best fit.

Discussion #1 - Rates & Inflation Expectations:

There are 2 primary pieces of information we want from the Bond market: Inflation/Growth Expectations and Risk Appetite. We'll break this discussion down into those two parts.

Inflation/Growth Expectations

Click on chart to enlarge view.

First, let's start with Rates on an absolute basis. Here's the US Five-Year Yield we've been watching for a long time. We made new all-time weekly closing lows for the last two weeks and remain stuck below long-term support/resistance near 0.55. If prices are below that, then the bias in Rates remains sideways to down.

On an ETF basis, the 20+ Year Treasury ETF (TLT) remains above its risk management level of 160, although the action remains choppy. With that being said, the 200-day moving average is rising and momentum has been in a bullish range since early 2019...so from any sort of intermediate to long-term perspective, the bias in Bond prices remains higher across the curve.

If Rates are falling/flat, that means growth and inflation expectations are also falling/flat.

We're also getting the same message from the ratio of short-term Treasuries relative to long-term Treasuries. Despite a bullish momentum divergence, this SHY/TLT ratio remains in a clear downtrend and is stuck below former support near 0.60. As long as prices are below that level, then short-duration Treasuries are set to underperform their longer-term counterparts.

This tells us inflation expectations continue to fall. If you're a market participant and you expect Interest Rates to continue to fall, how are you taking advantage of that? By owning long-duration Treasuries (or Zero-Coupon Bonds if you're better on pure price appreciation).

And it's not just a US phenomenon. Rates around the world, across Developed and Emerging Markets, remain depressed. It's unlikely that Rates in the US would decouple from these and begin to work higher while money continues to flow into Bonds globally. Here are just a few of the 10-Year Yields from various Developed countries around the world. Not much progress since the March lows...

From an Equity market perspective, let's look at some of the key ratios we track and see what they're saying about Interest Rate expectations going forward.

First is Regional Banks/REITs (KRE/IYR). This ratio confirmed a failed breakdown earlier in the year but is now back towards those lows. A break of support would signal that Equity market investors are positioning themselves for a lower Interest Rate environment by buying the sectors like REITs which benefit from lower rates and selling Regional Banks, which suffer.

The same can be said for Financials relative to the broader market, which are threatening to break below their 2009 lows. Hard to have a bull market in stocks with Financials crashing on a relative basis. They don't have to lead, but they at least have to participate.

Next on our list is the Copper/Gold ratio. The same positive correlation between this and inflation/growth expectation exists, so a break of this long-term support level would signal Commodity market participants positioning themselves for lower Interest Rates.

And then finally we're looking at Treasury Inflation-Protected Securities relative to similar duration Treasuries. If inflation-expectations were rising, we'd see the products that hedge against inflation being bought aggressively. We're not seeing that yet. Much like the ratios discussed above, prices have managed to hold above long-term support for the last few months, which is positive, but the long-term trend remains lower for now.

TIPs are attempting a breakout on an absolute basis, which would likely get its relative performance going as well. The level is 123.50. If TIP is above that, then the bias is higher.

The other reason we want to look at the Bond market is to identify the Risk Appetite of market participants. The Bond market is supposedly smarter than the Equity market, so if there are problems, the Bond market is likely the first to sniff it out.

Below we're looking at the ratio of High-Yield Bonds relative to similar duration Treasuries. Much like Copper/Gold and the other ratios we just discussed, prices bounced off of long-term support in March and are now pulling back. If there's true risk appetite in the Bond market, we'll continue to see High-Yield and other riskier forms of credit outperforming "safe haven" Treasuries.

Looking at US High-Yield Corporate Bond Options-Adjusted Spreads, we see a similar picture. All but one of them exceeded their 2016 highs in March, but have slowly pulled back and are now finding support at their 2018 highs. These spreads breaking to new lows and getting back below their 2018 highs would signal a continued improvement in risk appetite and be a positive for equities and other risk assets in general.

If risk appetite does continue to improve in the Bond market, the Investment Grade Corporate Bonds are likely to continue doing well too. If prices are above 132.80, the bias is higher towards 146.20 over the longer-term.

To conclude this section: Globally, Inflation/Growth expectations remain tepid from a longer-term perspective. As we discussed in this post in early June, a lot of the short-term improvements we saw in the charts above are being tested again today. Breaks of the levels outlined above will likely correspond with new lows in Rates. If/when that happens, we want to be buying the long end of the curve and "safe haven" Treasuries, as opposed to riskier forms of credit.

