Economic Growth
Highlights U.S. growth will remain firm over the next 12 months, but then will begin to slow from its above-trend pace as the economy runs out of spare capacity. Fiscal stimulus, by the time it is enacted, may simply end up pushing up wages, interest rates, and the dollar, rather than boosting corporate profits. While the U.S. is not at an imminent risk of a recession, the historic record suggests that recessions are more likely to occur when an economy has achieved full employment. Equity investors should favor Europe and Japan, two places where central banks are in no hurry to raise rates, profit margins still have room to expand, and valuations are reasonably favorable. Feature The Rusty Lining The U.S. economy is approaching full employment. The headline unemployment rate has fallen to 4.7%, close to most estimates of NAIRU. Broader measures of labor market slack, which incorporate marginally-attached and involuntary part-time workers, are also approaching pre-recession levels (Chart 1). Consistent with this observation, the job openings rate in the JOLT survey, the share of households reporting that jobs are "plentiful" versus "hard to get" in the Conference Board's Consumer Confidence survey, and the share of small businesses reporting difficulty in finding suitably qualified workers in the NFIB survey are near 2007 levels (Chart 2). Chart 1U.S. Labor Market: Not Much Slack Left Chart 2Most Labor Market Survey Measures ##br## Now Consistent With Full Employment It is obviously good news that most people in the U.S. who want to work are able to find jobs. However, at the risk of sounding like spoilsports, we see three risks associated with this development. First, and most obviously, the fact that the U.S. economy is close to full employment means that it will not be able to grow at an above-trend pace for much longer. Second, efforts by the Trump administration to lift aggregate demand with fiscal stimulus may prove to be counterproductive: Rather than boosting GDP growth, the stimulus may simply lead to higher wage inflation and a stronger dollar. This could hurt corporate profits. Third, there is compelling evidence that the risks of a recession rise as an economy approaches full employment and begins to overheat. We discuss all three issues in turn. Weak Supply Will Limit Growth One of the more striking aspects of the U.S. economic recovery is that the output gap - the difference between what an economy is capable of producing and what it actually is producing - has nearly disappeared even though GDP growth has been rather lackluster. This has occurred for one simple reason: Potential GDP growth has been extremely weak. Chart 3 shows that the slowdown in potential GDP growth has been a global phenomenon. In every major economy, the output gap would be larger today than in 2008 if potential GDP had grown at the rate that the IMF forecasted back then. Chart 3AWeak Supply Growth Has Narrowed Output Gaps Chart 3BWeak Supply Growth Has Narrowed Output Gaps Many commentators are hopeful that the combination of sizeable tax cuts and President Trump's pledge to reduce red tape will lead to a marked acceleration in potential U.S. GDP growth. There is some validity to this view. Statutory corporate tax rates in the U.S. are among the highest in the OECD, while the Code of Federal Regulations is 178,000 pages long, eight times the size that it was in 1960 (Chart 4). Still, we are skeptical that the economic benefits of slashing corporate taxes and cutting red tape would be as great as some pundits are touting. If one includes the various loopholes and deductions that companies can avail themselves of, effective corporate tax rates in the U.S. are not particularly high compared with those of other countries.1 Cutting corporate taxes may also do precious little to lift investment spending, given that U.S. companies are already flush with cash and have access to plenty of cheap financing. While the regulatory burden on U.S. businesses has increased somewhat over the past seven years, it is still quite low compared to other major economies according to the World Bank's Doing Business report (Chart 5). And many of the regulations that businesses routinely complain about serve a useful purpose, particularly in the areas of health, clean air and water, and financial stability. Consistent with the analysis above, there is little evidence that Reagan's tax cuts and deregulation initiatives had much effect on productivity growth in the 1980s (Chart 6). Meanwhile, Trump's efforts to crack down on illegal immigration will reduce labor force growth, curbing potential GDP growth in the process. Trade protectionism will also dent productivity in some sectors of the economy. The bottom line is that potential growth is unlikely to rise much above 2% for the foreseeable future. Chart 4There Are Prolific Writers In The U.S. Administration Chart 5Regulatory Burden In The U.S. Is Relatively Low Chart 6The Reagan Years Were No Boon For U.S. Productivity Flagging Fiscal Multipliers As we discussed last week, market participants may be overestimating the extent to which fiscal policy will be eased over the next two years.2 Suppose, however, that the optimists are right; suppose Donald Trump is able to fully deliver on his campaign pledge to raise infrastructure spending and slash taxes. Let us also suppose that, contrary to our expectations, lower personal and corporate tax rates do prompt households to significantly boost spending, while incentivizing firms to increase capital expenditures. What then? The answer is that this still may not translate into significantly faster economic growth. The reason is straightforward: When the output gap is small, an increase in aggregate demand will largely translate into higher inflation rather than increased output. An overheated economy, in turn, will drive up real interest rates, leading to less spending on rate-sensitive goods such as consumer durables, housing, and business equipment. In addition, higher interest rates will cause the dollar to strengthen, swelling imports and reducing exports. This "crowding out" effect will reduce the net effect of fiscal stimulus on growth. The empirical evidence bears this out. Table 1 shows the fiscal multipliers are much smaller when an economy is close to full employment. Table 1The Effect Of A $1 Increase In Fiscal Spending On Aggregate Demand The implication is that Trump's fiscal stimulus plan, by the time it is enacted, may simply end up lifting interest rates, the dollar, and wages, without delivering much acceleration in real business sales. Again, this is not just a theoretical possibility. Chart 7 shows that the ratio of corporate profits-to-GDP has tended to decline when the unemployment rate has fallen below its full employment level. This suggests that the re-acceleration in earnings growth that began last summer could run out of steam later this year. Chart 7The Effects Of Full Employment Recession Risks Are Slowly Rising Business cycle recoveries may not die of old age. However, as anyone who's been around long enough knows, old age isn't exactly conducive to good health either. Chart 8 shows that there is a positive correlation between the degree of labor market slack and the length of time until the next recession. This implies that recessions are more likely to occur when an economy approaches full employment. In fact, outside of the 1982 recession, which in many respects was just a continuation of the 1980 recession, there has never been a case in the post-war era