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Highlights Inflation: Inflation will trend higher this year, but at a measured pace. The impact of a tight labor market and accelerating wage growth will be mitigated by deflating import prices. Even if the economic recovery remains on track, year-over-year core PCE inflation is likely to still be below the Fed's 2% target by the end of this year. Yield Curve: With core inflation still low, the Fed will be quick to back away from its rate hike plans if there is any indication that inflation might reverse its uptrend. This supports a bear-steepening of the yield curve and the continued outperformance of TIPS versus nominal Treasuries. Spread Product: Excess returns to spread product are not likely to turn deeply negative until core PCE inflation is above 2% and Fed policy becomes more focused on halting inflation than supporting the recovery. We retain a neutral allocation to spread product in our portfolio. Feature Chart 1A Sustainable Recovery After seven years of false starts and disappointments, a durable recovery in inflation is finally under way (Chart 1). The key difference between the current uptrend and prior episodes of rising inflation - such as those witnessed in 2011 and 2014 - is that this time around most labor market indicators suggest the economy is very close to full employment. For this reason the recovery in core inflation is likely to persist, and will eventually settle at a level close to the Fed's 2% target for core PCE. That being said, it is still far too soon for investors to worry about inflation, particularly as it relates to the performance of risk assets. The remainder of this report discusses why the recovery in inflation is likely to be slow moving, and also how the inflation outlook impacts our major fixed income investment calls. Some Near-Term Headwinds There are two reasons why year-over-year measures of core inflation are likely to moderate during the next three months. First, diffusion indexes for both CPI and PCE inflation have recently dipped below the zero line (Chart 2), meaning that more components of each index have decelerating prices than have accelerating prices. Historically, rising year-over-year core inflation has been associated with diffusion indexes above zero. Second, January and February of last year saw incredibly large price increases in both core CPI and core PCE (Chart 3). This means that gains in January and February of this year will also have to be very strong to overcome the large base effect and cause the year-over-year growth rates to move higher. Chart 2Diffusion Indexes Point To Deceleration Chart 3A Large Base Effect In Jan & Feb Now these are only very short term arguments. The base effects will be out of the way by March and diffusion indexes can reverse course very quickly. However, they do suggest that inflation readings are likely to be relatively weak during the next few months. This will be critical for the near-term path of monetary policy and, in our view, makes it likely that the Fed will keep rates steady until the June FOMC meeting. The Phillips Curve Chart 4A Phillips Curve Model Of Inflation Turning to the longer run outlook for inflation, we employ a Phillips curve model of core PCE inflation based on one that Janet Yellen referred to in a speech from September 2015.1 In this framework, the year-over-year change in core PCE inflation is modeled using: Lagged core inflation Inflation expectations (from the Survey of Professional Forecasters) Non-oil import price inflation relative to core PCE inflation Resource utilization (calculated as the difference between the unemployment rate and the Congressional Budget Office's (CBO) estimate of the natural rate of unemployment) The model does an excellent job capturing changes in core PCE inflation since 1990 (Chart 4), and is also useful because it gives us a glimpse of the mental framework that Fed policymakers apply to the task of inflation forecasting. Most importantly, the model allows us to generate inflation forecasts given estimates for inflation expectations, the unemployment rate and the U.S. dollar (which closely tracks relative import prices). For example, in a base case scenario where we assume that inflation expectations and the dollar remain flat, but that the unemployment rate declines from its current level of 4.7% to 4.5% by the end of this year, the model predicts year-over-year core PCE inflation will rise from its current level of 1.65% to 1.87% by November, still below the Fed's 2% target. If we keep the same forecast for a steadily declining unemployment rate but also incorporate a 5% increase in the value of the trade-weighted U.S. dollar, then core PCE inflation is projected to rise to 1.76% by November. The stronger dollar means that import prices exert a bit more of a drag. Conversely, if we keep the same unemployment assumption but assume that the U.S. dollar depreciates by 5%, then core PCE inflation is projected to reach 1.98% by November. In this scenario import prices actually provide a slight boost to core inflation. Overall, to create a scenario where core inflation reaches the Fed's target before the end of this year we need to make a fairly optimistic assumption about the unemployment rate and also incorporate a substantial dollar depreciation. In our view, it is more likely that the dollar remains under mild upward pressure this year as the U.S. economy continues to de-couple from the rest of the world. Fiscal policy remains the wildcard, as any protectionist measures implemented by the new U.S. government could lead to import price shocks. Although at first blush any watering-down of trade deals, imposition of tariffs, or protectionist tweaks to the tax code would seem likely to send import prices higher, much depends on how much of the adjustment to the new trade policy occurs through the exchange rate or through prices. This is incredibly hard to determine until the details of any protectionist trade measures are known. Our Global Investment Strategy service explored the potential ramifications of one such trade proposal - a border-adjusted corporate tax - in a Special Report published last week.2 A Bottom-Up Perspective An alternative to the Phillips curve approach is to split core inflation into its major sub-components: shelter, core goods and core services excluding shelter. We can then examine each sub-component separately and identify different macro drivers for each (Chart 5). Shelter has been the strongest contributor to core inflation so far in this recovery and can be modeled using home prices, the rental vacancy rate and household formation (Chart 5, panel 1). Based on these relationships, we expect shelter inflation will remain elevated for quite some time, while our model suggests it is even likely to move a bit higher during the next few months. After briefly seeming like it might rebound earlier last year, the rental vacancy rate has since fallen to new lows while home price appreciation continues at a steady rate of just above 4% per year (Chart 6). Further, the vacancy rate should remain under downward pressure and home prices under upward pressure as long as household formation continues to outpace home construction. The top panel of Chart 6 shows that the difference between housing starts and household formation closely tracks the rental vacancy rate. The vacancy rate rose throughout the 1990s and early 2000s as housing starts outpaced the creation of new households, but starts have not been sufficiently robust so far in this recovery. In addition, housing inventory as a percent of households is near the lows of the early 1990s (Chart 6, bottom panel). This inventory calculation includes the "shadow inventory" from foreclosed homes which has almost normalized back to pre-crisis levels, in any case. Chart 5The Components Of Core CPI Chart 6Drivers Of Shelter Inflation We expect that shelter inflation will remain elevated at least until housing construction starts to outpace the creation of new households, but will moderate once that supply response starts to emerge. Chart 7Atlanta Fed Wage Growth Tracker* ##br##Versus Unemployment Rate Core goods inflation (Chart 5, panel 2) has been, and will continue to be, the major source of deflation in this cycle. A large fraction of core goods are imported and, as such, core goods inflation tends to follow the trend in the U.S. dollar. The bull market in the U.S. dollar will continue to keep a lid on core goods prices, and will limit how quickly inflation can rise. Any meaningful increase in inflation this year is likely to come from the core services excluding shelter component, which historically tends to track fluctuations in wage growth (Chart 5, bottom panel). As we have previously highlighted, the labor market is close to full employment and the relationship between the unemployment rate and wage growth remains strong (Chart 7). In this environment, even modest further declines in the unemployment rate should exert meaningful upward pressure on wages. Bottom Line: Inflation will trend higher this year, but at a measured pace. The impact of a tight labor market and accelerating wage growth will be mitigated by deflating import prices. Even if the economic recovery remains on track, year-over-year core PCE inflation is likely to still be below the Fed's 2% target by the end of this year. Investment Implications Duration & TIPS Chart 8Leading Inflation Indicators & Breakevens Long-maturity TIPS breakeven inflation rates still have upside, although the rate of increase is unlikely to maintain its current rapid pace. As core inflation converges with the Fed's target so should long-dated measures of inflation expectations such as TIPS breakevens. Historically, core PCE inflation close to 2% has coincided with long-dated TIPS breakevens in a range between 2.4% and 2.5%. With the 10-year breakeven currently at 2.05%, we expect it has another 35 to 45 basis points of upside. Measures of pipeline inflation pressure, such as producer prices and the prices paid and supplier deliveries components of the ISM manufacturing survey also point to rising breakevens (Chart 8). We continue to recommend an overweight allocation to TIPS versus nominal Treasury securities. With rate hike expectations still relatively depressed,3 real yields do not have much downside. Rising breakevens should therefore also pressure long-dated nominal yields higher in the months ahead. While we currently recommend a benchmark duration stance, we are actively looking for an opportunity to shift to below-benchmark duration, as was discussed in last week's report.4 Yield Curve As breakevens and nominal yields move higher the yield curve should also steepen (Chart 9). The strong positive correlation between the slope of the yield curve and TIPS breakevens is the result of the impact of Fed policy on both variables. Chart 9Wider Breakevens Correlated With A Steeper Yield Curve Fed policy tends to be accommodative in the early stages of a recovery, and this causes the yield curve to steepen and breakevens to widen as investors logically expect that easy money will cause both growth and inflation to move higher. In contrast, the yield curve tends to flatten and breakevens tend to fall later in the recovery once Fed policy turns more restrictive. Chart 105-Year Bullet Still Cheap Given that core inflation and TIPS breakevens both remain below the Fed's targets, it is too soon to expect a shift toward restrictive Fed policy. In other words, the Fed will be quick to back away from its rate hike plans if there is any indication that breakevens or inflation might reverse their uptrends. It is only once core inflation and TIPS breakevens have returned to the Fed's targets that the stated purpose of Fed policy will shift from supporting the recovery to snuffing out inflation. To profit from a steeper yield curve we entered a long 5-year bullet short duration-matched 2/10 barbell trade on December 20. So far this trade has returned 14 bps, and the 5-year bullet continues to look very cheap on the curve (Chart 10). Spread Product In prior research we considered the performance of spread product throughout the four phases of the Fed cycle (Chart 11).5 We define the four phases of the Fed cycle as follows: Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Chart 11Stylized Fed Cycle Using a very simple estimate of the equilibrium fed funds rate based on potential GDP and a long-run moving average of the funds rate itself, we have found that excess returns to investment grade corporate bonds are highest in phase IV and phase I, when the fed funds rate is below equilibrium (Table 1). However, the key problem with this analysis is that it is very difficult to estimate the equilibrium fed funds rate in real time. As stated above, the estimate used in Table 1 incorporates the CBO's estimate of potential GDP which is frequently revised after the fact. So while we are confident that we are currently in phase I of the Fed cycle, the challenge becomes looking for other indicators that might warn us about the transition from phase I to phase II, where excess returns are much worse. We have found that core PCE inflation is one such indicator. We calculated average monthly excess returns to investment grade corporate bonds when year-over-year core PCE inflation is below 1.5%, between 1.5% and 2%, and between 2% and 2.5% (Table 2). Table 1Investment Grade Corporate Bond Excess Returns* Under The Four Phases##br## Of The Fed Cycle (August 1988 To Present) Table 2Investment Grade Corporate Bond Excess Returns* Under Different Ranges##br## For Year-Over-Year Core** PCE (August 1988 To Present) The results show that the highest returns occur when inflation is below 1.5%. This should not be surprising since an environment of low inflation is most likely to coincide with phase IV of the Fed cycle. We found mixed results for when inflation is between 1.5% and 2%. In this environment average monthly excess returns are close to zero and a 90% confidence interval places them between -19 bps and +17 bps. This environment likely encompasses phase I of the Fed cycle and the transition into phase II. It is not until core PCE inflation is above 2% that excess returns turn decisively negative. Monthly excess returns average -13 bps in this environment, with a 90% confidence interval of -35 bps to +10 bps. With inflation likely to remain between 1.5% and 2% for the balance of the year, it is too soon to turn all-out bearish on spread product. For the moment we recommend a neutral allocation, but with an underweight allocation to high-yield bonds where valuations are exceedingly tight. Given that inflation is low and Fed policy is accommodative, we would be quick to upgrade both investment grade and high-yield corporates on any near-term sell off. The current uncertainty surrounding fiscal policy also complicates the outlook for spread product. On the one hand, it raises the risk of a near-term sell off if it appears as though some of the more stimulative aspects of Trump's agenda will not be implemented. On the other hand, in addition to headline-grabbing promises of increased infrastructure spending, there are many other policy details that could also have significant market implications. One example would be the elimination of the tax deductibility of corporate interest expenses. Such a provision is currently included in the Republican's plan for corporate tax reform, and would severely diminish supply in the corporate bond market if it is implemented. Bottom Line: Excess returns to spread product are not likely to turn deeply negative until core PCE inflation is above 2% and Fed policy becomes more focused on halting inflation than supporting the recovery. We retain a neutral allocation to spread product in our portfolio. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 http://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 2 Please see Global Investment Strategy, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017", dated January 20, 2017, available at gis.bcaresearch.com 3 The overnight index swap curve is priced for 54 basis points of rate hikes during the next twelve months. 4 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Investment Strategy / U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27, 2014, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Special Report Dear client, We have received several questions about a potential U.S. border tax adjustment. Peter Berezin, Senior Vice President of BCA's Global Investment Strategy service addresses this issue in the attached Special Report titled, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017". Peter analyses the economic and financial market implications of the plan and concludes it is likely to be an additional support to the dollar bull market should it be implemented in full. We trust you will find this report very interesting and relevant. As always, please do not hesitate if you have further questions. Best regards, Lenka Martinek Highlights House Republicans are pushing for a radical overhaul of the existing tax code, including adding a "border adjustment" mechanism that would effectively subsidize exports and tax imports. Despite President Trump's apparent mixed feelings about border taxation, we see a 50% chance that some version of the proposal will be implemented. This is a higher probability than the market currently is discounting. The trade-weighted dollar will rally by another 5% even in the absence of any tax changes, but could rise by 15% if the border adjustment tax is introduced. If the latter were to happen, it would take some time for the dollar to rise to its new equilibrium level. This, in conjunction with sticky import and export prices, would likely lead to a temporary narrowing of the U.S. trade deficit. Such an outcome could prompt the Fed to raise rates more aggressively than it otherwise would. Investors should underweight U.S. bonds on a currency-hedged basis. A stronger dollar will push down commodity prices and hurt external borrowers with dollar-denominated loans. A protectionist backlash against the U.S. might ensue. We are closing our long Chinese banks trade for a gain of 32%, and our long RUB/USD trade for a gain of 20%. Feature Making The Tax Code Great Again? Republicans in Congress are proposing an ambitious revamp of the tax code. A central element of their plan is the replacement of the existing corporate income tax with a so-called "destination-based cash flow tax." Key features of this plan include: Cutting the current federal corporate tax from a top rate of 35% to 20%. Allowing businesses to depreciate capital expenditures immediately, rather than writing them off over many years. Disallowing businesses from deducting interest expenses when calculating their tax bills. Moving to a system of territorial taxation, meaning that taxes would only be assessed on the value added of goods consumed in the United States. Since not all goods that are produced in the U.S. are consumed in the U.S., and not all goods that are consumed in the U.S. are produced in the U.S., a destination-based system requires what is known as a "border adjustment." Such an adjustment would tax the value added of imports and rebate the value added of exports at an equivalent rate. While border adjustments are routinely used in other settings - most notably by countries that have VATs - their application to corporate income taxes is a novel idea. As such, it is not surprising that the proposal has generated significant confusion among investors. With that in mind, we offer our thoughts on the matter using a Q&A format. Q: How exactly would a border adjustment on corporate income taxes work? A: Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred in the U.S.). Table 1 offers a simplified example to illustrate this point. Consider three types of companies: 1) A purely domestic producer whose revenues and costs are realized at home; 2) An exporter whose revenues are entirely derived from abroad but whose costs are all incurred in the U.S.; 3) An importer whose revenues are completely generated in the U.S. but whose costs are all incurred abroad. Suppose that all three companies have revenues of $100 and costs of $60 - implying $40 in pre-tax profits - and face a corporate tax rate of 20%. Before the border adjustment, each company would pay a tax of $8 ($40 times 0.2). The border adjustment is zero for the domestic producer. However, it would impose an additional tax of $12 on the importer ($60 times 0.2), while giving the exporter a rebate of $20 ($100 times 0.2). In the end, the importer and exporter face final tax bills of $20 and -$12, respectively, while the domestic producer continues to pay $8. Note that this conforms with the tax paid on domestic revenues minus domestic costs (for the domestic producer, domestic revenue minus domestic cost is equal to $40; for the exporter it is equal to -$60; and for the importer, it is equal to $100). Q: A tax on imports and a subsidy on exports? Sounds like massive protectionism! A: That depends on the extent to which the dollar appreciates. As Table 1 shows, if the dollar appreciates by 1/(1-tax rate) = 1/(1-0.2) = 25%, there would be no impact on the trade balance or on the distribution of after-tax corporate profits in the economy. This is because the stronger dollar would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits to their original level. Q: This seems like splitting hairs. If a country imposes a 20% tax on imports, most people would still regard this as a protectionist act, even if a currency appreciation offsets the impact. A: That's why a corresponding export subsidy is necessary. That may sound strange since export subsidies are also seen as protectionist measures, but consider the following: Imagine that the government only taxes imports. A tax on imports would curb import demand, implying less demand for foreign currency. This would push up the value of the dollar, leading to lower import prices. How high would the dollar go? Suppose it rose so much that the decline in import prices exactly offset the tariff, thereby restoring import volumes (and importer profits) back to their original level. Is that a stable equilibrium? The answer is no because a stronger dollar would also reduce the demand for U.S. exports, causing the trade deficit to swell. Thus, for the trade balance to remain unchanged, the dollar would have to rise only part of the way, leaving importers worse off than before the tariff was introduced. Such a policy would be protectionist because it would favor U.S.-based companies that produce for the domestic market over foreign exporters. Only in the case where importers are subject to a tax and exporters receive a subsidy will the dollar strengthen to the point that neither exports nor imports change. Intuitively, this is because an export subsidy indirectly benefits importers by pushing up the value of the dollar, while directly benefiting exporters by offsetting the effect of a stronger dollar on profits. Q: If there is no change in the trade balance, what is the advantage of border-adjusting the corporate income tax? A: Contrary to Donald Trump's assertion that border adjustments are "too complicated," their chief advantage is their simplicity. Accurately assessing taxes on worldwide income is hard. Companies routinely engage in practices that purposely lower taxable profits. In particular, importers may overstate the value of their imports and exporters may understate the value of their exports. In a world where many companies have overseas subsidiaries, such "transfer pricing" machinations are easy to pull off. Border adjustments eliminate such incentives in one fell swoop. Recall that with a border adjustment, taxes are assessed on the difference between domestic revenues and domestic costs - both of which the IRS has the means to monitor. Yes, a U.S. company that overstates imports will be able to report a lower gross profit to the IRS, but now it will be on the hook for a higher import tax. What it puts in one pocket it takes from the other. Likewise, an exporter that understates its overseas sales will end up with a lower gross profit, but will now receive a smaller subsidy. Q: And I suppose that because the U.S. imports more than it exports, the border adjustment will end up raising additional revenues? A: That is correct. The annual U.S. trade deficit currently stands at $500 billion. A border adjustment tax rate of 20% would thus raise $100 billion in additional revenue. Given that the corporate income tax brings in about $350 billion, this would allow corporate taxes to be substantially cut without any loss in overall revenue. And this calculation excludes any indirect revenue that would accrue to the Treasury from reducing the incentive for U.S. companies to engage in profit-shifting behavior. Keep in mind, however, that the revenue boost from the border adjustment will decline if the U.S. trade deficit narrows over time. To the extent that the U.S. must finance its trade deficit through the sale of assets such as stocks, bonds, and property, it is possible that foreigners will one day decide to swap all these assets in exchange for U.S. goods. This would lead to an improvement in the U.S. trade balance. Indeed, to the extent that the U.S. is a net debtor to the rest of the world, it is possible that the average future U.S. trade balance will be positive. If that were to happen, the government would lose revenue from the border adjustment over the long haul. Meanwhile, a 25% appreciation in the greenback would reduce the dollar value of the assets that Americans hold abroad, without much of a corresponding decline in U.S. external liabilities. A reasonable estimate is that this would impose a paper loss on the U.S. of about 13% of GDP.1 Q: Ouch! But this assumes that a 20% border adjustment tax will lead to a 25% appreciation in the dollar. That is a mighty big can opener your fellow economists are assuming! What's to say this actually happens? A: Good point. Less than 10% of the turnover in the global foreign exchange market is directly related to the cross-border trade in goods and services. The rest represents financial market transactions. There are many things that can influence the value of the dollar beside trade flows. For example, suppose the government introduces a border adjustment tax, but the Federal Reserve fails to raise rates sufficiently fast in response to rising inflation stemming from a narrowing trade deficit. In that case, U.S. real rates could actually decline, leading to a weaker dollar. Our sense is that this won't happen, but the point is that there is no automatic link between a border tax and the dollar. Much depends on how the Fed responds and the underlying economic conditions. And even if the Fed does hike rates to keep the economy from overheating, two important forces will limit the extent of any dollar appreciation: First, questions about the timing and magnitude of the border adjustment tax - including the possibility that such a measure could be reversed by a future Congress - are likely to lead to only a partial appreciation in the dollar. Second, other central banks - particularly in emerging markets - are liable to take steps to limit the dollar's ascent so as not to place too great a burden on borrowers with dollar-denominated debt. Q: So what happens to countries with hard currency pegs to the dollar? Borrowers with dollar-denominated loans will be spared, but won't these countries end up suffering due to a sharp loss of competitiveness against other economies that have more flexible currencies? A: Correct. It is damned if you do, damned if you don't. Assuming that countries with exchange rate pegs to the dollar are strong enough to fend off a speculative attack, they will still need to engineer an equivalent real depreciation of their currencies via a decline in their nominal wages relative to U.S. wages - what economists call an "internal devaluation." That could impose a deflationary impulse on those economies. Q: You're losing me. A: Think about an extreme case - one where all countries have currency pegs to the dollar. How would the economic adjustment to a U.S. border tax work then? The answer is that initially, a tax on U.S. imports, combined with a subsidy on U.S. exports, would lead to a smaller trade deficit. This would cause the U.S. economy to overheat, putting upward pressure on prices and wages. By definition, an improving trade balance in the U.S. implies a worsening trade balance in the rest of the world. This would sap demand in other countries, putting downward pressure on prices and wages abroad. The adjustment will be complete only after relative wages have shifted enough to restore the U.S. trade balance to its original level. The important point is that in a world where some countries have flexible exchange rates while others have fixed exchange rates or dirty floats, the economic adjustment to a U.S. border tax will come through some combination of a stronger nominal dollar, higher U.S. inflation, and lower inflation abroad. Q: Bullish for the dollar, but bearish for U.S. bonds, correct? A: Precisely. The degree to which bond yields adjust around the world depends on the extent to which nominal exchange rates and domestic prices are sticky. If exchange rates are slow to change, more of the adjustment has to occur through higher inflation in the U.S. and lower inflation everywhere else. But even if nominal exchange rates adjust quickly, sticky goods prices would still push up U.S. bond yields. To see this point, consider what would happen if the dollar appreciated by 25% in response to the introduction of a border adjustment tax, but neither import prices nor export prices (expressed in U.S. dollars) changed. If that were to happen, the profit margins of U.S. importers would tumble because they would now have to pay an import tax but would not benefit from lower import prices. Meanwhile, the margins of U.S. exporters would soar as export prices stayed firm and they received a subsidy from the government. The result would be less imports and more exports, and hence, an improved trade balance. This would raise U.S. aggregate demand and put upward pressure on inflation and Treasury yields. Considering that 97% of U.S. exports and 93% of U.S. imports are denominated in dollars, such an outcome is hardly far-fetched. The bottom line is that in the "real world," the introduction of a border adjustment tax would cause Treasurys to sell off and the dollar to rally. Q: What sort of numbers are we talking about? A: Assuming a 20% border tax is introduced, a reasonable guess is that the trade-weighted dollar would rise by 10% over a 12-month period above and beyond our current forecast of a 5% gain. This would imply 15% upside from current levels. The 10-year Treasury yield would probably rise to about 3%. Q: It still puzzles me how you can claim that bond yields will rise if the dollar strengthens. Wouldn't a stronger dollar normally lead to lower bond yields? A: Your premise is wrong. It is not the stronger dollar that leads to higher bond yields. It is a third factor - namely the improvement in the trade balance arising from the