From a risk appetite perspective, the slight outperformance from riskier forms of credit and ability for High-Yield Credit Spreads to continue tightening is worth noting...but all of that could unwind very quickly if we do see a breakout in Treasuries once again.

Signals remain mixed at best in the short-term, but the weight of the evidence still remains in favor of Bond bulls (lower Rates) over the intermediate/long-term.

Discussion #2 - Commodity Update

So inflation expectations are weak, and that's not very surprising given Commodities as an asset class remain in a long-term downtrend on an absolute and relative basis. With that being said, we could be at a major inflection point as we are for Inflation...but it's too early to tell.

Here's the Equally-Weighted CRB Commodity Continuous Index testing its 2008 lows near 320 successfully and beginning to work higher. Great progress so far, but from a structural perspective, its series of lower highs and lower lows continues. We'd really need to see prices above 445 to confirm a long-term trend reversal from down to up...which is about another 20% higher than current prices.

We see a similar, but weaker perspective form the Thomson Reuters CRB Index which holds the same components but in a different weighting. It has a much larger weighting towards Energy and Agriculture Commodities, hence the weaker performance. With that said, even this chart held long-term support near 116.50 and is trying to work higher. It's a start.

Now that we know Commodities as a group have a lot of work to do structurally, let's look at a few uncorrelated opportunities that exist before we talk about the real story...Precious Metals.

Here's Natural Gas continuing to hold above 1.60 as momentum diverges positively. From a structural perspective, 1.60 is the level and we think erring on the long side makes sense. If prices can continue to dig in here and work higher, we could easily see prices back up towards 4 over the next 6-12 months.

Another interesting chart is Live Cattle, which is putting in its own failed breakdown and bullish divergence in the near-term. If prices are above 94, then the bias is higher towards the top of its multi-year range at 130. (h/t to our intern Louis for pointing this one out. Kid's got an eye.)

Orange Juice Futures remain in focus as well. Prices have worked off their bearish divergence over time and are attempting another breakout above resistance at 128. A weekly close above that level would likely signal the beginning of its next leg higher and target 215 over the next few quarters/years.

The last thing to note in the Commodity space to note is the strength in Lumber. I know most of you reading this aren't trading Lumber Futures or an ETF that tracks them, so instead we're looking at this chart as another risk appetite barometer. If the world is ending and global growth is collapsing, then Lumber likely isn't doing well. But it is. So that certainly diverges from the picture we're getting from Interest Rates regarding growth/inflation. More importantly, though, the correlation between Homebuilding stocks and Lumber if strong, so strength here would be a tailwind for a very important sector of the Equity market. (h/t Strazza for this one).

Now let's move into the real story, Precious Metals. We wrote about this in late June and said we were keeping it simple...and that approach continues to work, so I'd suggest reading that post in full if you haven't already.

Let's review things from a structural perspective.

If Gold is above 1,560, the bias is higher towards its former all-time highs of 1,920. As of today, we're about 100 points from that target...at which point we'll reevaluate and figure out our next upside objective.

And here's Gold across a variety of currencies. New highs across the board, basically.

Silver has been a laggard but is now starting to break above resistance at 19. This would confirm a breakout from a 6-year base and suggest the start of a new uptrend, just like we saw in Gold during the summer of 2019 (and we see what it has done since). More importantly, if Silver is breaking out, that'd likely provide a strong tailwind for the entire Precious Metals space. You can't have bull markets in metals without SIlver...so this breakout is a big deal.

The bias in Platinum remains higher towards 1,050 as long as prices are above 750.

Palladium is at risk of losing its position as a leader in the space but hasn't broken down yet. We wrote about it in early June, but it hasn't managed to make any upward progress despite strength in the rest of the space. With that said, its Bollinger Bands are extremely tight, showing prices are setting up for a strong move in one direction or another. If that happens to be down, then we need to question our thesis and focus on the other metals. For now, though, it's innocent until proven guilty.

If there is one chart you need your eye on right now, it's Silver. If prices break above 19, we'd expect some serious acceleration in the trend of Precious Metals as a group.

From an intermarket perspective, this chart of S&P 500/Gold and S&P 500/Treasuries is one of the most important charts out there. We want to own asset classes that are trending higher on an absolute AND relative basis, so how this resolves will be big for the second half of the year.

Base Metals have been improving, especially Copper, but we'll save that for the International Equities space as they're particularly important to the performance of Emerging Market Equities.

To conclude: Commodities still have a lot of work to do from a structural standpoint. Our focus remains on the Precious Metals space that is trending well and delivering strong returns, while also taking mean reversion type trades in rangebound markets like Natural Gas and Live Cattle.