where a recession began at a time when the unemployment rate was above its full employment level. Formal econometric analysis bears this out: According to our calculations, the U.S. has had nearly a 31% chance of falling into recession over the subsequent 12-month period when the economy was at or above full employment, compared with only an 8% chance at all other times.3 Part of the relationship between economic slack and recession risk can be explained by the fact that the unemployment rate is mean reverting. Thus, when the unemployment rate is very low, it is more likely to go up than down. And history suggests that even a slight rise in the unemployment rate is a powerful harbinger of recession. In fact, Chart 9 shows that there has never been a case where the unemployment rate has risen more than one third of a percentage point without the U.S. falling into a recession. Chart 8U.S.: A Tighter Labor Market Means We Are Getting Closer To The Next Recession Chart 9Even A Small Increase In The Unemployment Rate Warns Of A Recession When Animal Spirits Bite Back Mean reversion, however, is only part of the story. As Hyman Minsky famously noted, stability begets instability. By this, he meant that good economic times tend to encourage excessive risk taking, and this sows the seeds of a future crisis. The good news is that the U.S. does not currently suffer from any major economic imbalances. Perhaps it was the severity of the crisis; perhaps it was the lackluster recovery; but whatever the reason, animal spirits have been slow to return this time around. Sure, stocks have soared thanks to ultra-low interest rates, but both business and residential investment remain subdued (Chart 10). Nevertheless, signs of excess are starting to appear in places. Corporations may have been restrained in their capital spending plans, but that did not stop them from piling on new debt to finance share buybacks, and mergers and acquisitions (Chart 11). As a result, our Corporate Health Monitor has been in deteriorating territory since the second half of 2013 (Chart 12). Chart 10Business And Residential Investment Remain Subdued Chart 11Companies Have Been Piling On New Debt Chart 12U.S. Corporate Health Keeps Deteriorating Policy risks have also increased. These include the possibility of a global trade war, rising support for anti-establishment parties in Europe, and a pronounced slowdown in China that precipitates mass capital flight and a sharp depreciation of the RMB. Complicating matters is the fact that policy rates remain quite low across all major economies, which limits the ability of central banks to respond to another economic downturn. Investment Conclusions Chart 13More Optimism About The ##br##Longevity Of The Business Cycle Fears of secular stagnation, which were all the rage just 12 months ago, have given way to unbridled confidence about the future. Investors now dismiss the exact same things they once feared from Donald Trump, even though Trump the President has proven to be little different from Trump the Candidate. Among participants in the New York Fed's Survey of Primary Dealers who assign a non-zero probability that rates will fall back to zero at some point over the next three years, the median respondent expects that it would take 27 months to reach this sorry state of affairs, up from 11 months in April 2016 (Chart 13).4 If one uses this as proxy for when investors believe the next recession will roll around, it implies that market participants now believe that the recovery will last more than twice as long as they thought last summer. We agree that U.S. growth is likely to remain firm over the next 12 months. As we argued last October in a report entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen," the U.S. economy has a lot of momentum behind it.5 As such, we continue to expect Treasury yields to rise and the dollar to appreciate over the next 12 months. Nevertheless, we are cognizant that much can go wrong with this assessment. Chart 14 shows that most of the recent better-than-expected data has been confined to survey measures of economic activity - what economists call "soft data." The so-called "hard data" has been mediocre. This is not a major red flag, as the hard data often lags the survey results, but it does underscore the fragile nature of the recovery. Chart 14Survey Measures Have Improved More Than The Hard Data All this puts U.S. stocks in a difficult position. If growth does end up disappointing, equities will suffer. However, if growth remains strong, bond yields are likely to rise further, taking the dollar up with them. Meanwhile, a tight labor market will increasingly put upward pressure on real wages, hurting corporate profit margins in the process. With that in mind, investors should overweight equity markets in Europe and Japan, two places where central banks are in no hurry to raise rates, profit margins still have room to expand, and valuations are more favorable. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 According to a report by the Congressional Research Service, the U.S. statutory corporate tax rate was 39.2% while the GDP-weighted average rate in the OECD excluding the U.S. was 29.6% (based on 2010 data). Meanwhile, the U.S. effective tax stood at 27.1% versus the 27.7% average of its OECD peers (based on 2008 data). Studies conducted before the Great Recession also show that the U.S. effective rate is about the same as the GDP-weighted average rate of other major countries. For further details, please see Jane G. Gravelle, "International Corporate Tax Rate Comparisons and Policy Implications," Congressional Research Service (January 6, 2014). 2 Please see Global Investment Strategy Weekly Report, "Two Speed Bumps For The Global Reflation Trade," dated January 27, 2017, available at gis.bcaresearch.com. 3 The probability of a U.S. recession occurring within the next 12 months is calculated by employing a simple logistic model using data from 1960 to the present. The dependent variable (Y) is assigned the value "1" during months when a recession occurs over the subsequent 12-month period, or "0" otherwise. An independent variable (X) is assigned the value "1" when the economy is at full employment, or "0" otherwise. Assuming full employment is reached when the unemployment rate is at least 25 bps lower than the non-accelerating inflation rate of unemployment, the resulting probabilities for a recession within the next year are as follows: P(Y=1 given that X=1) = 31%; P(Y=1 given that X=0) = 8%; P(Y=1 given that X=1 or given that X=0) = 17%. In a nutshell, the probability of a recession occurring increases by 23 percentage points (from 8% to 31%) once full employment is reached. 4 In both the April 2016 and December 2016 surveys, all but one respondent indicated that there was a non-zero chance that rates will fall to zero over the relevant forecast horizon. 