decision to tax imports and subsidize exports - that causes both the dollar and bond yields to rise. This is similar to what happens when the government loosens fiscal policy. Mind you, at some point the positive correlation between the dollar and bond yields could break down. If the dollar rises too much, emerging markets will crumble under the stress. This will trigger safe-haven flows into the Treasury market, leading to a stronger dollar and lower yields. Such an outcome is not our base case, but it cannot be dismissed. Q: Got it. Presuming that the global economy holds up, it sounds like a border tax would be great news for Boeing, but bad news for Walmart? A: Yes, but there are two important qualifications to consider. First, it is possible that the dollar overshoots its new long-term equilibrium level, so that the pain to Boeing from the appreciation of the greenback ends up outweighing the benefits from the export subsidy it receives. Second, given the potential economic and financial dislocations from the shift to a destination-based tax system, there is likely to be some delay between when the tax bill is signed into law and when it is implemented. And even once implementation begins, the adjustment in tax rates may be phased in only gradually. Since the dollar will rise in anticipation of all this, it is possible that exporters will actually suffer initially, while importers receive a temporary boost to profits. Nevertheless, we think that investors will see through the near-term hit to exporter margins and focus on the medium-term gains. As such, equity investors should maintain a preference for exporting companies over those that heavily rely on imports (Chart 1). Q: This assumes that the market has not fully priced in this outcome already. What are the chances that this border adjustment tax proposal actually sees the light of day? A: The border tax idea originated in the House of Representatives and has its strongest support there. There might be more opposition in the Senate, but this could be overcome if enough Democrats with protectionist leanings can be found. President Trump panned the idea in an interview with the Wall Street Journal earlier this week.2 He noted that "Anytime I hear about border adjustment, I don't love it... because usually it means we're going to get adjusted into a bad deal. That's what happens." Trump's comments suggest he may not fully understand how border adjustments work. This implies that he might be persuaded to go along with the idea if Republican legislators are able to reach a "great deal" on adjustments in his eyes, whatever that means. Subjectively, we would assign 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. This might entail excluding certain types of imports from a border tax if they are consumed disproportionately by the poor or represent an important input for U.S. manufacturing firms. Apparel and energy products would probably be on that list. It might also entail reducing the border adjustment tax to a lower level, say 10%, as Tom Barrack, head of Donald Trump's inaugural committee, has suggested. It is hard to know how much of this is already reflected in asset prices. The dollar fell after the WSJ article was published, but that may have had less to do with border adjustments and more to do with Trump's comment that he prefers a weaker dollar - an unprecedented statement for a U.S. president. Goldman Sachs' securities group has constructed two baskets using firm-level data, one comprised of "destination tax winners" and the other of "destination tax losers."3 The loser basket actually outperformed in the immediate aftermath of the election. While the relative performance of the winner basket has recovered more recently, it still remains below where it was last April (Chart 2). The limited reaction to the prospect of a border adjustment tax has been echoed in the fact that market expectations of the future volatility of the dollar has not changed much since the election, despite the possibility that the coming legislative debate could lead to wild swings in the greenback (Chart 3). Chart 3Dollar Volatility Has Not Escalated On balance, we conclude that investors are understating the likelihood of even a watered down border adjustment tax being introduced as part of a comprehensive tax reform program. This is broadly consistent with our client discussions, which have revealed that most investors - with a few notable exceptions - are only vaguely aware of the issue. Q: Won't the WTO rule against a border adjustment tax? That could explain why investors are discounting it. A: Yes, it probably will. The WTO permits border adjustments in the case of "indirect" taxes such VATs, but not in the case of direct taxes such as income or corporate profit taxes. Granted, the U.S. has brushed off WTO decisions in the past, such as when it ignored the trade body's ruling that U.S. laws restricting internet gambling contravened the General Agreement on Trade in Services. Considering that Donald Trump threatened to pull the U.S. out of the WTO during the election campaign, such an outcome cannot be easily dismissed. Nevertheless, given the magnitude of the border tax issue, even the Trump administration is likely to think twice about running afoul of WTO rules. Nevertheless, it might be possible to modify the border adjustment proposal to make it WTO-compliant. The distinction between direct and indirect taxes is one of those things self-styled experts like to pretend is important, but is not. It does not really matter whether a tax is levied on the sale of a good or service, or whether it is levied on income. In the end, someone has to pay the tax - be it a worker or a shareholder. The adoption by the U.S. of a border-adjusted destination tax would move the global economy in the direction of greater harmonization, not away from it. As noted at the outset, most other countries border adjust their value-added taxes. They do this so that their VATs mirror a consumption tax, as Table 2 illustrates with a simple example. Conceptually, a corporate cash flow tax coupled with a payroll tax functions in much the same way as a VAT (bottom part of Table 2). The U.S. already has both a corporate income and a payroll tax, so it is not that far away from having a VAT. All that is missing is a few tweaks to depreciation rules and the addition of the border adjustment. Yes, the dollar would strengthen if that were to happen, but this would put the greenback on par with other currencies. Chart 4 shows that the U.S. has run a trade deficit with the rest of the G7 since 1990, despite the fact that the dollar has traded on average 9% below its Purchasing Power Parity (PPP) over this period. One of the reasons this has occurred is that other G7 economies have a VAT, whereas the U.S. does not (Chart 5). This has kept the dollar weaker than it otherwise would have been. Chart 4The Dollar Was Cheap For A Reason Q: Okay, let's wrap this up. What are the main investment implications I should take away from this? A: Our main takeaway is that investors are underestimating the likelihood that the U.S. adopts a destination-based tax system. This suggests that the risks to the dollar are to the upside, as are the risks to U.S. Treasury yields. Global investors should underweight U.S. bonds on a currency-hedged basis. The implications for global equities are more nuanced. It may take some time for the dollar to adjust to the border tax. This, combined with the fact that import and export prices tend to be sticky in the short run, implies that the U.S. trade deficit will decline, boosting U.S. aggregate demand in the process. While that is potentially good news for U.S. corporate profits, the benefits will be curtailed by the fact that the U.S. economy is approaching full employment. This means that any further stimulus could simply result in higher real wages for workers without any offsetting increase in unit sales for U.S. companies. A shrinking U.S. trade deficit will diminish America's role as "the global consumer of last resort." This is problematic for export-dependent emerging markets. While a border adjustment may be justifiable on economic grounds, politically, it could be seen as the first volley in a global trade war. This could sour sentiment towards EM stocks. To make matters worse, a stronger dollar would harm emerging markets with high levels of dollar-denominated debt such as Turkey, Malaysia, and Chile, while also weighing on commodity prices. We recommend that investors underweight EM stocks relative to their DM counterparts. With these considerations in mind, we are closing our long Chinese banks trade for a gain of 32% and our long RUB/USD trade for a gain of 20%. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 U.S. external assets amount to 133% of GDP, while foreign liabilities stand at 175% of GDP. About 68% of U.S. external assets are denominated in foreign currency, compared with only 16% of external liabilities. Thus, the paper loss to the U.S. from a 25% appreciation in the dollar would be (175*0.16-133*0.68)*(1-1/1.25) = 12.5% of GDP. 2 Please see "Donald Trump Warns On House Republican Tax Plan," The Wall Street Journal, dated January 16, 2017, available at www.wsj.com. 3 The Bloomberg tickers for these baskets are GSCBDTW1 and GSCBDTL1. For more information, please see "US Daily: What Policy Changes Is The Equity Market Expecting?" Goldman Sachs Economic Research, dated January 11, 2017.
Highlights Portfolio Strategy Media stocks are poised to challenge previous relative performance highs as sales growth reaccelerates. Stay overweight. The materials sector has lagged behind the commodity price rally, a sign of underlying weakness rather than latent strength. Chemicals overcapacity will remain a headwind until U.S. competitiveness improves. Stay clear. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) Feature The broad market has been very strong since the November election. While advance/decline lines have firmed, participation in the rally has been uneven and may be fraying around the edges. For example, the number of groups trading above their 40-week moving average has been diverging negatively from the broad market in the last few months, suggesting diminishing breadth (Chart 1). In fact, the industrials (I) and financials (F) sectors have carried the market since November. Other deep cyclical sectors, such as energy, materials and tech, have mostly matched market performance. The 'IF' rally is based on an expected upgrade to the economic growth plane that matches the surge in various sentiment gauges. If validation does not occur, then the IF rally will become iffy indeed, unless sector breadth improves. Last week we showed that market cap-to-GDP was so far above its long-term average that even if nominal growth boomed at 8% per annum for the next five years this valuation ratio would still not have normalized. That valuation backdrop may not upend additional short-term market momentum, but it is a true measure of just how bullish sentiment has become and should be a critical input to the portfolio construction process, because of its warning about divergences from fundamental supports. Another unconventional sentiment gauge is observed from sub-surface market patterns. Chart 1 shows that the number of defensive groups with a positive 52-week rate of change, in relative terms, is in freefall, plunged to virtually nil. In the last two decades, investors eschewing capital preservation and non-cyclical sectors so aggressively has typically preceded major market peaks (Chart 1). The steep drop in the put/call ratio confirms that euphoria and greed are trumping mistrust and fear. The put/call ratio has recently bounced, but is well below levels that signal investors are accumulating significant portfolio protection. The Fed's tightening bias, contracting U.S. dollar-based financial liquidity amid the strong U.S. dollar all threaten to keep a lid on corporate sector sales prospects. As such, we remain biased toward non-cyclical and consumer sectors, even excluding fiscal policy uncertainty. Chart 2 shows that these areas are in a base-building phase, in relative terms, following their post-election drubbing. We expect momentum to steadily build toward sustained outperformance by midyear. Conversely, a reversal in the 'IF' sectors already appears to be developing, while other capital spending-dependent sectors are unable to gain momentum (Chart 3). This week we highlight both a winning group and an area we expect to disappoint. Chart 1The Rally Is Fraying Around The Edges Chart 2Defensive Base-Building? Chart 3Cyclical Sector Distribution New Highs Ahead For Media While the consumer discretionary sector has a poor track record during Fed tightening cycles, the S&P media sub-component can buck this trend. Media stocks outperformed in the second half of the 1990s and also trended higher in the 1980s while the Fed was tightening. The key was the U.S. dollar (Chart 4). As long as the dollar was strong, media companies sustained a profit advantage over the rest of the corporate sector owing to limited external exposure. A replay is currently playing out, and has the potential to persist for at least the next few quarters based on upbeat cyclical indicators. Media sales growth is in recovery mode. Consumers have significantly boosted spending on media services, as measured by personal consumption expenditures data (Chart 5). Pricing power has surged in response to demand strength (Chart 5, bottom panel). In turn, strong demand is boosting measures of productivity: our proxy for sales/employment is accelerating toward the double-digit growth zone (Chart 5). Productivity is diverging positively from relative forward earnings expectations, implying there is room for a re-rating. As long as the U.S. economy is growing, media companies should be able to garner an increasing share of consumer wallets. Chart 6 shows that real spending on media services has been in a steady uptrend for well over a decade, reflecting its ability to continually innovate, only pausing during recessions when consumers are forced to retrench. Typically, a rise in spending pulls up pricing power (Chart 6). Chart 4Media Stocks Like Dollar Strength Chart 5Sales Are Set To Accelerate Chart 6Secular Strength All of this has spurred a recovery in media cash flow growth (Chart 7, top panel). Relative performance and cash flow move hand-in-hand. Rising cash flows also imply that the media sector can further reduce shares outstanding through buybacks and/or M&A activity (Chart 7), bolstering ROE. The S&P movies & entertainment index has been one of the driving forces behind the broader media index recovery. We upgraded the former to overweight after the vicious selloff related to Disney's ESPN woes and the takeover saga at Viacom had pushed the index to an undervalued extreme. While slightly early, this upgrade is now paying off (Chart 8). The expectations hurdle remains surmountable. Both forward earnings and sales growth estimates are deeply negative (Chart 8), reflecting the well-known cooling in cable subscriber growth. But even here, there is room for potential upside surprises. Consumer spending on recreation has been growing at a low single-digit clip, but the surge in consumer confidence, courtesy of rising wage growth and a positive wealth effect from rising real estate and financial asset prices, should support increased discretionary consumer spending. The message from the jump in the ISM services index is bullish for recreation spending (Chart 9, second panel). Chart 7Shareholder-Friendly Chart 8Cheap With Low