Discussion #3 - US Dollar Topping?

The next discussion we need to have is about the US Dollar, which is on the verge of confirming a major top. In late May we took a simple, very long-term approach towards analyzing the Dollar and saw that it was still in a clear uptrend relative to the majority of the currencies we track it against. The problem is, since then its strength has deteriorated significantly.

Here's the Euro, which makes up 60% of the US Dollar Index. It has held long-term support near 1.05 with momentum in a bullish regime for years and is now beginning to work its way higher despite massive short positions from commercial hedgers. That remains a headwind, but as we've seen in other markets, hedgers have deep pockets and can often take a lot of pain before they're ultimately proven right. So for now, we're erring on the side of price, and long-term if prices are above 1.05 it's hard to be too bearish the Euro.

Here's a daily chart showing the significance of a breakout above 1.1450, which represents former support/resistance and the 38.2% Fibonacci Retracement of its 2018-2020 decline. Above that, and it looks like EUR/USD could be headed to 1.25 once again.

Then on the Emerging Markets front, we're also seeing weakness in the US Dollar. A month ago we outlined the Emerging Market Currency ETF at resistance, but after some initial weakness, prices are gaining momentum again and look to be attempting a breakout. Strength in this basket of EM currencies signals weakness from the US Dollar. A breakout above 17.75 would be huge and likely occurs in the same type of environment where EUR/USD is above 1.1450.

The reason this seems like a higher probability outcome today than a month ago is because of the reaction we're seeing in these currency pairs (or lack thereof!).

Here's the US Dollar/South African Rand pair retesting a major breakout near 16.50...and not continuing to the upside. If there was meaningful strength in the US Dollar we'd have seen this pair explode higher on a retest of the breakout level...not meander around it for weeks. And we're seeing the same across other currencies in this basket.

And then on the strength front, we have currencies like the Filipino Piso, which barely budged during the Emerging Market Currency selloff and is now pressing to new highs relative to the US Dollar. A break of 49 in the US Dollar/Filipino Piso ratio would be a big breakdown and suggest 20% downside is ahead in the quarters/years ahead.

And finally here's the US Dollar Index. Prices are testing this 96.00 level for the fourth time in about 1.5-years after failing to exceed the its 2016/2017 highs earlier in the year. If we get a weekly close below 96 (and a breakout above 1.1450 in the Euro/USD pair), then we can stick a fork in the US Dollar and look for downside towards 89 in the coming months/quarters.

To conclude: The US Dollar is at a clear inflection point here and its next direction will have major implications for International Equities (specifically Emerging Markets - See Discussion #4) and Commodities (specifically Precious Metals - See Discussion #2). Just as 19 is the key level in Silver, 96 in the Dollar Index and 1.145 in EUR/USD are the equivalents for this section.

Discussion #4 - International Equities Set To Outperform (Asia, EEM, Base Metals, etc.)

The last topic we want to look at is International Equities and the potential for Emerging Markets to outperform in the coming months/quarters.

First, we need to discuss the construction of the most popular indexes that track Emerging Market stocks, like EEM. In terms of geography, 41% of the fund is China, 12% is Taiwan, and 11% is South Korea...which combined is nearly 65% of the index. So we're going to focus on those three countries as we outline this thesis.

First, let's start with the Shanghai Composite, which appears to be starting another one of its "boom-bust" cycles. Base breakouts like the one we saw this week have led to massive rallies in the index over the last two decades, so our bet is this one is no different. As long as prices are above 3,000, then the bias is higher with an initial target at the 2015 highs near 5,200.

Here's a shorter-term view showing that breakout. If you want to be aggressive with your stops then 3,300 is the level, but if you want to give it room to work then as long as prices are above 3,000 we think weakness can be bought in this market.

Hong Kong is up next. Prices break below long-term support during the February-March selloff, stabilized, and are now breaking back above former support at 24,500. If prices are above that level, then the bias is higher and this failed breakdown could act as the catalyst for a move back towards its all-time highs near 32,000-33,500.

Next up is Taiwan, which is testing all-time highs. The level here is 12,500. If prices break above that level, it'd be a major structural breakout that signals a lot more upside ahead. And given the composition of this index, a breakout would likely correspond with continued strength in US Semiconductors and Technology as a sector.

South Korea is stuck former support/resistance near 295. Prices moving above that level would be a major structural breakout and target its all-time highs near 340.