5 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Duration: Rising political tensions in the U.S. will not offset the cyclical upward momentum in global growth, which is supported by accelerating corporate profits. Bond yields are unlikely to fall much in the near term, despite significant bearish investor duration positioning. Shift back to a below-benchmark overall portfolio duration stance and position for bear-steepening of yield curves. Country Allocation: Downgrade U.S. Treasuries to underweight (2 of 5) in global hedged bond portfolios. Corporates: A better global growth outlook should continue to support U.S. corporate debt markets, despite tight valuations and a strong U.S. dollar. Upgrade allocations to U.S. Investment Grade to above-benchmark (4 of 5) and U.S. High-Yield to neutral (3 of 5), at the expense of U.S. Treasuries. Favor the higher quality tiers (i.e. above Caa) in U.S. junk. Feature Optimism reigns supreme in the markets at the moment, particularly in the U.S. where bullish investors traded in their "Make America Great Again" hats for "Dow 20,000" ballcaps last week. The string of better-than-expected economic data across the world is continuing - a fact confirmed by the latest corporate profit releases showing that an earnings recovery was already underway before Donald Trump's election victory. We have been looking for a meaningful pullback in government bond yields, and a widening of credit spreads, before returning to a below-benchmark portfolio duration stance and raising corporate allocations. That opportunity may not come to pass as economic data remains solid and leading indicators are accelerating. With no major inflation hiccups likely in the near-term to force the major central banks to rapidly shift to a more hawkish stance, and with equity markets remaining supported by accelerating earnings growth, the current "sweet spot" for risk can continue. Return expectations must be tempered, though, as much of the recent growth improvements is already reflected in bond and equity valuations. Any sign that the optimism shown in confidence surveys is not translating into improving hard economic data could trigger an equity market correction and a risk-off move to lower government bond yields and wider credit spreads. Given our view that global growth will be faster than consensus expectations in 2017, however, we think that a pro-risk overshoot phase is more likely than a risk-off correction in the near term. Any upset in equity markets would represent a medium-term opportunity to increase credit risk and reduce duration. This week, we are adapting a more pro-growth, pro-risk stance in our recommended portfolio allocations this week, making the following changes: Reduce overall portfolio duration to below-benchmark Reduce U.S. Treasury exposure to below-benchmark (2 of 5) Upgrade U.S. Investment Grade corporate exposure to above-benchmark (4 of 5) Upgrade U.S. High-Yield corporate exposure to neutral (3 of 5), favoring B- & Ba-rated names Importantly, we are maintaining our current allocations to Euro Area corporates (above-benchmark) and Emerging Market sovereign and corporate debt (neutral for both), given that we see more potential for upside surprises in the U.S. economy relative to the rest of the world. Duration: Re-Establish A Cyclical Below-Benchmark Stance We moved to a neutral stance on our overall duration recommendation back on December 6th, which we viewed as a tactical profit-taking exercise on our previous successful bearish bond call dating back to last July.1 Our view at the time was that global bonds were still in a cyclical bear phase, led by rising inflation expectations and better economic growth prospects in the developed world (especially in the U.S.). Given the extreme bearish positioning in government bond markets, at a time of oversold momentum, our stated plan of attack was to look to move back to a below-benchmark stance after a meaningful pullback in yields. The likely trigger for that move was expected to be some disappointment on actual economic data, especially given the heightened growth expectations in the U.S. after Trump's electoral victory. Global economic data continues to trend in a positive direction, however, which is preventing any pullback in bond yields despite a deeply oversold market (Chart of the Week). The Citigroup Data Surprise index for the major developed economies is at the highest levels since early 2014. The Global ZEW indicator, one of our favorites, is at the highest level since mid-2015. The global leading economic indicator from the OECD is back to levels last seen in 2013, suggesting that the positive growth momentum can continue to put upward pressure on real bond yields. There are few signs of disappointment at the country level, with the Purchasing Managers Indices for all major developed markets, as well as for China, all pointing to expanding global activity (Chart 2). Chart of the WeekYields Supported By Faster Growth Chart 2A Broad Based Upturn It will be interesting to see if this uptrend can withstand the "bull in the China shop" approach of the new Trump administration with regards to U.S. trade policy. Already, in just the first week of his presidency, Trump has aggressively pushed to implement much of his protectionist campaign promises, like pulling out of the Trans-Pacific Partnership, pushing to renegotiate the North American Free Trade Agreement and threatening the imposition of tariffs or border taxes in an effort to reduce the U.S. trade deficit. Global confidence surveys will be critical to monitor in the next month or two for any sign that Trump uncertainty is having a detrimental effect on business optimism outside the U.S. Importantly, the starting point is strong, with both consumer and business confidence measures in Europe and China rising steadily, as are net earnings revisions for global equities (Chart 3). A combination of improving economic sentiment, confirmed by stronger corporate profits, may be enough for the global economy to withstand the shifting plate tectonics of U.S. economic policy. In the U.S. itself, the GDP report released last week showed that 2016 ended on a soft note, with annualized growth of only 1.9% in the 4th quarter. However, a sector-by-sector forecast for U.S. GDP presented last month by our colleagues at BCA U.S. Bond Strategy shows that there is upside risk for most major elements of the U.S. economy (Chart 4).2 Rising consumer confidence amid a tight labor market should help boost consumption, while the large drag from inventory destocking seen last year will not be repeated in 2017. Chart 3An Improving Corporate Profit Backdrop Chart 4Upside Risks For U.S. Growth The wild cards for U.S. growth will come from all the sectors most impacted by potential policies from the Trump administration: business investment, government spending and net exports. Trump has been going full steam ahead with his protectionist leanings in his initial days in office, but how much he can quickly implement remains to be seen. For now, the U.S. dollar is not rising rapidly enough to generate much of a drag on U.S. GDP growth, unlike the 2014/15 surge in the greenback (see the bottom panel of Chart 4). More importantly, the improving trend in U.S. corporate profit growth and post-election surge in business confidence should support faster growth in U.S. capital spending, which is already showing signs of perking up a bit (Chart 5). As we discussed in a Weekly Report earlier this month, the bigger upside surprise for the U.S. economy this year will come from capital spending, not government spending, as Trump will have a much easier time passing pro-growth corporate tax cuts than getting his infrastructure spending program green-lighted quickly through the U.S. Congress.3 U.S. growth will be much faster than the Fed's current forecast of 2.1%, which will embolden the Fed to deliver on additional rate hikes later this year. The Fed will likely want to see some sign of clarity on the fiscal policy outlook before contemplating the next rate hike, and we are not expecting a rapid acceleration of U.S. inflation in the next few months that would force to Fed to act more quickly. The next rate