Expectations Chart 9Still Early In The Recovery In turn, faster spending would support ongoing pricing power gains (Chart 9). The industry is already sporting one of the most robust selling price increases of all that we track, as advertising rate inflation is growing anew. Importantly, real outlays on cable services have recovered after a steep decline (Chart 9), suggesting that the drag from disappointing cable subscriber growth and cord cutting may be easing. Less churn implies more pricing power. Content cost inflation also remains under wraps. The implication is that the fundamental forces to propel a retest of previous relative performance highs are in place. Technical conditions are also sending a bullish signal. Cyclical momentum, as measured by the 52-week rate of change, is on the cusp of breaking into positive territory (Chart 9), while the share price ratio has already crossed decisively above key resistance at its 40-week moving average. A dual breakout would confirm a new bull trend. Bottom Line: Media stocks have good odds of retesting previous relative performance highs as discretionary consumer spending perks up. Stay overweight the overall media group, and the S&P movies and entertainment index in particular. Chemical Stocks: A Toxic Portfolio Blend The commodity price recovery has not carried over into the S&P materials sector, as relative performance has been moving laterally for much of the last twelve months. Rather than view this as an opportunity to play catch up, the more likely outcome is that the sector has missed its chance to outperform. In fact, downside risks have intensified. The strong U.S. dollar will exact a toll on U.S. exporters, particularly if emerging markets and China do not experience accelerating final demand. While there has been a massive amount of stimulus in China over the past 18 months, the thrust of that impulse is fading. Fiscal spending growth has dropped sharply and the authorities trying to cool rampant real estate speculation. The yield curve remains flat (Chart 10), as local funding costs rise on the back of the authorities attempt to mitigate capital outflows, and loan demand remains weak. Persistent weakness in the Chinese currency may reflect a lack of confidence in local returns, i.e. sub-par growth. All of that argues against expecting a major impetus to raw materials demand, at a time when the materials sector total wage bill is inflating more aggressively. Our Cyclical Macro Indicator for the materials sector is hitting new lows (Chart 10), heralding earnings underperformance, underscoring that below-benchmark allocations remain appropriate. The S&P chemicals group represents for than 70% of the overall materials market cap. It has underperformed since its peak and our underweight call in 2014, pulled lower by the soaring U.S. dollar and sagging industry productivity (Chart 11). Net earnings revisions have been consistently revised lower over the past few years, and are unlikely to recover without a reflationary push (global real yields are shown inverted, second panel, Chart 11) that revives chemical final demand. Analysts have latched on to the firming in global purchasing manager survey sentiment, aggressively pushing up sales growth expectations in recent months (Chart 12). Clearly, manufacturing sector expansion is expected to reverse the contraction in chemical output growth (Chart 12). Chart 10Higher PMIs Are Not Enough Chart 11Higher Yields Are A Bad Omen Chart 12Expectations Are Inflated However, this may be yet another case of analysts chronically overestimating the industry's earnings power. Global manufacturing improvement seems likely to accrue mostly to firms outside the U.S. Chart 13 shows that chemicals relative performance is heavily influenced by the U.S. dollar. Valuations and sentiment are tightly linked with chemical export growth (Chart 13), as the latter represent 14% of total U.S. exports. The U.S. dollar surge is diverting orders away from U.S. manufacturers: German chemical new orders have surged, and the IFO survey of chemical industry executives signals optimism about the future (Chart 14). Chart 13The Dollar Is Hurting The U.S. ... Chart 14... But Helping Foreign Competitors U.S. executives appear to be equally confident, but that optimism is misplaced. The American Chemical Council expects U.S. chemical exports to increase 7% a year through 2021. Over $170B is expected to be invested in U.S. chemical manufacturing capacity, representing nearly 25% of the total industry size, which is anticipated to boost the chemical trade surplus to new records. So far, roughly $76B of projects has either been completed or is under construction. If these planned projects all come to fruition, our concern is that new capacity will be idle rather than productive. The industry is in the crosshairs of anti-globalization and protectionism, and a strong U.S. dollar and rising domestic cost structures threaten to reduce competitiveness. Chemical imports are a fairly large portion of sales, rendering profitability vulnerable should an import-tax ever be introduced. From a cyclical standpoint, deflationary pressures are already very acute. Chemical capacity is growing much faster than production, warning that pricing power will be under significant pressure (Chart 15). Many chemical products are destined for interest rate-sensitive end markets such as autos, underscoring that a Fed tightening cycle is a headwind. While capacity expansion was planned when interest rates and feedstock costs were expected to remain at rock bottom levels for the foreseeable future, this is no longer the case. Chemical companies can either use natural gas (ethane) or oil (naphtha) as a primary feedstock. U.S. production is largely ethane-based, while global capacity is geared to naphtha. Rising U.S. natural gas prices are undermining the U.S. input cost advantage (Chart 16). Chart 15Persistent Deflation Pressures Chart 16U.S. Cost Structures Are Unattractive Increased capacity has also put significant upward pressure on wage costs, as our proxy for the total wage bill is rising at a high single-digit rate (Chart 16). With capital spending slated to stay robust in the coming years, it will likely continue to take a larger share of sales, impairing profit margins. While the planned merger between heavyweights Dow Chemical and Dupont may eventually help to rationalize costs, this is a necessary but not sufficient step in the face of a loss of global market share. Without accelerating sales, U.S. chemical makers will be hard pressed to improve productivity sufficiently to reverse the slide in relative forward earnings estimates. Bottom Line: The S&P materials sector hasn't been able to outperform during a period of improving global manufacturing activity, raising doubts about its performance potential when global output growth inevitably slows. Part of this reflects the challenging outlook for the sector heavyweight chemicals index, and we recommend staying underweight both. The symbols for the stocks in this index are: BLBG: S5CHEM - APD, ARG, CF, DOW, EMN, ECL, DD, FMC, IFF, LYB, MON, MOS, PPG, PX, SHW. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
Dear client, This week, we are sending you an abbreviated version of our weekly bulletin as we are also publishing a piece written by our colleague Peter Berezin, Senior Vice President for our Global Investment Strategy service. This report, titled “U.S. Border Adjustment Tax: A Potential Monster Issue For 2017”, deals in great details with the Republican tax plans. In this report, Peter analyses the economic and financial market implications of the plan and concludes it is likely to be an additional support to the dollar bull market if it gets implemented in full, but not one without repercussions. I trust you will find this report very interesting and relevant. Best regards, Mathieu Savary Feature After continuing to sell off, the dollar regained some composure toward the end of the week. Not only did an elevated CPI print for December contribute to this rally, but so did Fed Chair Janet Yellen's comment that the U.S. economy was getting closer to the FOMC objectives and that the Fed was now closer to being capable of raising rates multiple times a year between now and 2019. Chart 1Froth Had Dissipated##br## From Treasury Yields Additionally, we had been expecting a correction in the dollar as we worried that U.S. bond yields would retrace some of their ascent. The pullback materialized and U.S. bond yields traded in line with our fair value estimate earlier this week (Chart 1). This meant that much of the froth in the dollar had dissipated. Based on these developments, is it time to buy the dollar again? On a cyclical basis, the dollar will make new highs in 12-18 months. However, short-term considerations remain complex. There are two President Trump out there: "Good Trump" and "Bad Trump". Good Trump is a president that talks about deregulation and tax cuts as well as various stimulus measures. This is the president that turbo charged the dollar after the election on hopes of a stronger U.S. economy. Bad Trump is the campaign Trump, the populist president that wants to revive protectionism and that promotes acrimonious international relations between the U.S. and the rest of the world, China in particular. The markets had expected Good Trump to be the first Trump to emerge, yet, the new president seems to have elected to present his Bad Trump profile first. In a way, this makes sense. Trump is focusing on the more economically painful parts of his program, campaign promises wanted by his electorate. This way, Good Trump can swoosh in and save the day by helping the economy closer to the mid-term election in late 2018, in the aim of solidifying the Republican control of Congress. With the 10-year yield back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is not pricing in any flare up of tensions with China, nor any deflationary shock that could emanate from such tensions (Chart 2). Investors were hoping that the talks of stimulus and deregulation would come first, instead they are getting a president that bullies corporations and build up tensions in Asia. The deflationary nature of the tension comes from the reality that while the Chinese economy has improved, China remains handicapped by a large debt load and a low demand for credit. It is ill equipped to handle foreign shocks. Moreover, the easing in Chinese monetary conditions will soon lose steam. Chinese monetary conditions eased because Chinese real rates fell from nearly 12% to -2% on the back of a powerful rebound in the Chinese producer prices (PPI) (Chart 3). This improvement in PPI was itself a byproduct of a rebound in commodity inflation. However, this rebound is soon behind us. Commodity prices troughed in Q1 2016, and have recently slowed their pace of ascent. This means that in the coming months, Chinese PPI will rollover as well and Chinese real borrowing costs will rise again (Chart 4). Chart 2All Must ##br##Go Well Chart 3Can Chinese Monetary ##br##Conditions Improve Further? Chart 4The Commodity Rebound Was A Key Factor##br## Behind The Chinese PPI Rebound This could prove problematic for China where loan demand remains very tepid, pointing to a potential down leg in Chinese industrial activity (Chart 5). This also raises the specter of renewed devaluation pressures on the Chinese yuan, as this would create another valve to alleviate deflationary pressures in the Chinese economy (Chart 6). Further RMB weakness would be welcomed neither by Trump, nor by the markets. Chart 5Chinese Loan Demand ##br##Remains Moribund Chart 6The RMB Is Another Relief Value For##br## Chinese Deflationary Pressures Taking all these factors into account, we remain warry of betting on a strong dollar against the euro and the yen in the coming weeks, at least not until bonds become cheap on our fair value gauge, reflecting these Chinese deflationary risks and a higher geopolitical risk premium. Chart 7EUR/GBP Is Misaligned##br## With Fundamentals Also, this means that we could see a dichotomy emerge between the narrow dollar (DXY) and the broad dollar. While lower bond yields are supportive of the euro and the yen, they do very little for EM and commodity currencies. In fact, EM and commodity currencies are highly leveraged to the Chinese economy and will be vulnerable to any flare up of tensions between China and the U.S., especially after currencies like the AUD and the CAD had already rallied 5% and 4% respectively since the last week of 2016. Thus, we would recommend investors favor risk-off currencies like the euro, the Swiss franc, and the yen at the expense of the AUD, NZD, CAD, and NOK. For the GBP, last week, we published an optimistic take on the British economy. We are looking to short EUR/GBP as rate differentials are still widely bearish of that cross (Chart 7). However, we warned that in anticipation of the actual triggering of article 50 of the Lisbon treaty, the GBP could come under duress. A risk-off event would only strengthen this case. Thus, we remain confident in our preferred strategy to short EUR/GBP once it hits 0.93. Bottom Line: The dollar correction is advanced but is now likely to become more differentiated. Tensions created by a protectionist and bellicose Trump are likely to push bonds into expensive territory. While the attending bond rally could support the euro, the Swiss franc, and the yen against the dollar, these same tensions are likely to support the dollar against EM and commodity currencies. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Special Report Highlights House Republicans are pushing for a radical overhaul of the existing tax code, including adding a "border adjustment" mechanism that would effectively subsidize exports and tax imports. Despite President Trump's apparent mixed feelings about border taxation, we see a 50% chance that some version of the proposal will be implemented. This is a higher probability than the market currently is discounting. The trade-weighted dollar will rally by another 5% even in the absence of any tax changes, but could rise by 15% if the border adjustment tax is introduced. If the latter were to happen, it would take some time for the dollar to rise to its new equilibrium level. This, in conjunction with sticky import and export prices, would likely lead to a temporary narrowing of the U.S. trade deficit. Such an outcome could prompt the Fed to raise rates more aggressively than it otherwise would. Investors should underweight U.S. bonds on a currency-hedged basis. A stronger dollar will push down commodity prices and hurt external borrowers with dollar-denominated loans. A protectionist backlash against the U.S. might ensue. We are closing our long Chinese banks trade for a gain of 32%, and our long RUB/USD trade for a gain of 20%. Feature Making The Tax Code Great Again? Republicans in Congress are proposing an ambitious revamp of the tax code. A central element of their plan is the replacement of the existing corporate income tax with a so-called "destination-based cash flow tax." Key features of this plan include: Cutting the current federal corporate tax from a top rate of 35% to 20%. Allowing businesses to depreciate capital expenditures immediately, rather than writing them off over many years. Disallowing businesses from deducting interest expenses when calculating their tax bills. Moving to a system of territorial taxation, meaning that taxes would only be assessed on the value added of goods consumed in the United States. Since not all goods that are produced in the U.S. are consumed in the U.S., and not all goods that are consumed in the U.S. are produced in the U.S., a destination-based system requires what is known as a "border adjustment." Such an adjustment would tax the value added of imports and rebate the value added of exports at an equivalent rate. While border adjustments are routinely used in other settings - most notably by countries that have VATs - their application to corporate income taxes is a novel idea. As such, it is not surprising that the proposal has generated significant confusion among investors. With that in mind, we offer our thoughts on the matter using a Q&A format. Q: How exactly would a border adjustment on corporate income taxes work? A: Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred in the U.S.). Table 1 offers a simplified example to illustrate this point. Consider three types of companies: 1) A purely domestic producer whose revenues and costs are realized at home; 2) An exporter whose revenues are entirely derived from abroad but whose costs are all incurred in the U.S.; 3) An importer whose revenues are completely generated in the U.S. but whose costs are all incurred abroad. Suppose that all three companies have revenues of $100 and costs of $60 - implying $40 in pre-tax profits - and face a corporate tax rate of 20%. Before the border adjustment, each company would pay a tax of $8 ($40 times 0.2). The border adjustment is zero for the domestic producer. However, it would impose an additional tax of $12 on the importer ($60 times 0.2), while giving the exporter a rebate of $20 ($100 times 0.2). In the end, the importer and exporter face final tax bills of $20 and -$12, respectively, while the domestic producer continues to pay $8. Note that this conforms with the tax paid on domestic revenues minus domestic costs (for the domestic producer, domestic revenue minus domestic cost is equal to $40; for the exporter it is equal to -$60; and for the importer, it is equal to $100). Q: A tax on imports and a subsidy on exports? Sounds like massive protectionism! A: That depends on the extent to which the dollar appreciates. As Table 1 shows, if the dollar appreciates by 1/(1-tax rate) = 1/(1-0.2) = 25%, there would be no impact on the trade balance or on the distribution of after-tax corporate profits in the economy. This is because the stronger dollar would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits to their original level. Q: This seems like splitting hairs. If a country imposes a 20% tax on imports, most people would still regard this as a protectionist act, even if a currency appreciation offsets the impact. A: That's why a corresponding export subsidy is necessary. That may sound strange since export subsidies are also seen as protectionist measures, but consider the following: Imagine that the government only taxes imports. A tax on imports would curb import demand, implying less demand for foreign currency. This would push up the value of the dollar, leading to lower import prices. How high would the dollar go? Suppose it rose so much that the decline in import prices exactly offset the tariff, thereby restoring import volumes (and importer profits) back to their original level. Is that a stable equilibrium? The answer is no because a stronger dollar would also reduce the demand for U.S. exports, causing the trade deficit to swell. Thus, for the trade balance to remain unchanged, the dollar would have to rise only part of the way, leaving importers worse off than before the tariff was introduced. Such a policy would be protectionist because it would favor U.S.-based companies that produce for the domestic market over foreign exporters. Only in the case where importers are subject to a tax and exporters receive a subsidy will the dollar strengthen to the point that neither exports nor imports change. Intuitively, this is because an export subsidy indirectly benefits importers by pushing up the value of the dollar, while directly benefiting exporters by offsetting the effect of a stronger dollar on profits. Q: If there is no change in the trade balance, what is the advantage of border-adjusting the corporate income tax? A: Contrary to Donald Trump's assertion that border adjustments are "too complicated," their chief advantage is their simplicity. Accurately assessing taxes on worldwide income is hard. Companies routinely engage in practices that purposely lower taxable profits. In particular, importers may overstate the value of their imports and exporters may understate the value of their exports. In a world where many companies have overseas subsidiaries, such "transfer pricing" machinations are easy to pull off. Border adjustments eliminate such incentives in one fell swoop. Recall that with a border adjustment, taxes are assessed on the difference between domestic revenues and domestic costs - both of which the IRS has the means to monitor. Yes, a U.S. company that overstates imports will be able to report a lower gross profit to the IRS, but now it will be on the hook for a higher import tax. What it puts in one pocket it takes from the other. Likewise, an exporter that understates its overseas sales will end up with a lower gross profit, but will now receive a smaller subsidy. Q: And I suppose that because the U.S. imports more than it exports, the border adjustment will end up raising additional revenues? A: That is correct. The annual U.S. trade deficit currently stands at $500 billion. A border adjustment tax rate of 20% would thus raise $100 billion in additional revenue. Given that the corporate income tax brings in about $350 billion, this would allow corporate taxes to be substantially cut without any loss in overall revenue. And this calculation excludes any indirect revenue that would accrue to the Treasury from reducing the incentive for U.S. companies to engage in profit-shifting behavior. Keep in mind, however, that the revenue boost from the border adjustment will decline if the U.S. trade deficit narrows over time. To the extent that the U.S. must finance its trade deficit through the sale of assets such as stocks, bonds, and property, it is possible that foreigners will one day decide to swap all these assets in exchange for U.S. goods. This would lead to an improvement in the U.S. trade balance. Indeed, to the extent that the U.S. is a net debtor to the rest of the world, it is possible that the average future U.S. trade balance will be positive. If that were to happen, the government would lose revenue from the border adjustment over the long haul. Meanwhile, a 25% appreciation in the greenback would reduce the dollar value of the assets that Americans hold abroad, without much of a corresponding decline in U.S. external liabilities. A reasonable estimate is that this would impose a paper loss on the U.S. of about 13% of GDP.1 Q: Ouch! But this assumes that a 20% border adjustment tax will lead to a 25% appreciation in the dollar. That is a mighty big can opener your fellow economists are assuming! What's to say this actually happens? A: Good point. Less than 10% of the turnover in the global foreign exchange market is directly related to the cross-border trade in goods and services. The rest represents financial market transactions. There are many things that can influence the value of the dollar beside trade flows. For example, suppose the government introduces a border adjustment tax, but the Federal Reserve fails to raise rates sufficiently fast in response to rising inflation stemming from a narrowing trade deficit. In that case, U.S. real rates could actually decline, leading to a weaker dollar. Our sense is that this won't happen, but the point is that there is no automatic link between a border tax and the dollar. Much depends on how the Fed responds and the underlying economic conditions. And even if the Fed does hike rates to keep the economy from overheating, two important forces will limit the extent of any dollar appreciation: First, questions about the timing and magnitude of the border adjustment tax - including the possibility that such a measure could be reversed by a future Congress - are likely to lead to only a partial appreciation in the dollar. Second, other central banks - particularly in emerging markets - are liable to take steps to limit the dollar's ascent so as not to place too great a burden on borrowers with dollar-denominated debt. Q: So what happens to countries with hard currency pegs to the dollar? Borrowers with dollar-denominated loans will be spared, but won't these countries end up suffering due to a sharp loss of competitiveness against other economies that have more flexible currencies? A: Correct. It is damned if you do, damned if you don't. Assuming that countries with exchange rate pegs to the dollar are strong enough to fend off a speculative attack, they will still need to engineer an equivalent real depreciation of their currencies via a decline in their nominal wages relative to U.S. wages - what economists call an "internal devaluation." That could impose a deflationary impulse on those economies. Q: You're losing me. A: Think about an extreme case - one where all countries have currency pegs to the dollar. How would the economic adjustment to a U.S. border tax work then? The answer is that initially, a tax on U.S. imports, combined with a subsidy on U.S. exports, would lead to a smaller trade deficit. This would cause the U.S. economy to overheat, putting upward pressure on prices and wages. By definition, an improving trade balance in the U.S. implies a worsening trade balance in the rest of the world. This would sap demand in other countries, putting downward pressure on prices and wages abroad. The adjustment will be complete only after relative wages have shifted enough to restore the U.S. trade balance to its original level. The important point is that in a world where some countries have flexible exchange rates while others have fixed exchange rates or dirty floats, the economic adjustment to a U.S. border tax will come through some combination of a stronger nominal dollar, higher U.S. inflation, and lower inflation abroad. Q: Bullish for the dollar, but bearish for U.S. bonds, correct? A: Precisely. The degree to which bond yields adjust around the world depends on the extent to which nominal exchange rates and domestic prices are sticky. If exchange rates are slow to change, more of the adjustment has to occur through higher inflation in the U.S. and lower inflation everywhere else. But even if nominal exchange rates adjust quickly, sticky goods prices would still push up U.S. bond yields. To see this point, consider what would happen if the dollar appreciated by 25% in response to the introduction of a border adjustment tax, but neither import prices nor export prices (expressed in U.S. dollars) changed. If that were to happen, the profit margins of U.S. importers would tumble because they would now have to pay an import tax but would not benefit from lower import prices. Meanwhile, the margins of U.S. exporters would soar as export prices stayed firm and they received a subsidy from the government. The result would be less imports and more exports, and hence, an improved trade balance. This would raise U.S. aggregate demand and put upward pressure on inflation and Treasury yields. Considering that 97% of U.S. exports and 93% of U.S. imports are denominated in dollars, such an outcome is hardly far-fetched. The bottom line is that in the "real world," the introduction of a border adjustment tax would cause Treasurys to sell off and the dollar to rally. Q: What sort of numbers are we talking about? A: Assuming a 20% border tax is introduced, a reasonable guess is that the trade-weighted dollar would rise by 10% over a 12-month period above and beyond our current forecast of a 5% gain. This would imply 15% upside from current levels. The 10-year Treasury yield would probably rise to about 3%. Q: It still puzzles me how you can claim that bond yields will rise if the dollar strengthens. Wouldn't a stronger dollar normally lead to lower bond yields? A: Your premise is wrong. It is not the stronger dollar that leads to higher bond yields. It is a third factor - namely the improvement in the trade balance arising from the decision to tax imports and subsidize exports - that causes both the dollar and bond yields to rise. This is similar to what happens when the government loosens fiscal policy. Mind you, at some point the positive correlation between the dollar and bond yields could break down. If the dollar rises too much, emerging markets will crumble under the stress. This will trigger safe-haven flows into the Treasury market, leading to a stronger dollar and lower yields. Such an outcome is not our base case, but it cannot be dismissed. Q: Got it. Presuming that the global economy holds up, it sounds like a border tax would be great news for Boeing, but bad news for Walmart? A: Yes, but there are two important qualifications to consider. First, it is possible that the dollar overshoots its new long-term equilibrium level, so that the pain to Boeing from the appreciation of the greenback ends up outweighing the benefits from the export subsidy it receives. Second, given the potential economic and financial dislocations from the shift to a destination-based tax system, there is likely to be some delay between when the tax bill is signed into law and when it is implemented. And even once implementation begins, the adjustment in tax rates may be phased in only gradually. Since the dollar will rise in anticipation of all this, it is possible that exporters will actually suffer initially, while importers receive a temporary boost to profits. Nevertheless, we think that investors will see through the near-term hit to exporter margins and focus on the medium-term gains. As such, equity investors should maintain a preference for exporting companies over those that heavily rely on imports (Chart 1). Q: This assumes that the market has not fully priced in this outcome already. What are the chances that this border adjustment tax proposal actually sees the light of day? A: The border tax idea originated in the House of Representatives and has its strongest support there. There might be more opposition in the Senate, but this could be overcome if enough Democrats with protectionist leanings can be found. President Trump panned the idea in an interview with the Wall Street Journal earlier this week.2 He noted that "Anytime I hear about border adjustment, I don't love it... because usually it means we're going to get adjusted into a bad deal. That's what happens." Trump's comments suggest he may not fully understand how border adjustments work. This implies that he might be persuaded to go along with the idea if Republican legislators are able to reach a "great deal" on adjustments in his eyes, whatever that means. Subjectively, we would assign 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. This might entail excluding certain types of imports from a border tax if they are consumed disproportionately by the poor or represent an important input for U.S. manufacturing firms. Apparel and energy products would probably be on that list. It might also entail reducing the border adjustment tax to a lower level, say 10%, as Tom Barrack, head of Donald Trump's inaugural committee, has suggested. It is hard to know how much of this is already reflected in asset prices. The dollar fell after the WSJ article was published, but that may have had less to do with border adjustments and more to do with Trump's comment that he prefers a weaker dollar - an unprecedented statement for a U.S. president. Goldman Sachs' securities