Now that we know where these markets stand on an absolute basis, let's look at them relative to the S&P 500 using their respective US-based ETFs.

Here's Chinese A-Shares ETF ASHR, which tracks holdings of the Shanghai Composite, carving out a multi-year base and trying to resolve to the upside.

Here's Hong Kong, which is a laggard, but has been trying to stabilize near all-time lows as momentum diverges. A break above former support at 0.075 would help inspire confidence in this being a longer-term inflection point as opposed to a short-term pop within its downtrend.

Here's Taiwan carving out a multi-year base as well as momentum diverges, very similar to the action we're seeing in ASHR.

And then finally we have South Korea, which recently undercut long-term support and quickly reversed...confirming a failed breakdown and bullish momentum divergence. As long as prices are above their year-to-date lows, this thesis remains intact and the bias is sideways to higher.

And that brings us to the chart of Emerging Markets relative to the S&P 500, which undercut its post-ipo lows and quickly reversed as momentum diverged positively. A major inflection point?

Potentially, but it's also important to consider the factors that would have to be working for a mutli-year period of outperformance to exist here. We would need a sustained bull market in the Shanghai Composite (not a boom & bust cycle like the past two), a weak US Dollar, and continued strength in Base Metals and Commodities. The recent progress is a start, but it's still got a lot of work to do. With that said, from a short/intermediate-term perspective if we're above the year-to-date lows then we'd rather be long this ratio than short.

And here's Emerging Markets on an absolute basis. We're right smack in the middle of its longer-term 35.50 - 51.00 range. If the factors discussed above continue to work, then we'd expect an eventual retest of those highs near 51...but not an immediate structural breakout. Let's get to 51 first before and then we'll cross that bridge when we get there.

The last major factor we want to consider is Base Metals. Copper has been the clear standout, but when we look at an equally-weighted basket of the six major Base Metals, we see a much worse picture. Prices are still stuck below their breakdown level, so this retest is going to be very important information for us. Below the chart, you can see this index's rolling 63-day correlation with Emerging Market Stock ETF (EEM), which shows a strong positive relationship between them. In addition to the factors discussed above, Base Metals are a big deal for EEM.

To conclude: In the short-term, it appears that the strength in the Emerging Market Index's largest components is a major tailwind for prices on both an absolute and relative basis. With that being said, we'd expect its trend of relative underperformance vs the US to take many many quarters and potentially years to reverse completely and begin to trend higher.

Remember, these trends are driven by massive asset allocation shifts by investors all over the world...they cannot happen overnight. So it's important to know your timeframe here. If you're playing for the next quarter or second half of 2020, then Emerging Markets look like a good place to be, but if you're looking out years and years, the jury is still out on US Stock's outperformance relative to the rest of the world.

To repeat what I stated in the above paragraph, we'd need to see the following factors in order for a long-term trend of outperformance from Emerging Markets stocks to develop.

1. A sustained bull market in China's indexes and Asian markets like Taiwan & South Korea
2. Weakness in the US Dollar
3. Strength in Commodities, particularly Base Metals

As you can see, a lot of these themes tie together very closely from an intermarket perspective...so whether you care about that particular topic or trade on its own, I'd encourage you to read the entire thing as each has important context about the current market environment.

And if you were looking for the summary version of these four sections:

1. Inflation/growth expectations remain weak
2. Precious Metals remain the key trend we're taking advantage of in Commodities
3. The weight of the evidence is shifting towards a major top in the US Dollar
4. Emerging Markets may outperform in the near-term because of several factors

Now, let's get into the India-specific portion of the International Equities/FICC section of our playbook.

Inflation - Inflation expectations in India appear to be as weak as those around the globe.

Here are the 10-Year Yields among the BRICKS nations of Brazil, Russia, India, China, South Korea, and South Africa. Mixed at best, with three pressing towards new lows, two pressing higher, and one flat. Combine that with what we're seeing in Developed Markets and the theme of lower yields globally seems intact.

And in India, Rates across all segments along the yield curve continue to make new lows. Money continues to flow into Bonds.

From a Commodity perspective, things are similar to the US. Several uncorrelated trades present opportunity, but Precious Metals (and Copper) remain the real story.

Here's Crude Oil, which we're monitoring from a risk appetite perspective. If prices can break above resistance near 3,100, that would be positive for Equities and other risk assets. With that said, if prices are stuck below 3,100 and/or break below 2,725, that would be a meaningful headwind.

Here's Natural Gas, which continues to build a base above long-term support at 115. If prices are above that level, then the thesis for a breakout above 145 and move towards 205 remains intact.