hike will come at the June FOMC meeting, with the Fed delivering at least the 50bps of rate hikes by year-end currently discounted in the market, and possibly the full 75bps of hikes shown in the latest FOMC projections if the economy delivers faster growth in 2017, as we expect. When looking at the other major bond yields in the "Big-4" developed markets, all elements of valuation have repriced higher (Chart 6): Chart 5U.S. Corporate Profits & Confidence Are Stronger, Capex Is Next Chart 6All Yield Components Are Rising Central bank policy rate expectations have shifted away from cuts in the Euro Area, Japan and the U.K., with a small hike from the Bank of England now discounted in the U.K. Overnight Index Swap (OIS) curve; Term premiums have risen from the mid-2016 lows, but remain negative in the countries where central banks are still actively engaging in asset purchase programs; Inflation expectations are well off the 2016 lows in all markets, but with higher levels in the U.K. and U.S. We see much higher upside risks for growth and inflation, and tighter monetary policy, in the U.S. and U.K. than the Euro Area or Japan. To reflect this in our model portfolio, we are downgrading our U.S. country allocation to below-benchmark (2 of 5) this week, while maintaining our underweight in the U.K. (also 2 of 5). We are keeping the Euro Area at above-benchmark (4 of 5) and Japan at benchmark (3 of 5). Government bond yield curves should see mild steepening pressure from rising inflation expectations before central banks are forced to turn more hawkish. We are focusing our decision to reduce overall portfolio duration more at the longer end of yield curves, especially in the U.S. and U.K. (Chart 7). A large headwind to any significant move higher in bond yields remains investor positioning, with only the "active client" portion of the JP Morgan duration survey showing a flip back to a net long duration stance in recent weeks (Chart 8). A full unwind of the large short positions in government bond markets is unlikely in the absence of much weaker economic data or a big correction in equity markets. The latter is impossible to time, but nothing that we are seeing in the forward-looking data is pointing to an imminent slowing of economic growth. Thus, we are choosing to shift back to our desired strategic below-benchmark duration stance this week. Chart 7Rising Inflation = Steeper Yield Curves Chart 8Large Short Positions Still An Issue Bottom Line: Rising political tensions in the U.S. will not offset the cyclical upward momentum in global growth and inflation. Bond yields are unlikely to fall much in the near term, despite significant bearish investor duration positioning. Shift back to a below-benchmark overall portfolio duration stance and position for bear-steepening of yield curves. Downgrade U.S. Treasuries to underweight (2 of 5) in global hedged bond portfolios. Corporate Bonds: A Cyclical Upgrade In The U.S., Despite Tight Valuations Global corporate debt has enjoyed solid relative performance versus government bonds over the past several months, driven by the improvements in economic growth and earnings. Credit spreads have narrowed in response, for both Investment Grade and High-Yield. In the Euro Area, the U.K. and Japan, central bank asset purchases of corporate bonds have also helped to keep spreads tight and help support the overall positive backdrop for credit markets. High levels of corporate leverage remain an issue, especially in the U.S., but an improving profit backdrop and faster nominal GDP growth will help paper over problems associated with high company debt. In the U.S., the items in our "Corporate Checklist" are providing a generally positive signal (Chart 9): Our Corporate Health Monitor (CHM) is starting to signal a slight improvement in corporate credit metrics after several years of deterioration; Bank lending standards are no longer tightening, according to the Fed's Senior Loan Officer Survey, after a brief period of more stringent standards in 2015 & 2016; Bank equities are outperforming the overall market, which in the past has been a positive signal for credit availability and corporate debt performance; Monetary conditions are still only just neutral, even with the U.S. dollar at very expensive levels. The monetary backdrop could become a concern later on in the year if Fed rate hikes lead to another period of rapid U.S. dollar appreciation. Until then, the more positive backdrop for profits will continue to boost balance sheet health, resulting in reduced equilibrium risk premiums (i.e. spreads) on corporate bonds. Already, U.S. corporate debt has priced in the better news (Chart 10). In High-Yield, the massive rally in energy-related names after the recovery in oil prices last year (top panel) has driven the spread on the Energy sub-component of the Barclays Bloomberg benchmark index back to levels last seen when oil was at $100/bbl ... even though the price of oil is still in the low $50s! Meanwhile, junk spreads ex-energy now reflect the benign macro volatility environment, as proxied by the VIX index (middle panel). Chart 9A Better Fundamental Backdrop Chart 10Corporate Valuations Are Not Cheap... In Investment Grade, spreads have also tightened alongside falling volatility, although spreads are still somewhat higher than during the previous period when the VIX was this low back in 2014 (bottom panel), suggesting that spreads could compress even further if the macro backdrop stays benign. We have maintained a generally cautious stance on U.S. corporate credit for much of the past year, given the combination of poor corporate health, contracting profits and slowly tightening monetary conditions. Now that the backdrop has changed, the case for upgrading U.S. corporates versus U.S. Treasuries is more compelling. This is especially so given the improvement in global economic growth momentum, which usually correlates with periods of positive excess returns for both Investment Grade and High-Yield versus Treasuries (Chart 11). Given our more optimistic tone on global economic growth, led by the potential for upside surprises in the U.S., this week we are upgrading our recommended stance on U.S. Investment Grade corporates to above-benchmark (4 of 5) and U.S. High-Yield to at-benchmark (3 of 5). Within High-Yield, we are focusing our exposure on the high-to-middle quality tiers, as both B-rated and Ba-rated spreads look far more attractive than Caa-rated debt. That can be seen in Chart 12, which shows the option-adjusted spread (OAS) for the overall U.S. High-Yield index and the three main credit tier buckets, divided by the 12-month trailing volatility of excess returns for each grouping. These "vol-adjusted" spreads are at the long-run median level for B-rated and Ba-rated debt, while Caa-rated bonds (which are dominated by the now-expensive debt of energy-related companies) offers poor value relative to their volatility. Chart 11...But The Growth Outlook Remains Supportive Chart 12Avoid The Lower Credit Tiers In U.S. Junk Differentiating within the credit tiers is important, as the overall U.S. High-Yield spread is not particularly cheap once expected default losses are taken into account (Chart 13). If U.S. economic growth surprises to the upside, as we expect, then the default outlook will look better and High-Yield spreads will look more attractive. For this reason, we would look to shift to an above-benchmark stance on any risk-off correction in global equities or corporates. With the business cycle improving, buying any