group has constructed two baskets using firm-level data, one comprised of "destination tax winners" and the other of "destination tax losers."3 The loser basket actually outperformed in the immediate aftermath of the election. While the relative performance of the winner basket has recovered more recently, it still remains below where it was last April (Chart 2). The limited reaction to the prospect of a border adjustment tax has been echoed in the fact that market expectations of the future volatility of the dollar has not changed much since the election, despite the possibility that the coming legislative debate could lead to wild swings in the greenback (Chart 3). Chart 3Dollar Volatility Has Not Escalated On balance, we conclude that investors are understating the likelihood of even a watered down border adjustment tax being introduced as part of a comprehensive tax reform program. This is broadly consistent with our client discussions, which have revealed that most investors - with a few notable exceptions - are only vaguely aware of the issue. Q: Won't the WTO rule against a border adjustment tax? That could explain why investors are discounting it. A: Yes, it probably will. The WTO permits border adjustments in the case of "indirect" taxes such VATs, but not in the case of direct taxes such as income or corporate profit taxes. Granted, the U.S. has brushed off WTO decisions in the past, such as when it ignored the trade body's ruling that U.S. laws restricting internet gambling contravened the General Agreement on Trade in Services. Considering that Donald Trump threatened to pull the U.S. out of the WTO during the election campaign, such an outcome cannot be easily dismissed. Nevertheless, given the magnitude of the border tax issue, even the Trump administration is likely to think twice about running afoul of WTO rules. Nevertheless, it might be possible to modify the border adjustment proposal to make it WTO-compliant. The distinction between direct and indirect taxes is one of those things self-styled experts like to pretend is important, but is not. It does not really matter whether a tax is levied on the sale of a good or service, or whether it is levied on income. In the end, someone has to pay the tax - be it a worker or a shareholder. The adoption by the U.S. of a border-adjusted destination tax would move the global economy in the direction of greater harmonization, not away from it. As noted at the outset, most other countries border adjust their value-added taxes. They do this so that their VATs mirror a consumption tax, as Table 2 illustrates with a simple example. Conceptually, a corporate cash flow tax coupled with a payroll tax functions in much the same way as a VAT (bottom part of Table 2). The U.S. already has both a corporate income and a payroll tax, so it is not that far away from having a VAT. All that is missing is a few tweaks to depreciation rules and the addition of the border adjustment. Yes, the dollar would strengthen if that were to happen, but this would put the greenback on par with other currencies. Chart 4 shows that the U.S. has run a trade deficit with the rest of the G7 since 1990, despite the fact that the dollar has traded on average 9% below its Purchasing Power Parity (PPP) over this period. One of the reasons this has occurred is that other G7 economies have a VAT, whereas the U.S. does not (Chart 5). This has kept the dollar weaker than it otherwise would have been. Chart 4The Dollar Was Cheap For A Reason Q: Okay, let's wrap this up. What are the main investment implications I should take away from this? A: Our main takeaway is that investors are underestimating the likelihood that the U.S. adopts a destination-based tax system. This suggests that the risks to the dollar are to the upside, as are the risks to U.S. Treasury yields. Global investors should underweight U.S. bonds on a currency-hedged basis. The implications for global equities are more nuanced. It may take some time for the dollar to adjust to the border tax. This, combined with the fact that import and export prices tend to be sticky in the short run, implies that the U.S. trade deficit will decline, boosting U.S. aggregate demand in the process. While that is potentially good news for U.S. corporate profits, the benefits will be curtailed by the fact that the U.S. economy is approaching full employment. This means that any further stimulus could simply result in higher real wages for workers without any offsetting increase in unit sales for U.S. companies. A shrinking U.S. trade deficit will diminish America's role as "the global consumer of last resort." This is problematic for export-dependent emerging markets. While a border adjustment may be justifiable on economic grounds, politically, it could be seen as the first volley in a global trade war. This could sour sentiment towards EM stocks. To make matters worse, a stronger dollar would harm emerging markets with high levels of dollar-denominated debt such as Turkey, Malaysia, and Chile, while also weighing on commodity prices. We recommend that investors underweight EM stocks relative to their DM counterparts. With these considerations in mind, we are closing our long Chinese banks trade for a gain of 32% and our long RUB/USD trade for a gain of 20%. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 U.S. external assets amount to 133% of GDP, while foreign liabilities stand at 175% of GDP. About 68% of U.S. external assets are denominated in foreign currency, compared with only 16% of external liabilities. Thus, the paper loss to the U.S. from a 25% appreciation in the dollar would be (175*0.16-133*0.68)*(1-1/1.25) = 12.5% of GDP. 2 Please see "Donald Trump Warns On House Republican Tax Plan," The Wall Street Journal, dated January 16, 2017, available at www.wsj.com. 3 The Bloomberg tickers for these baskets are GSCBDTW1 and GSCBDTL1. For more information, please see "US Daily: What Policy Changes Is The Equity Market Expecting?" Goldman Sachs Economic Research, dated January 11, 2017.
In early 2016, our sister publication Global Alpha Sector Strategy did a cycle-on-cycle analysis on the ISM manufacturing index and relative industrials performance in the following twelve months every time the ISM sank below the boom/bust line for 5 or more consecutive months. The conclusion was that it did not pay to underweight industrials stocks, as too much bearishness was already baked in the cake. The opposite is also true. We analyzed relative industrials performance since the early 1990s every time the ISM manufacturing new orders sub-index hit 60. The bottom panel of the chart shows median relative performance in the ensuing twelve months. The implication is that industrials stocks will suffer in the coming quarters as too much optimism is already discounted since the post-election reflex advance. Bottom Line: We reiterate our recent high-conviction underweight stance on the S&P industrials sector.
Special Report Feature Which of the following activities requires more brainpower: beating a grandmaster at chess, or cleaning the table underneath the chessboard? The answer is cleaning the table. This explains why Artificial Intelligence (AI) can now trounce the best human chess player, but no AI can (yet) reliably pick up the chessboard and dust underneath it. The cognitive scientist Steven Pinker points out that the human mind can understand quantum physics, send a rocket to the moon and decode the genome, but reverse-engineering simple human movements involves a mind-boggling complexity. "The hard problems are easy and the easy problems are hard." AI researchers call this Moravec's Paradox:1 the counterintuitive result that much less computing power is required for advanced problem solving than for simple sensorimotor skills.2 Feature ChartCooks, Waitresses And Bartenders Is The Fastest Growing Employment Sector Pay Deflation For The Many... The hard problems that are easy for AI are those that require the application of complex algorithms and pattern recognition to large quantities of data - such as beating a grandmaster at chess. Or a job such as calculating a credit score or insurance premium, translating a report from English to Mandarin Chinese, or managing a stock portfolio. The easy problems that are hard for AI are those that require the replication of human movement in everyday tasks. Jobs such as cleaning, gardening, or cooking. Therefore: "As the new generation of intelligent devices appears, it will be the stock analysts who are in danger of being replaced by machines... (Cleaners), gardeners, and cooks are secure in their jobs for decades to come." For societies and economies, Moravec's Paradox generates a chilling deflationary headwind. Many of the jobs that AI will destroy - like credit scoring, language translation, or managing a stock portfolio - are regarded as skilled, and require years of advanced education and training. They have limited human competition, and are well-paid. Conversely, many of the jobs that AI cannot (yet) destroy - like cleaning, gardening or cooking - are relatively unskilled. They have unlimited human competition, and are low-paid. ...Pay Inflation For The Tiny Few As well as sensorimotor skills, humans still beat AI in three other fields: creativity, innovation, and complex communication. As Erik Brynjolfsson and Andrew McAfee3 observe in The Second Machine Age: "Computers are still machines for generating answers, not posing interesting new questions... We've never seen a truly creative machine, or an entrepreneurial one, or an innovative one." Hence, these are the skills you should encourage your children to acquire as their defence against AI. Moreover, the leaders in these fields - the very best entrepreneurs, innovators and communicators as well as top sportsmen and musicians - now find themselves in a particularly strong position. This is because a second powerful dynamic is at play. As we showed in the first Special Report in this series The Superstar Economy,4 the internet allows the very best entrepreneurs, innovators and communicators to sell their services to an effectively unlimited audience. And social media, as a large-scale validation system, reinforces the winner-takes-all dynamic. Therefore, as the proliferation and power of the internet and social media have increased dramatically, so too have both the earnings growth rate and the longevity of the superstars - exaggerating the skew in the Pareto distribution of incomes. Simply put, the superstars in sensorimotor skills, creativity, innovation, and complex communication will continue to see very strong pay inflation (Chart I-2). Chart I-2The Cost Of Living Extremely Well Continues To Rise Unabated The Hollowing Out Of The Middle Class Sadly, only a tiny fraction of the population can become superstars. As AI takes over mid-skill knowledge work, the vast majority of displaced workers start going after jobs lower on the skills and wage ladder. As these jobs also have lower security, this keeps a lid on credit growth, because without income security, households are less willing to borrow and banks are less willing to lend. The result is that the on-going Second Machine Age - the ushering in of Artificial Intelligence - is hollowing out the middle class. Contrast this with the First Machine Age - the ushering in of 'Artificial Strength'. The steam engine replaced muscle power, both human and animal. Thereby, it destroyed mostly low-skill work and effectively created the middle class. But does the evidence support the narrative for the Second Machine Age? The answer is yes. The changing sectoral profile of the jobs market through 1997-2017 is almost identical to the changing profile of output, as captured by GVA.5 Which means that job destruction and creation has kept relative productivity between sectors broadly unchanged through the past 20 years (Tables I-1-I-5). In other words, human jobs have disappeared where AI can do them better. And they have gone to where AI cannot do them better, because the jobs involve some degree of sensorimotor or communication skill. Table I-1U.K. Jobs Have Gone To Where Machines Cannot (Yet) Beat Humans Table I-2The U.K. Value Added Profile Is Similar To The Jobs Profile Table I-3U.S. Jobs Have Gone... Table I-4...To Where Machines Cannot (Yet) Beat Humans Table I-5The U.S. Value Added Profile Is Similar To The Jobs Profile U.S. data provides fascinating sub-sector detail. The employment sub-sectors that have grown the most are relatively low-income but which require sensorimotor skills: Food Services and Drinking Places - cooks, waitresses and bartenders - and Social Services, followed by communication-dependent Education Services (Feature Chart). And now comes the bombshell. A separate study by Ball State University carried out an attribution analysis of the 6 million U.S. manufacturing destroyed through 2000-20106 (Table I-6). The study's salutary conclusion was that only 13% of the job losses resulted from trade, and almost 90% resulted from productivity improvements - in other words, because AI can do the jobs better than humans. Table I-6Only 13% Of Manufacturing Job Losses Are Due To Trade It follows that short of reversing the advance of technology, no amount of "Take Back Control", "Build A Wall" or "Make America Great Again" can change the powerful wind of change in the employment market. The Implications Of The Superstar Economy In terms of implications for policymakers and investors, all of the conclusions in the original Special Report The Superstar Economy remain valid, so we will reiterate them. Bear in mind that we originally wrote these on March 24, 2016. Several of the predictions have already proved eerily prescient. Headline and aggregate-economy statistics such as GDP and income are no longer representative statistics for the living standards of the vast majority of the population. Therefore, politicians will need to pay close attention to the underlying distribution of these statistics. But as many politicians seem blissfully unaware of the extreme skews in the Pareto distribution, we can expect a higher frequency of shocks at the ballot box. If economic growth is mostly happening at the top-end of the Pareto distribution, the vast majority of incomes will be stagnating or declining.7 So we can expect structurally weak private sector credit growth. Lacking rampant house price inflation or confidence in income growth, households and firms will be unwilling to borrow, and banks will be unwilling to lend. Hence, the opportunities to own bank equities will be limited to short-term tactical timeframes. If economic growth is mostly happening at the top-end of the Pareto distribution, and credit growth is weak, we can expect a continued absence of generalised price inflation. Monetary policymakers need to immediately discard discredited concepts such as the Phillips curve relationship between headline growth, unemployment and the inflation rate. But as many of these conventionally-trained economists will find it difficult to change their thinking, we can expect a higher frequency of policy errors. Interest rates and bond yields will remain structurally depressed. Bond yields will move cyclically, but there will be no persistent uptrend. A long sequence of rate hikes anywhere will be unsustainable. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Named after the roboticist Hans Moravec 2 Evolutionary biology provides a good explanation for Moravec's Paradox. The part of the brain - the cerebellum - that is responsible for sensorimotor skills has experienced much more evolution and development compared with the part of the brain - the neocortex - that is responsible for problem-solving. It follows that AI requires exponentially greater computational resources to replicate even low-level sensorimotor skills than it does to replicate problem-solving. 3 Andrew McAfee spoke at our 2015 New York Conference. 4 Published on March 24, 2016 and available at eis.bcaresearch.com 5 Gross Value Added 6 The Myth and the Reality of Manufacturing in America by Michael J. Hicks and Srikant Devaraj, June 2015 Ball State University Center for Business and Economic Research. 7 Please also see Chart 10 in the Global Investment Strategy Weekly Report, titled "Low Rates Forever", dated March 4, 2016 available at gis.bcaresearch.com
Highlights Trump's protectionism supercharges our theme of Sino-American tensions. China is at a stark disadvantage to the U.S. in a trade war. China cannot give concessions easily; it may batten down the hatches. Remain short RMB; but go long "One China," i.e. mainland stocks versus Taiwan/Hong Kong. Feature "Life's short span forbids us to enter on far reaching hopes." - Horace, Odes "Of course, you know, this means war." - Bugs Bunny, Looney Tunes President-elect Trump has said he will not designate China a "currency manipulator" on the first day of his presidency, contrary to what he promised during the campaign. Is this a sign that Trump is "normalizing" after the wild threats of his campaign? What are the real risks of a U.S.-China "trade war"? How should investors prepare? Trade War Is More Likely Than You Think BCA's Geopolitical Strategy has long cautioned investors that geopolitical tensions in East Asia were severely underestimated by the market.1 In 2013, we argued that a Sino-American military conflict was more likely than most of our clients dared to think.2 And over the past several years, in one-on-one conversations and in presentations at numerous conferences, we have stressed that tensions in East Asia could imperil the largest trade relationship. Why so alarmist? We have always based our analysis on three key pillars: Multipolarity: With the U.S. in a relative decline, containing China's rise has become a national security issue. The U.S. "Grand Strategy" operates under the imperative that no regional power is allowed to become a regional hegemon, as that would be a stepping stone to global competition. "Pivot" To Asia: The U.S. geopolitical deleveraging from the Middle East was from the start designed to free up more U.S. resources for Asia. While the Obama Administration pursued the pivot cautiously, it was putting the infrastructure in place for a confrontation with China. Regional dynamics: China is surrounded by neighbors that are cautious about Beijing's intentions for geographic, historical, and strategic reasons. They have therefore sought to balance their increasing economic addiction to China with deeper military and political links to the U.S. Chart 1China, Not NAFTA, In Trump's Crosshairs Trump's victory has made markets considerably less oblivious to the risks we have stressed to clients for the past five years. The idea that a trade war might erupt is now widely discussed. And Trump's repeated statements about Taiwan, North Korea, and the South China Sea have awoken some investors to the reality that a trade conflict could spill over into strategic areas, and vice versa. Nevertheless, judging by the ebullient market reaction relative to previous U.S. presidential transitions, most investors think that cool heads will inevitably prevail. They may be right, but from where we sit it is premature - and imprudent - to bet on it. Make no mistake, China, not NAFTA, will suffer the brunt of Trump's efforts to fulfill his protectionist campaign promises (Chart 1). We see 70% odds that a "crisis event" will affect U.S.-China trade patterns in a significant way over the next four years. How Did We Get Here? The Global Financial Crisis caused a sharp break in Sino-American relations: It interrupted the economic symbiosis between China and American households refused to keep re-leveraging, forcing China to become more internally driven economy (Chart 2). With final demand in the U.S. declining, China decided to re-leverage with credit, injecting its existing overproduction and overcapacity with steroids. But this only accelerated China's capture of global export market share, while supercharging the deflationary global effects (Chart 3). On top of its credit policies, China has struggled to internationalize the RMB. So now, it is not only still washing the world with its industrial overcapacity but also inadvertently - or not so innocently - reducing the prices of its goods with the weakening of its currency (Chart 4). Chart 2U.S.-China Symbiosis Has Died Chart 3China's Historic Export Grab Chart 4China Still Exporting Deflation U.S.-China trade disputes have a long history. China's WTO entrance was agreed only with the stipulation that China be treated as a "non-market economy" for 15 years. Punitive trade bills almost passed through Congress in 2005 and 2010-11, for instance, but were held back at the last minute.3 Since 2009, in particular, protectionist policies have emerged. President Obama began his term with an unprecedented use of the authority under Section 421 of the 1974 Trade Act to punish China for "market distorting" exports of car tires, and with protectionist "Buy America" provisions in his economic stimulus package. After that, a sequence of tit-for-tat punitive measures took place affecting a range of goods on both sides, attempted Chinese investments in the U.S., and American companies operating in China. China's meteoric rise, surging trade surpluses with the U.S., and the rapid loss of U.S. manufacturing jobs was the main cause of tension (Chart 5). Americans benefited from China's rise, namely from cheaper goods and lower interest rates, but it caused significant economic dislocations.4 Meanwhile Chinese protectionism discouraged American elites that had endorsed China's rise on the hopes of gradually unfolding market access. Amid the heightened political risks of the global recession and its aftermath, China intensified intellectual property theft, non-tariff barriers, indigenous innovation policies, and cyber-attacks.5 The saving grace, for markets, was that the aforementioned tensions always remained within bounds. The WTO was a mutually recognized adjudicator. Also, the rival American and Chinese commercial authorities played a slow, step-by-step, predictable game, with the punitive measures being mostly proportional. When pressures flared in the U.S., the executive branch stayed Congress's hand; meanwhile China's government could steamroll any internal opposition to its trade policies. No more. Hillary Clinton might have helped contain trade tensions, but the outlook has darkened irrespective of Trump. Notably, American multinational corporations have increasingly decried Chinese protectionism and lobbied for the U.S. government to help persuade China to give them greater market access and a better legal-regulatory climate (Chart 6). As the Obama administration exited the stage in December 2016, the U.S., Japan and others refused to accept China's "market economy" status despite the fifteen-year deadline coming due. This means the U.S. and its allies explicitly wanted to reserve the power to impose anti-dumping duties more easily on China, which is what "Non-Market Economy" status entails (Chart 7).6 China considers this delay an outright violation of U.S. commitments under WTO. Chart 5A Tale Of Two Manufacturers Chart 6American Business Under Pressure In China Chart 7China's Non-Market Status A Liability Further, Clinton had promised to create a special prosecutor for trade disputes and to triple the number of enforcement officers. More broadly, she wanted to continue Obama's "Pivot to Asia" policy that had roiled U.S.-China strategic relations. Bottom Line: U.S.-China trade relations had already turned sour as a result of the divergence of interests following the Global Financial Crisis. China has emerged as a trade juggernaut and the U.S. corporate and political establishments have become far more anxious about it recently. Now Trump has supercharged the situation. Will Trump "Normalize" In Office? With Trump, the U.S. is likely to undergo a "regime change" in terms of how trade policy is conducted - the only question is how long-lasting it will be. U.S. presidents have very few constraints on trade and foreign policy (Table 1). Ignore Trump's statements and look at his team: Incoming Commerce Secretary Wilbur Ross, National Trade Council chief Peter Navarro, and U.S. Trade Representative Robert Lighthizer.7 This group, especially Navarro, is stridently hawkish on China and appears ready to bring the full weight of the United States' economic and strategic advantages to the table in order to negotiate a new framework of relations. Table 1Trump Is Not Constrained On Trade Policy The model is the renegotiation of trade relations with an ascendant Japan in the 1980s. And China looks ripe for a crackdown by this yardstick. The penetration of Chinese exports meet or exceed Japan's position at its peak in the 1980s (Chart 8). Meanwhile the RMB has not appreciated nearly as much as the yen had done by this time (Chart 9). Ultimately the two resolved their differences because Japan acceded to major U.S. demands, strengthening its currency after the 1985 Plaza Accord and accelerating financial liberalization. It helped that the two were staunch allies without genuine security tensions (unlike the U.S. and China today). Chart 8China Has Gotten Away ##br##With More Than Japan Did Chart 9Reagan Forced Faster ##br##Appreciation On Japanese Yen From the Trump administration's point of view, the standard trade remedies have failed given that U.S. trade deficits have deteriorated all along. True, China has made considerable structural adjustments in recent years (Chart 10). But relative to the U.S., China has not really changed its ways. In fact, the current account surplus, which has collapsed from 10% to around 2% since 2008, is now roughly equal to the trade surplus with the United States (Chart 11). Chart 10China's Economic Rebalancing Under Way Chart 11China's Trade Surplus With U.S. Indispensable Therefore we do not put much stock in Trump's claim that he will not call China a currency manipulator on day one - this does not signal a "normalization" or softening of Trump's protectionist line. There was always a technical issue with this pledge that made the timing awkward.8 The manipulator charge will remain a Sword of Damocles hanging over China this year and next, but it is also only one tool in Trump's toolkit - and not the most intimidating one either (Diagram 1). Diagram 1Calling China A Currency Manipulator: The Process At a minimum, Trump could easily do what Obama did in February 2009 on tires - simply approve recommendations from his own Treasury Department for tariffs on specific goods. At a more aggressive level, he has the example of Richard Nixon before him. Nixon imposed a 10% surcharge on all dutiable goods in 1971. We would not put it beyond Trump to take arbitrary actions within the four-year term if international economic conflicts heat up dramatically. (We will be especially leery in the lead-up to the 2018 or 2020 elections if Trump's touted deal-making is not going his way.) Congress is not likely to prove a major constraint, at least not at first. Trump's election is a strong signal that the U.S. populace wants more protectionist policies. Congressional Republicans are limited, given the laws empowering the president on trade, and they will face the reality that his electoral strategy succeeded in great part because of voter demand for protectionism in key Midwestern states. Democrats, in these and other competitive states, have to perform verbal gymnastics to oppose Trump's positions on trade that substantially echo their own. And as mentioned, U.S. multinationals are not likely to "domesticate" Trump - rather, they will lobby for relative moderation or tactfulness within his general framework. Bottom Line: Trump is relatively unconstrained on trade policy. We expect his administration to begin with a "shot across the bow" in the first 100 days - a mostly but not entirely symbolic punitive measure against China - and then to seek high-level negotiations toward a framework for the administration's relations with China over the next four years. We expect the initial shot to rattle markets, then for a calming period to ensue, which will give a false sense of security. But given the lack of constraints on Trump, we are not optimistic. What Are China's Options? In a trade war with the U.S., China is outgunned on every front. Its economy is far more vulnerable to a disruption of exports to the U.S. than vice versa (Chart 12). It does not have ready alternatives to the U.S., given that U.S. imports of Chinese goods are roughly equal to Japanese, South Korean, German, Vietnamese and British imports combined. And China is most competitive in goods that the U.S. can easily source elsewhere (Chart 13). Chart 12The Numbers Favor The U.S. In A Trade War Chart 13The U.S. Can Find Substitutes For China Yes, China can disrupt the supply chain for the iPhone, but no, the Trump administration is not going to confuse Apple's interests with what it views as the "National Interest." Certainly China will favor non-American companies - Airbus over Boeing, etc - but the U.S. growth model is not reliant on exports, so it is not clear that the Trump administration will heed Boeing's cries about long-term competitiveness. The states most exposed to Chinese retaliation - Alaska, Oregon, Washington, Louisiana, and South Carolina - will not harm his electoral base. His Midwestern Rust Belt states could suffer, according to some research, but voters there may approve of his protectionist measures and Trump's other economic policies may blunt the short-term impact of Chinese retaliation.9 Looking at major Chinese export categories to the U.S., like textiles, electrical machinery, and equipment, suggests that 30 million Chinese jobs could be affected - perhaps ten times as many as the comparable U.S. jobs at risk from Chinese retaliation (far more than proportional given population). There is one factor that stands in China's favor. The history of trade wars says something different than the raw balance of trade. Like all wars, trade wars seek political ends, and a government's internal unity and resilience can be critical to its ability to bear out the worst.10 Politically, it is not clear that the U.S. has a better stomach for a full trade war than China: The U.S. remains divided - Polarization will worsen under Trump given his low approval ratings, low favorability, narrow popular victory margin, and controversial policy inclinations. Though China-bashing and economic patriotism can win some support, and we do not expect Congress or the corporate lobby to prevent Trump from launching a trade crusade if he wishes, nevertheless we see a fair chance that Trump would lose credibility and be forced to moderate his stance once negative trade consequences began to be felt at home. China is relatively unified - Xi has set himself up to be the "core" of power in the Communist Party in anticipation of worsening domestic conditions.11 It is worth remembering that the original use of the "core leader" moniker emerged in the wake of the Tiananmen Square crackdown when the Western world imposed sanctions on a newly liberalized China and it was forced to retreat into its shell from 1989-1992 (Chart 14). China's leadership wants to