Here's Jeera, which we continue to watch. A breakout above 14,200 would signal the start of a move towards 18,250, while a breakdown below 13,200 would signal the start of further downside forwards 11,250.

Turmeric continues to test support near 5,300. A break of 5,000 would signal a clear breakdown and get us short with a long-term target near 3,400.

Copper has successfully broken out above 470. That is a significant structural breakout that signals further upside towards 576. Some consolidation would be nice given how far it has come from the March lows, but if we're above these former highs, then the bias remains higher.

Gold continues to work in India, as it does in most currencies around the globe. From a structural perspective, as long as prices are above 44,500, the bias is higher towards 56,840.

From a short-term perspective, our next upside objective in Gold is 50,500, where we'd expect some sort of consolidation before continuing higher.

Just as Silver is breaking out in US Dollars, its breakout in Rupees continues. As long as prices are above 48,000, the bias is higher towards 58,100.

From a currency perspective, if the US Dollar is topping...where does that leave the Rupee?

As we outlined in this post earlier in the week, USD/INR is at risk of confirming a major failed breakdown and bearish momentum divergence if it closes below 74.50.

The reason this is looking more and more likely to confirm is that prices have tried to break out several times and failed miserably. A break below 74.50 would be a big level and signal the start of a move towards 69.

Meanwhile, EUR/INR continues to consolidate below 86.50. A breakout above that would signal the continuation of the pair's long-term uptrend, targeting 101.50 over the coming years.

Here's JPY/INR also pressing up against resistance near 0.715. A breakout above that level would signal the start of a move towards 0.838, but for now, prices are rangebound with 0.67 being the lower bound.

And here's GBP/INR which continues to trade sideways. Nothing to do until prices break above 97, which would signal the start of a move towards 104.

Equities in the US and globally remain mixed to positive. With that as our context, let's move into Indian Equities at the index level.

Here's the Equally-Weighted Develop Market Index we've created, which held long-term support in March and is now pressing back towards its 2018 highs. Equities remain innocent until proven guilty.

The Equally-Weighted BRICKS chart looks the same.

Here's the ratio of the two, showing BRICKS outperforming Developed Markets over the last couple of months.

Although India has rallied a bit relative to its peers, this chart still looks very vulnerable from a longer-term perspective.

Moving into the major indexes. We've spoken about the tactical levels that would warrant getting more defensive in the Equity market, but from a structural perspective the levels remain very clear for our "New Bull Market Thesis" to remain intact.

For the Nifty 50, as long as prices are above 10,000, then the bias is higher towards all-time highs (12,450).

The Nifty Next 50 level we're paying most attention to is 25,000. If prices are above that, then the bias is higher towards 28,500.

Mid-Cap stocks need to say above 14,000 for the long-term thesis to remain intact, but above that, the bias is higher towards 18,000.

And here's the Nifty Small-Cap 100. The bullish thesis remains intact above 4,300, with a longer-term upside target of 6,500.

The other point we want to make is that it's hard to be too bearish Equities as an asset class if the largest 10 stocks in the Nifty 500, which account for roughly 43% of the index, are trending higher. As the chart below shows, prices have reclaimed support near 900, so the bias here remains higher.

Here's the Nifty 500 also trying to reclaim its 200-day moving average (which remains downward-sloping for the time being). A transition from a bearish trend to a bullish one isn't usually a V-Shape, so we'd expect some volatility along the way. With that being said, the weight of the evidence remains positive.

The last major theme we're watching in India and globally is Small-Caps outperforming Large-Caps. We've not seen sustained outperformance from Small-Cap stocks since January 2018, but that changed a couple of weeks ago. As long as prices of this ratio are below 2.30, Small-Cap outperformance is likely to continue, which is supportive of risk assets.

And here's the ratio of Small-Caps vs Large-Caps in the US at a potential inflection point.

To conclude, the weight of the evidence continues to point towards higher prices for Equities around the globe and in India. There will be corrections and consolidations along the way, but it does not appear that the conditions which permit large-scale declines as we saw in January-March currently exist. Rotation into more of the cyclical areas of the market and continued expansion of participation will fuel the next leg higher. If we don't see that play out, then we'll have to reevaluate our bullish thesis.

That's it for Part 1. Check out the Trade Ideas Page for a summary of the actionable ideas from this post...and be sure to read all four parts for our full outlook.

Read Part 1, Part 2, Part 3, and Part 4 for our full outlook, and please let us know if you have any questions.

Allstarcharts Team