dips in U.S. corporate credit markets should pay off in 2017. One final point: we have had a long-standing recommendation to overweight Euro Area Investment Grade corporate debt versus U.S. equivalents. That view was based on the underlying support for Euro Area corporates from ECB purchases, coming at a time when Euro Area balance sheets were improving in absolute terms, and relative to the U.S., as shown by our Euro Area Corporate Health Monitor (Chart 14). However, with our U.S. CHM now showing some modest improvement, and with U.S. likely to show more upside growth surprises in 2017, we are not upgrading Euro Area debt from the current above-benchmark (4 of 5) ranking, even as we boost our U.S. corporate allocation. Chart 13Expect Carry-Like Returns, Given Tight Spreads Chart 14A Bullish Case For Both U.S. and Euro Area IG Bottom Line: A better global growth outlook should continue to support U.S. corporate debt markets, despite tight valuations and a strong U.S. dollar. Upgrade allocations to U.S. Investment Grade to above-benchmark (4 of 5) and U.S. High-Yield to neutral (3 of 5), at the expense of U.S. Treasuries. Favor the higher quality tiers (i.e. above Caa) in U.S. junk. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Vigilantes Take A Break For The Holidays", dated December 6, 2016, available at gfis.bcaresearch.com 2 Please see BCA U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "A "Post-Truth" Economic Upturn?", dated January 17, 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: Treasuries are now slightly expensive relative to global growth indicators, and the global economic recovery appears sustainable. Despite lingering concerns about policy uncertainty and bearish bond positioning, we recommend shifting back to a below-benchmark duration stance. Spread Product: The combination of an improving global growth back-drop and still-accommodative Fed policy will be positive for spread product. As such, we increase our allocation to investment grade corporate bonds - and spread product more generally - from neutral (3 out of 5) to overweight (4 out of 5). We also upgrade high-yield bonds from underweight (2 out of 5) to neutral (3 out of 5). Economy: U.S. GDP growth will be solidly above trend in 2017, driven in large part by accelerating consumer spending. Feature The divergence in economic growth between the U.S. and the rest of the world has been one of our key investment themes for much of the past two years. All else equal, the greater the divergence in growth between the U.S. and the rest of the world, the more the U.S. dollar comes under upward pressure. A strengthening dollar limits how far the Fed can lift rates and caps the upside in long-dated yields. In fact, in a report published last October titled "Dollar Watching: An Update"1 we wrote: Our continued expectation that the Fed will lift rates in December leads us to maintain below-benchmark portfolio duration and a neutral allocation to spread product until a December rate hike has been fully discounted by the market. Beyond December, our investment strategy will depend largely on how the dollar responds to an upward re-rating of rate expectations. Strong dollar appreciation would likely cause us to reverse our below-benchmark duration stance and become even more cautious on spread product. Conversely, a tame dollar could mean that the sell-off in bonds and rally in spreads have further to run. With the December rate hike now in the rearview mirror, global growth divergences do not appear to be a strong headwind for bond yields. In fact, the trade-weighted dollar has flattened off since the Fed lifted rates and bullish sentiment toward the dollar has plunged even though rate hike expectations remain elevated (Chart 1). This suggests that the dollar is so far not having much of an impact on the U.S. growth outlook or the expected path of monetary policy. Digging a little deeper, it appears we are witnessing a synchronized upturn in global growth led by the manufacturing sector (Chart 2). The Global Manufacturing PMI is in a clear uptrend, while the diffusion index suggests the improvement is broad based. Similarly, our Global Leading Economic Indicator is once again expanding, while its diffusion index is holding steady above the 50% line. Chart 1Dollar Sentiment: A Key Indicator Chart 2Synchronized Global Recovery Although the extremely high level of economic policy uncertainty increases the odds of a near-term selloff in risk assets and related flight-to-quality into Treasury securities, the strength of the global growth impulse and sustainability of the U.S. economic recovery (see section titled "U.S. Economy: A Healthy Consumer Leads The Way" below) means we would view any risk-off episode as an opportunity to reduce portfolio duration and increase exposure to spread product. As such, given our 6-12 month investment horizon and the inherent difficulty in forecasting near-term market riot points, this week we begin the process of shifting our portfolio in this direction. Specifically, we move from an "At Benchmark" back to a "Below Benchmark" duration stance and we also upgrade spread product from neutral (3 out of 5) to overweight (4 out of 5), while downgrading Treasuries from neutral (3 out of 5) to underweight (2 out of 5). Within spread product we upgrade investment grade corporates from neutral (3 out of 5) to overweight (4 out of 5) and upgrade high-yield from underweight (2 out of 5) to neutral (3 out of 5). We expand on the rationale for each move below. Portfolio Duration Chart 3Treasuries Now Expensive Two weeks ago,2 we detailed our bearish 6-12 month outlook for U.S. bonds, while also pointing to three factors that had so far prevented us from adopting a below-benchmark duration stance. The three factors were: (i) valuation, (ii) economic policy uncertainty and (iii) sentiment & positioning. Factor 1: Valuation Two weeks ago the 10-year Treasury yield was trading 9 basis points cheap on our 2-factor model based on Global PMI and bullish dollar sentiment. Since then, bullish sentiment has declined and Flash3 PMI readings from the U.S., Eurozone and Japan were all strong. If we assume that final PMIs from these regions are in line with the Flash numbers and that the PMIs from all other countries remain flat, then we calculate that the 10-year Treasury yield is actually 4 basis points expensive relative to fair value (Chart 3). In short, valuation argues even more in favor of reducing portfolio duration than it did two weeks ago. Factor 2: Uncertainty Economic policy uncertainty remains elevated and, unusually, has de-coupled from surveys of consumer and business confidence (Chart 4). Certainly, there is a risk that confidence measures relapse in the near-term if it appears as though some of the new President's promises related to tax cuts and deregulation will not be delivered. However, this risk needs to be weighed against the bond-bearish combination of protectionism and fiscal stimulus favored by the new administration, especially at a time when the economy is close to full employment. Factor 3: Sentiment & Positioning Bond sentiment and positioning remain decidedly bearish according to our Bond Sentiment Indicator and net speculative positioning in Treasury futures, although the J.P. Morgan client survey shows that clients' duration positioning is close to neutral (Chart 5). It is likely that some further capitulation of short positions is necessary before Treasury yields can move decisively higher. However, these shifts in positioning can occur very