make the country less dependent on the U.S., and more autarkic, but is having difficulty imposing austere changes on itself. Trump may hasten the reforms while giving Chinese leaders a convenient "foreign devil" to distract the populace from the pain of restructuring. Chart 14China Rode Out Western Pressure In 1989 The above should not suggest that China wants a trade war, however. Trump is threatening to kick the export leg out from under its growth model at a time when the other leg - investment - stands at risk from domestic credit excesses.12 But the recent case study of Russia and economic sanctions is instructive. President Vladimir Putin used sanctions to blame all of the economic ills that befell Russia on the West, even though the Kremlin was often at fault. That policy largely worked. Bottom Line: China stands to suffer the most economically in a trade war with the United States. Chinese policymakers may therefore choose to ride out the economic costs of a trade war while blaming the U.S. for the pain. But closing its economy today would derail global growth and cause a dramatic spike in geopolitical risk, unlike in 1989. Strategic Spillover Trump's approach is likely to increase geopolitical risk because he wants to use the strategic disagreements plaguing Sino-American relations as leverage to get concessions on trade. The three hot spots are: Taiwan - Tensions with Taiwan spiked when Trump revealed that his administration considers the "One China" policy to be up for negotiation. China has engaged in serious saber-rattling in response, both around Taiwan and in the South China Sea. By linking trade disputes with Taiwan, Trump likely made it harder for Xi to compromise on the former without looking weak on the latter. Trump's negotiating style may work in business, but will not work with China on Taiwan, which is a matter of sovereignty and a clear red line. North Korea - Trump has said North Korea will not manage to test an Intercontinental Ballistic Missile (ICBM), which it is preparing to do. He is threatening to hold China to account for not curbing the North's violations of UN resolutions on nuclear proliferation and missile development. This would likely mean an expansion of the practice adopted under Obama of sanctioning Chinese entities for dealing with North Korean partners. This situation would likely shake up markets that have normally been able to ignore North Korea. South China Sea - Trump has repeatedly signaled that China has militarized the South China Sea, and his incoming Secretary of State Rex Tillerson suggested that China be deprived of access, a policy that would trigger a shooting war if operationalized. Persistent tensions here are unlikely to go away anytime soon and could spark a diplomatic crisis or naval conflict (if not with the U.S. then with regional players like Vietnam). Thus Trump's administration is likely to make serious demands on China regarding its strategic situation and national security even while demanding an overhaul of trade policies that will force difficult economic reforms on China. Bottom Line: China's political strengths at home make it unlikely to compromise on Trump's major strategic demands. Contrary to adding leverage in trade negotiations - where the U.S. already has the upper hand - using these issues as negotiating tools is likely to cause China to fear for its security and thus become more defiant. Risks To The View The risk to this view would be that the U.S. and China manage to negotiate a new framework and actually improve relations, with the U.S. giving more respect to China's legitimate rights and regional initiatives in exchange for Chinese concessions. But is China capable of conceding significantly on Trump's major demands? RMB appreciation? No. Many commentators have pointed out that Trump's view of the RMB is outdated - the PBoC is now propping it up, not suppressing it. The driver of RMB weakness is China's excessive monetary and credit expansion, weakening productivity growth, domestic investors' desires to move capital out, corporate deleveraging, the need for stimulus, tightening Fed policy, and rising geopolitical risks. While it is possible that the PBoC will defend the RMB to the hilt, the near-term path of least resistance is down, and that sets China on a collision course with the Trump administration. Market access and dumping? Yes. Trump complains that China taxes U.S. imports unfairly and dumps goods into the American market, killing jobs. To appease the U.S., China could take concrete steps to remove non-tariff barriers and open wider investment avenues for U.S. businesses - it has recently suggested it might do so.13 Less likely, it could accelerate overcapacity cuts and reduce subsidies to state-owned enterprises. These moves would fit with its avowed reform goals and strengthen Chinese self-sufficiency in the long run, and Xi's administration likely has the power to do them. China could also improve intellectual property protections and declare a ceasefire on cyber-attacks on companies. All of this is possible, but clearly extremely difficult to achieve. Strategic concerns? Maybe. It is conceivable but unlikely that China could de-escalate matters in the South China Sea and agree to a "freedom of navigation" guarantee for the United States, which is not a party to the territorial disputes. A significant compromise on North Korea would be even less likely, since China is unwilling to move beyond the usual, ineffective management and impose real hardship on the regime for its violations of UN resolutions and improving nuclear and missile capabilities. One impetus for China to concede on these points is that it is fearful of creating instability in a politically sensitive year in which it will oversee a major five-year leadership rotation at its National Party Congress. Trump may deliberately threaten to disrupt the transition in order to extract concessions. Bottom Line: We operate on a constraint-based methodology: Trump has very few constraints on trade policy, China has major constraints on making these concessions, so there is no basis for assuming that the two countries will skip conflict and go directly to a new level of cooperation. Investment Recommendations We remain short the RMB. The currency has fallen by 5.62% since we initiated this trade. The trade itself has suffered a bit since the end of last year as a result of the PBoC's efforts to fight speculation. But monetary expansion sans productivity improvements continues apace in China, and we expect USD strength to persist, so we think there is room for the RMB to fall further. In the near term, however, the USD could experience further pullback as investors start pricing the negatives of the Trump administration. Therefore we are closing our long USD/EUR trade for a 4.55% gain. We remain somewhat positive on China relative to EM - because of the relative unity and centralization of its government and financial resources at its disposal - but we would not recommend investing in Chinese assets in the absolute due to the heightened internal and external risks outlined above. Hence we propose going long the "One China" policy, i.e. long Chinese mainland stocks versus Taiwan and Hong Kong (Chart 15). This enables us to play the fact that mainland valuations are depressed while the global trend of de-globalization and the conflicts within Greater China and with the U.S. are likely to increase uncertainties about Hong Kong and Taiwan. These two are particularly vulnerable to tighter regulations or sanctions from Beijing. Yan Wang, Senior Vice-President at BCA's China Investment Strategy, argues that while there is no case for a clear directional move in Chinese stocks - especially given the ongoing tightening of policies on the property sector - nevertheless they should be favored relative to global equities, given that growth is improving, fiscal policy will remain accommodative, and valuations are depressed (Chart 16).14 Meanwhile our negative outlook on China in absolute terms supports a globally negative outlook on cyclical equities relative to defensives. Cyclicals move with EM in general and China in particular. Anastasios Avgeriou, Vice President in charge of U.S. Equity Strategy, notes that EM performance does not warrant the sharp rise in U.S. cyclicals versus defensives, nor that in globally oriented versus domestically oriented stocks (Chart 17).15 This creates the opportunity for a tactical short. Chart 15Chinese Stocks Are Cheap Chart 16China Trades With Cyclicals Chart 17Go Long The 'One China Policy' Finally, we caution investors about investing in companies with major exposure to China (Table 2). We would recommend that clients short a "China, Inc" Index of the top 20 S&P 500 stocks exposed to trade with China relative to the rest of S&P 500. The "China, Inc" stocks have been outperforming the market for a while (Chart 18). We fear that China may retaliate against some of these firms as the trade war with the U.S. heats up. Table 2'China, Inc.' May Suffer From Trade War Chart 18Short 'China, Inc.' Relative To Market Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President, marko@bcaresearch.com Jesse Anak Kurri, Research Analyst 1 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 3 Please see Imad Moosa, The U.S.-China Trade Dispute: Facts, Figures And Myths (Northampton, MA: Edward Elgar, 2012). 4 For prominent research on this topic, please see David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning From Labor-Market Adjustment To Large Changes In Trade," Annual Review of Economics 8 (2016), pp. 205-40, available at www.annualreviews.org; Autor et al., "Foreign Competition And Domestic Innovation: Evidence From U.S. Patents," NBER Working Paper No. 22879, December 2016, available at www.nber.org. 5 Please see BCA Geopolitical Strategy Special Reports, "Reflections On China's Reforms," dated December 11, 2013, and "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 6 Scholars have shown that countries granting China market economy status have subsequently initiated fewer antidumping cases against it. Please see Francisco Urdinez and Gilmar Masiero, "China And The WTO: Will The Market Economy Status Make Any Difference After 2016?" The Chinese Economy 48:2 (2015), pp. 155-172. Technically speaking, the difference in duty rates can be substantial between market and non-market economies; please see the U.S. Government Accountability Office, "U.S.-China Trade: Eliminating Nonmarket Economy Methodology Would Lower Antidumping Duties For Some Chinese Companies," GAO-06-231, January 2006, available at www.gao.gov. 7 Ross has criticized China more heavily since joining Trump; Navarro is the author of Death By China: Confronting The Dragon, A Global Call To Action (Pearson, 2011); together they criticized China in a paper for Trump's campaign, "Scoring The Trump Economic Plan: Trade, Regulatory, & Energy Policy Impacts," dated September 29, 2016, available at assets.donaldjtrump.com. Lighthizer worked on Ronald Reagan's Treasury Department's team that engaged in the tough trade negotiations with Japan in the mid-1980s. 8 The existing statutory procedure, now enshrined in Title VII of the Trade Facilitation and Trade Enforcement Act of 2015, involves the Treasury Department making semi-annual assessments and potentially initiating bilateral or multilateral negotiations. According to the more or less standard time frame since 1988, any charges of currency manipulation would occur in the April report at earliest, and more likely in the October report or thereafter. For Trump to have designated China a manipulator on day one, he would either have had to issue a simple statement of intent or an executive directive that bypassed the formal foreign exchange review process. 9 Please see Andy Kiersz, "Here's Every State's Biggest International Trading Partner," Business Insider, October 20, 2016, available at www.businessinsider.com. See also Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 10 Serbia "defeated" the much larger Austria-Habsburg in their "Pig War" in the early 1900s, while Ireland won most of its key demands from England despite losing the "Economic War" of the 1930s. Russia's attempts over the past decade to bully Ukraine into submission have not succeeded in achieving Russia's political aims. In each of these cases, a far greater economic disparity existed than currently exists between the U.S. and China, and yet even then the weaker country's popular support, and the willingness of neighbors to exploit the new trade opportunities that opened up, enabled the weaker country to win the political clash of wills. 11 Please see "China: Xi Is A "Core" Leader... So What?" in BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 12 Please see BCA Emerging Markets Strategy Special Report, "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 13 Please see "China unveils new plan to further open economy to foreign investment," Reuters, January 17, 2017, available at www.reuters.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017, available at cis.bcaresearch.com. 15 Please see BCA U.S. Equity Strategy Weekly Report, "2017 High-Conviction Calls," dated January 9, 2017, available at uses.bcaresearch.com.
The sharp packaged food share price decline means that difficult conditions are now being discounted. Sales growth expectations have cratered, reflecting the negative impact of food price deflation and the strong U.S. dollar on this export-dependent industry. However, the strong currency no longer appears to be crimping demand: real exports of food and beverage products have surged in recent months. On the flipside, imports have declined, suggesting less fierce foreign competition. In addition, a strong U.S. dollar should continue to keep a lid on raw food prices. Low input commodity costs have helped propel our profit margin proxy to new cyclical highs, heralding ongoing margin expansion. The latter demonstrates impressive operating discipline amidst a tough sales backdrop. We recommend using the sell-off to lift underweight positions up to neutral. The ticker symbols for the stocks in this index are: BLBG: S5PACK-MDLZ, KHC, GIS, K, TSN, CAG, SJM, HSY, MJN, CPB, MKC, HRL.
While momentum and buoyant expectations have been a powerful support for equity markets, it is critical to keep a close on eye on the cyclical valuation backdrop to avoid getting caught up in any hype. For instance, the total market capitalization (MC) of the U.S. stock market is more than 120% of (nominal) GDP, more than double the 2008 trough. MC as a share of GDP has only been higher during the TMT bubble in the late-1990s. Since the 2008 low, central bank balance sheet expansion and the accrual of earnings to the corporate sector rather than to laborers have powered this remarkable surge. Low interest rates have also incented investors to bid up MC using leverage. Margin debt is now at previous peaks relative to GDP. MC to GDP has averaged 75% over the last forty five years. Even if nominal GDP boomed at 8% per annum for the next five years, market cap would still be over 80% of GDP, or well above the average. It may be too optimistic to expect market cap to stay above average over the next five years even if economic growth booms, because strong growth would imply a shift from interest rate normalization to more restrictive settings, and wages would take an ever increasing share of corporate profits, removing two key valuation supports. Consequently, we recommend a capital preservation mindset and a focus on controlling risk, as opposed to chasing short-term momentum driven returns.