quickly and given the reading from our valuation model we feel that now is the appropriate time to reduce duration exposure. Chart 4Elevated Uncertainty Remains A Near-Term Risk... Chart 5...As Does Bearish Positioning Bottom Line: Treasuries are now slightly expensive relative to global growth indicators, and the global economic recovery appears sustainable. Despite lingering concerns about policy uncertainty and bearish bond positioning, we recommend shifting back to a below-benchmark duration stance. Spread Product In last week's report,4 we explored the performance of spread product throughout the four phases of the Fed cycle (Chart 6), which are defined as follows: Chart 6Stylized Fed Cycle 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. Based on the fact that core PCE inflation remains below the Fed's target and the view that its uptrend will proceed only gradually, we concluded that we are presently in Phase I of the Fed cycle and would probably remain there for the balance of the year. Historically, spread product has performed well in Phase I of the Fed cycle, with only Phase IV producing higher average monthly excess returns. However, the Fed cycle is only part of the story. Our Corporate Health Monitor (CHM) - a composite measure of balance sheet health for the nonfinancial corporate sector - has been in "deteriorating health" territory since late 2013. Historically, this measure has an excellent track record of flagging periods of spread widening (Chart 7). Chart 7The Corporate Health Monitor And Credit Spreads To augment our analysis, this week we re-examine average monthly excess returns for investment grade corporate bonds in the four phases of the Fed cycle but this time we also split each phase into periods of improving and deteriorating corporate health (Table 1). Table 1Investment Grade Corporate Bond Excess Returns* Given Reading From ##br##BCA Corporate Health Monitor And The Phase Of The Fed Cycle (July 1989 To Present) Table 1 shows there have been 14 months since 1989 when Phase I of the Fed cycle coincided with deteriorating corporate health, according to the CHM. Conversely, Phase I of the Fed cycle coincided with improving corporate health in 25 months. However, 13 of the 14 months when Phase I of the Fed cycle coincided with deteriorating corporate health are the most recent 13 months. In other words, the current combination of tightening (but still-supportive) monetary policy and weak corporate balance sheets is unprecedented. The other factor we have not yet considered is valuation, as measured by the starting level of corporate spreads. In Table 2 we present average monthly excess returns for investment grade corporate bonds split by both the phase of the Fed cycle and the investment grade corporate option-adjusted spread. At present, the average option-adjusted spread for the Bloomberg Barclays investment grade corporate index is 120 bps. Table 2Investment Grade Corporate Bond Excess Returns* Given Previous Month Option-Adjusted Spread** ##br##And The Phase Of The Fed Cycle (July 1989 To Present) In Table 2 we observe that usually spreads are much lower in Phase I of the Fed cycle, typically between 50 bps and 100 bps, and that periods when spreads are above 100 bps generally coincide with higher excess returns. However, we must also recall that corporate health is typically still improving in Phase I of the Fed cycle, so today's higher spread levels might be justified by worse credit quality. Chart 8Value Is Stretched In Junk It goes without saying that the unusual combination of deteriorating corporate health and still-supportive Fed policy is a complicated environment for credit investors to navigate. Our view is that accommodative Fed policy will prevent material spread widening, at least until inflation breaks above the Fed's target and we shift into Phase II of the Fed cycle, but it is also probably not reasonable to expect spreads to tighten much further from current levels. We are looking for low, but positive, excess returns from spread product, consistent with the available carry. Bottom Line: The combination of an improving global growth back-drop and still-accommodative Fed policy will be positive for spread product. As such, we increase our allocation to investment grade corporate bonds - and spread product more generally - from neutral (3 out of 5) to overweight (4 out of 5). We also upgrade our allocation to high-yield bonds from underweight (2 out of 5) to neutral (3 out of 5). We retain only a neutral allocation to high-yield due to the longer-run risks posed by poor corporate health, and tight valuations for high-yield bonds (Chart 8). U.S. Economy: A Healthy Consumer Leads The Way U.S. GDP growth decelerated to 1.9% in Q4 from 3.5% in Q3. Growth in consumer spending slowed to 2.5% from 3.0%, while fixed investment spending picked up to 4.2% from 0.1%. The headline 1.9% GDP print also includes a -1.7% contribution from net exports and +1.0% contribution from inventories. Taking a step back from the quarterly data, we see that the growth in real final sales to domestic purchasers - a measure of growth that strips out the volatile trade and inventory components - has clearly shifted into a higher range during the past couple of years (Chart 9). Further, leading indicators for each individual component of growth all suggest that further acceleration is in store (Chart 10). Chart 9Growth Finds A Higher Gear Chart 10Contributions To GDP Growth But crucially, it is the fundamental drivers underpinning the outlook for consumer spending that lead us to believe that U.S. economic growth will maintain an above-trend pace throughout 2017. As was observed by our U.S. Investment Strategy service in a recent report,5 income growth - the main driver of consumption trends - appears poised to accelerate, driven by accelerating wage growth that is starting to kick in now that the economy has finally reached full employment (Chart 11). The boost in consumer confidence could also lead to a lower savings rate, further increasing the impact on spending (Chart 11, bottom panel). Chart 11Consumer Spending = Income + Confidence Bottom Line: A healthy consumer is the back bone of the U.S. economy, and elevated consumer demand will also lend support to corporate fixed investment and the housing market. We expect that U.S. growth will be solidly above trend in 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, titled "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 3 The flash estimate is typically based on approximately 85%-90% of total PMI survey responses each month and is designed to provide an accurate advance indication of the final PMI data. 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Table 1Recommended Allocation The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)
Highlights Undue pessimism about global growth is giving way to unbridled optimism. Chinese growth has accelerated. However, there is a risk that the economy hits a speed bump later in 2017, as fiscal policy becomes less accommodative, monetary policy is tightened in an effort to curb capital outflows, and recent steps by the authorities to crack down on rampant speculation in the property sector begin to bite. The threat of a trade war will also loom large. U.S. fiscal policy will remain stimulative, but may fail to live up to expectations: There is little appetite among Republicans for increasing infrastructure spending; the multiplier effects from the proposed tax changes are likely to be small; and many GOP leaders are already chomping at the bit to take an ax to government spending. Fortunately, the U.S. economy has enough momentum to continue growing solidly above trend, even if fiscal policy disappoints. This will allow the Fed to raise rates three times this year, one more hike than the market is currently pricing in. Developed market equities are overbought and vulnerable to a correction, but will be higher 12 months from now. Favor Europe and Japan over the U.S. in local-currency terms. Stay underweight EM. Feature Global Growth Is Accelerating, But Headwinds Persist The global economy is on the mend. Measures of current activity are rebounding, as are a variety of leading economic indicators (Charts 1 and 2). Chart 1Global Economy ##br##Springing Back To Life Chart 2Global Leading Economic ##br##Indicators Are Improving Investors have taken notice: Market-based inflation expectations have risen, as have growth-sensitive commodity prices. Earnings growth expectations have surged, rising in the U.S. to nearly the highest level in a decade. Cyclical stocks have also bounced back, after having lagged the overall market for five years (Chart 3). We agree with the market's positive re-rating of global growth prospects, but worry that undue pessimism is starting to give way to excessive optimism. Two potential developments in particular could end up giving investors pause: A slowing of China's economy later this year. The possibility that U.S. fiscal policy will end up being less stimulative than expected. China: Living On Borrowed Time? Chinese growth has been surprising to the upside of late (Chart 4). Timely indicators such as excavator sales and railway freight traffic, which are well correlated with industrial activity, have been rising at a fast clip. Manufacturing inventory levels have come down, corporate profitability has improved, and producer price inflation has turned positive. The labor market has also picked up steam, as evidenced by the expansion in the employment subcomponents of the PMI indices. Chart 3Market's Positive Re-Rating Of Growth Prospects Chart 4Chinese Growth Has Been Surprising To The Upside Looking out, however, there are reasons to worry that the economy will weaken anew. Growth in government spending slowed from a high of 25% in November 2015 to nearly zero in December (Chart 5). Recent efforts by policymakers to clamp down on rampant property speculation could also cause the economy to cool. Meanwhile, capital continues to flee the country (Chart 6). This has put the government in a no-win situation: Raising domestic interest rates could entice more people to keep their money at home, but such a step could increase debt-servicing costs and undermine the country's creaky financial system. Chart 5China: Fiscal Stimulus Is Running Off Chart 6China: Ongoing Capital Outflows A Problem Of Inadequate Demand There is no shortage of commentary discussing the problems that ail China. Much of the analysis, however, has focused on the country's inefficient allocation of resources and other supply-side considerations. While these are obviously important issues, they overlook what has actually been the most significant binding constraint to growth: a persistent lack of aggregate demand. It has been this deficiency of demand - the flipside of a chronic excess of savings - that has kept the economy teetering on the edge of deflation. If a country suffers from excess savings, there are only three things that it can do. First, it can try to reduce savings by increasing consumption. The Chinese government has been striving to do that by strengthening the social safety net in the hopes that this will discourage precautionary savings. However, this is a slow process which will take many years to complete. Second, it can export those excess savings abroad by running a current account surplus. This would allow the country to save more than it invests domestically through the famous S-I=CA identity. The problem here is that no one wants to have a large current account deficit with China. Certainly not Donald Trump. Third, it can channel those excess savings into domestic investment. This is what China has done by pressing its banks to extend credit to state-owned companies and local governments. Remember that debt is the conduit through which savings is transformed into investment. From this perspective, China's high debt stock is just the mirror image of its high savings rate. The problem is that China already invests too much. Chart 7 shows that capacity utilization has been trending lower over the past six years and is back down to where it was during the Great Recession. The good news is that as long as there is plenty of savings around, Chinese banks will have enough liquid deposits on hand to extend fresh credit. The bad news is that there is no guarantee that borrowers taking on this debt will be able to repay it. This has made the Chinese economy increasingly sensitive to changes in financial conditions. And that sensitivity has, in turn, made global financial markets more fragile. Chart 8 shows that global equities have sold off whenever China stresses have flared up. The risk of another such incident remains high. Chart 7China: Capacity Utilization Back ##br##To Pre-Recession Levels Chart 8When China Has a Cold, ##br##Global Equities Sneeze China Trade War: The U.S. Holds The Trump Card Chart 9China Would Suffer More ##br##From A Trade War With The U.S. Adding to the pressure on China is the prospect of a trade war with the United States. Donald Trump has flip-flopped on almost every issue over the years, but he's been perfectly consistent on one: trade. Trump has always been a mercantilist at heart, and nothing that has happened since the election suggests otherwise. It is sometimes argued that the damage to the U.S. economy from a trade war with China would be so grave that Trump would not dare initiate one. This is wishful thinking. Chinese exports to the U.S. account for 3.5% of Chinese GDP, while U.S. exports to China account for only 0.6% of U.S. GDP (Chart 9). And much of America's exports to China are intermediate goods that are processed in China and then re-exported elsewhere. Blocking these exports would only hurt Chinese companies. Yes, China could threaten to dump its huge holdings of U.S. Treasurys. However, this is a hollow threat. The yield on Treasurys is largely determined by the expected path of short-term interest rates, which is controlled by the Federal Reserve. To be sure, the dollar would weaken if China started selling Treasurys. But why exactly is that a problem for the U.S.? Donald Trump wants a weaker dollar! In short, the U.S. would not lose much by provoking a trade war with China. Where does this leave us? The most likely outcome is that China blinks first and takes more concerted steps to open up its market to U.S. goods. This would hand Donald Trump a major political victory. However, the path from here to there is likely to be a very rocky one, which means that the reflation trade could suffer a temporary setback. A Trumptastic Fiscal Policy? Getting tough with China was one of Trump's key campaign promises; increasing infrastructure spending and cutting taxes was another. Unfortunately, investors may end up being disappointed both by how much fiscal stimulus is delivered and by the bang for the buck that it generates. For starters, much of Trump's proposed infrastructure program may never see the light of day. The $1 trillion ten-year program that he touted during the campaign was scaled back to $550 billion on his transition website. And even that may be too optimistic. Most Republicans in Congress have little interest in expanding public infrastructure spending. They opposed a big public works bill in 2009 when millions of construction workers were out of a job, and they will oppose one now. The public-private partnership structure that Trump's plan envisions will also limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Granted, the definition for what counts as public infrastructure could be expanded to include such things as hotels and casinos, to cite two completely random examples. But even if one ignores the obvious governance problems that this would raise, such a step could simply crowd out private investment that would otherwise have taken place. The reason that governments invest in infrastructure to begin with is because there are certain categories of public goods that do not lend themselves well to private ownership. To purposely exclude such goods from consideration, while devoting public funds to projects that the private sector is already perfectly capable of doing, is the height of folly. Trump And Taxes House Republicans are pursuing a sweeping tax reform agenda. There is much to like about their proposal. In particular, the shift to a cash flow destination-based tax system could encourage new investment over time, while making it more difficult for firms to carry out a variety of tax-dodging strategies. However, as with many major policy initiatives, the Republican tax proposal could generate significant near-term economic dislocations. Most notably, as we discussed in detail last week, the inclusion of a border adjustment tax could lead to a sharp appreciation in the dollar.1 This would benefit foreign holders of U.S. assets, but hurt debtors with dollar-denominated loans. Such an outcome could put stress on emerging markets, potentially undermining the global reflation trade. Trump's proposed cuts to personal income taxes may not boost spending by as much as some might hope. The Tax Policy Center estimates that the top one percent of income earners will see their after-tax incomes increase by 13.5%, while those in the middle quintile of the distribution will receive an increase of only 1.8% (Table 1). Since the very rich tend to save much of their income (Chart 10), measures which boost their disposable income may not translate into a substantial increase in spending. In fact, cutting the estate tax, as Trump has proposed, could actually depress spending by reducing the incentive for older households to blow through their wealth before the Grim Reaper (and The Taxman) arrive. Table 1Trump's Proposed Tax Cuts Would Largely Favor The Rich Chart 10Savings Heavily Skewed Towards Top Earners Spending Cuts On The Horizon? Then there is the question of whether Congressional Republicans will try to take an ax to government spending. The Hill reported last week that several senior members of Trump's transition team have proposed a plan to cut federal spending by $10.5 trillion over the next 10 years.2 The plan contains many of the same elements as the Republican Study Committee's Blueprint for a Balanced Budget, which called for $8.6 trillion in cuts over the next decade. Separately, Representative Sam Johnson of Texas, the chairman of the House Ways and Means subcommittee on Social Security, has introduced legislation seeking large cuts to pension benefits. Under his plan, workers in their mid-thirties earning $50,000 per year would see a one-third reduction in lifetime Social Security payments.3 Paul Ryan and other Congressional Republicans have also begun to argue that the goal of health care reform should be to guarantee "universal access" to high-quality medical care, rather than "universal coverage." This is a bit like arguing that the goal of transportation policy should be to ensure that everyone has access to a Bentley, provided that they can pony up $200,000 to buy one. It remains to be seen whether President Trump will acquiesce to these changes. He has repeatedly insisted that no one will lose medical coverage under his administration. However, one of his first actions in office was to loosen the mandate that requires healthy individuals to purchase insurance under the Affordable Care Act. Such a measure, however well intentioned, could greatly undermine the Act. If healthy people can wait until they are sick to sign up for insurance, only sick people will sign up. In order to cover their costs, insurance providers would have to raise premiums, ensuring that even fewer healthy people sign up. Such a vicious "adverse selection cycle," as economists call it, could lead to the collapse of health insurance exchanges, which currently provide coverage for 12.7 million Americans. Our guess is that Trump will ultimately put the kibosh on any plan to radically cut government spending or curtail Medicare and Social Security benefits. Say what you will of Trump, he has proven to be a skilled political operator for someone who has never been elected to public office. He knows that people were chanting "build the wall" at his rallies, not "cut my Medicare." Indeed, it is possible that Trumpcare will ultimately look a lot like Obamacare but with more generous subsidies for health care providers. Nevertheless, the path to this more benign investment outcome will be a bumpy one, suggesting that market volatility could rise in the months ahead. Investment Conclusions Chart 11DM Stocks Are Overbought Markets tend to swing from one extreme to another. This time last year, investors were fixated on secular stagnation. Now they are convinced that we are on the edge of a new global economic boom. Neither position is justified. Global growth has picked up, and this should provide a tailwind to risk assets over the next 12 months. However, as this week's discussion makes clear, there are still plenty of headwinds around. This suggests that the recovery will be a halting affair, with plenty of setbacks along the way. The surge in developed market equities since the U.S. presidential election has pushed stocks deep into overbought territory (Chart 11). A correction is likely over the next few weeks. We expect global equities to fall by 5%-to-10%, paving the way for higher returns over the remainder of the year. Once that recovery begins, European and Japanese stocks will outperform their U.S. counterparts in local-currency terms. We continue to expect EM equities to lag DM. In contrast to stocks, bond yields have already moved off their highs. As we discussed in our Strategy Outlook in early January, the transition from deflation to inflation will be a protracted one.4 Nevertheless, the path of least resistance for yields is to the upside. The Fed is likely to raise rates three times this year, one more hike than the market is currently pricing in. This should be enough to keep the dollar bull market intact. We expect the trade-weighted dollar to rise another 5% by year-end, with the risk tilted to the upside if Congress ends up approving a border adjustment tax. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 2 Please see Alexander Bolton, "Trump Team Prepares Dramatic Cuts," The Hill, dated January 19, 2017. 3 Please see Stephen C. Goss memorandum to Sam Johnson, "Estimates Of The Financial Effects On Social Security Of H.R. 6489, The 'Social Security Reform Act Of 2016,' Introduced On December 8, 2016 By Representative Sam Johnson," Social Security Administration, Office Of The Chief Actuary (December 8, 2016). 4 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades