Policy
Highlights Economic Outlook: Global growth will remain strong over the next 12 months, but will start to slow in the second half of 2018, potentially setting the stage for a recession in 2019. Overall Strategy: Investors should overweight equities and spread product for now. However, be prepared to pare back exposure next summer. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S. Treasurys, stay neutral Europe, and overweight Japan. Equities: Remain overweight developed market equities relative to their EM peers. Within the DM sphere, favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares have significant upside. Currencies: The selloff in the dollar is overdone. The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar, as does the euro. Commodities: Oil will rally over the coming months as global inventories decline. Gold will continue to struggle, before exploding higher towards the end of this decade. Feature I. Global Macro Outlook End Of The Global Manufacturing Recession Global growth estimates have been trending higher over the past 12 months, having bottomed last summer. Ironically, the collapse in oil prices in late 2014 was both the main reason for the deterioration in global growth as well as its subsequent rebound. Plunging oil prices led to a massive decline in capital spending in the energy sector and associated industries. In the U.S., energy capex dropped by 70% between Q2 of 2014 and Q3 of 2016. The economic fallout was even more severe in many other economies, especially emerging markets such as Russia and Brazil. The result was a global manufacturing recession and a pronounced slump in international trade (Chart 1). When thinking about oil and the economy, the distinction between levels and rates of change is important: While rapidly falling oil prices tend to be bad for global growth, lower oil prices are good for it. By the middle of 2016, the damage from the oil crash had largely run its course. What was left was a massive windfall for households, especially poorer ones who spend a disproportionate share of their paychecks at the pump. Industries that use oil as an input also benefited. Simply put, the oil crash went from being a bane to a boon for the global economy. A Solid 12-Month Outlook We expect global growth to remain firm over the next 12 months. Financial conditions in most countries have eased substantially since the start of the year thanks to rising equity prices, lower bond yields, and narrower credit spreads (Chart 2). Our empirical analysis suggests that easier financial conditions tend to lift growth with a lag of 6-to-9 months (Chart 3). This bodes well for activity in the remainder of this year. Chart 1The Manufacturing Recession Has Ended Chart 2Financial Conditions Have Eased Globally A number of "virtuous cycles" should amplify the effects of easier financial conditions. In the U.S., a tight labor market will lead to faster wage growth, helping to spur consumption. Rising household spending, in turn, will lead to lower unemployment and even faster wage growth. Strong consumption growth will also motivate firms to expand capacity, translating into more investment spending. Chart 4 shows that the share of U.S. firms planning to increase capital expenditures has risen to a post-recession high. Chart 3Easier Financial Conditions Will Support Growth Chart 4U.S. Firms Plan To Boost Capex The euro area economy continues to chug along. The purchasing manager indices (PMIs) dipped a bit in June, but remain at levels consistent with above-trend growth. The German Ifo business confidence index hit a record high this week. Corporate balance sheets in the euro area are improving and credit growth is accelerating. This is helping to fuel a rebound in business investment (Chart 5). The fact that the ECB has no intention of raising rates anytime soon will only help matters. As inflation expectations begin to recover, short-term real rates will fall. This will lead to a virtuous circle of stronger growth, and even higher inflation expectations. The Japanese economy managed to grow by an annualized 1% in the first quarter. This marked the fifth consecutive quarter of positive sequential growth, the longest streak in 11 years. Exports are recovering and both the manufacturing and non-manufacturing PMIs stand near record-high levels (Chart 6). Chart 5Euro Area Data Remain Upbeat Chart 6Japanese Economy Is Rebounding Chart 7China: Slight Slowdown, But No Need To Worry The Chinese economy has slowed a notch since the start of the year, but remains robust (Chart 7). Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production are rising at a healthy clip. Exports are accelerating thanks to a weaker currency and stronger global growth. Retail sales continue to expand, while the percentage of households that intend to buy a new home has surged to record-high levels. The rebound in Chinese exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 8). A better profit picture should support business capital spending in the coming months. Meanwhile, the Chinese government's "regulatory windstorm" - as the local press has called it - has largely bypassed the real economy. In fact, medium and long-term lending to nonfinancial corporations, a key driver of private-sector capital spending and physical commodity demand, has actually accelerated over the past eight months (Chart 9). Chart 8China: Higher Selling Prices Fueling A Rebound In Profits Chart 9China: Credit To The Real Economy Is Accelerating All Good Things Must Come To An End We remain optimistic about global growth over the next 12 months. Unfortunately, things are likely to sour in the second half of 2018, possibly setting the stage for a recession in the U.S. and several other countries in 2019. The odds of a recession rise when economies approach full employment (Chart 10). The U.S. unemployment rate now stands at 4.3% and is on track to break below its 2000 low of 3.8% next summer. A cursory look at the data suggests that the unemployment rate is usually either rising or falling (Chart 11). And once it starts rising, it keeps rising. In fact, there has never been a case in the postwar era where the three-month average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing. Chart 10Recessions Become More Likely When The Labor Market Begins To Overheat Chart 11Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Modern economies contain numerous feedback loops. When unemployment starts increasing, this fuels a vicious cycle where rising joblessness saps confidence and incomes, leading to less spending and even higher unemployment. History suggests that it is almost impossible to break this cycle once it starts. The Fed is well aware of the risks of letting the unemployment rate fall to a level where it has nowhere to go but up. Unfortunately, calibrating monetary policy in a way that achieves a soft landing is easier said than done. Changes in monetary conditions affect the economy with a lag of about 12-to-18 months. Once it has become obvious that a central bank has either loosened or tightened monetary policy too much, it is often too late to right the ship. The risks of a policy error are particularly high in today's environment where there is significant uncertainty about the level of the long-term neutral rate. Question marks about the future stance of fiscal policy will also complicate the Fed's job. We expect the Trump administration to succeed in passing legislation that cuts both personal and corporate income taxes later this year or in early 2018. The bill will be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This will generate a modest amount of fiscal stimulus over the next few years. That being said, the proposed changes to health care legislation could more than neutralize the effects of lower tax rates. The Senate bill, as currently worded, would lead to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Our base case is that Republicans in Congress fail to pass a new health care bill, thus leaving the Affordable Care Act largely unscathed. However, if they succeed, the overall stance of federal fiscal policy would likely shift from being somewhat accommodative, on net, to somewhat restrictive. This would expedite the timing of the recession. How Deep A Recession? If the U.S. does succumb to a recession in 2019, how bad will it be? Here, there is both good news and bad news. The good news is that financial and economic imbalances are not as severe today as those that existed in the lead-up to the past few recessions. The Great Recession was preceded by a massive housing bubble, associated with overbuilding and a sharp deterioration in mortgage lending standards (Chart 12). Today, residential investment stands at 3.9% of GDP, compared to a peak of 6.6% of GDP Q1 of 2006. Lending standards, at least judging by FICO scores, have remained fairly high over the course of the recovery. In relation to income and rents, home prices are also much lower today than they were a decade ago. Likewise, the massive capex overhang that preceded the 2001 recession is largely absent at present. Chart 12No New Bubble In The U.S. Housing Sector Chart 13Consumer Credit: Making A Comeback... The bad news is that cracks in the economy are starting to form. In contrast to mortgage debt, student debt has gone through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 13). Not surprisingly, this is starting to translate into higher default rates (Chart 14). The fact that this is happening when the unemployment rate is at the lowest level in 16 years is a cause for concern. Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 15). Chart 14...With Defaults Starting To Rise In Some Categories Chart 15U.S. Corporate Sector Has Been Feasting On Credit We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 16). U.S. financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 17). Chart 16Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 17CRE Debt Is Rising The retail sector is already under intense pressure due to the shift in buying habits towards E-commerce. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 18 and Chart 19). The number of apartment units under construction stands at a four-decade high, despite a structurally subdued pace of household formation (Chart 20). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Vacancies in the office sector are also likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. Chart 18Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 19...While Rent Growth Is Losing Steam If vacancy rates across the CRE sector start rising in earnest, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further. Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins late next year when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it would further add to the risks of a recession. Chart 20Apartment Supply Is Surging, But Will There Be Enough Demand? Gauging The Global Spillover Effects What repercussions would a U.S. recession have for the rest of the world? Simply based on trade flows, the answer is "not much." U.S. imports account for less than 5% of global ex-U.S. GDP. Thus, even a significant decline in U.S. spending abroad would not make much of a dent in overseas growth. More worrisome are potential financial spillovers. As the IMF has documented, these have been the dominant drivers of the global business cycle in the modern era.1 Chart 21Global Debt Levels Are Still High Correlations across global markets tend to increase when risk sentiment deteriorates. Thus, if U.S. stocks buckle in the face of rising recessionary risks, risk assets in other economies are sure to suffer. The fact that valuations are stretched across so many markets only makes the problem worse. A flight towards safety could trigger a pronounced decline in global equity prices, wider credit spreads, and lower property prices. This, in turn, could lead to a sharp decline in household and corporate net worth, resulting in tighter financial conditions and more stringent lending standards. Elevated debt levels represent another major source of vulnerability. Total debt as a share of GDP is greater now than it was before the Great Recession in both advanced and emerging markets (Chart 21). High debt burdens will prevent governments from loosening fiscal policy in countries that are unable to issue their own currencies. The monetary transmission mechanism also tends to be less effective in the presence of high debt. This is especially the case in today's environment where the zero lower-bound on nominal interest rates remains a formidable challenge. The presence of these fiscal and monetary constraints implies that the severity of the next recession could be somewhat greater than one might expect based solely on the underlying causes of the downturn. II. Financial Markets Overall Strategy The discussion above implies that the investment outlook over the next few years is likely to be of the "one step forward, two steps back" variety. The global economy is entering a blow-off stage where growth will get better before it gets worse. We are bullish on global equities and spread product over the next 12 months, but expect to turn bearish on risk assets next summer. Until then, investors should position for a stronger dollar and higher bond yields. We recommend a slight overweight allocation to developed market equities over their EM peers. Within the DM sphere, we favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares stand out as offering an attractive risk-reward profile. Comparing government bonds, we are underweight U.S. Treasurys, neutral on European bonds, and overweight Japan. These recommendations are broadly in line with the output of our in-house quantitative models (Table 1 and Chart 22). Table 1BCA's Tactical Global Asset Allocation Recommendations* Chart 22Message From Our U.S. Stock Market ##br##Timing Model Equities Earnings Are Key Earnings have been the main driver of the global equity bull market. In fact, the global forward P/E ratio has actually declined slightly since February, despite a 3.9% gain in equity prices (Chart 23). Strong global growth should continue to boost corporate earnings over the next 12 months. Consensus bottom-up estimates call for global EPS to expand by 14% in 2017 and a further 11% in 2018. The global earnings revision ratio moved into positive territory earlier this year for the first time in six years (Chart 24). Chart 23Earnings Have Been The Main Driver ##br##Of The Global Equity Bull Market Chart 24Global Earnings Picture ##br##Looks Solid Global monetary conditions generally remain favorable. Our U.S. Financial Conditions Index has loosened significantly. Historically, this has been a bullish signal for stocks.2 Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Chart 25Individual Investors Are Not Overly Bullish On U.S. Equities But... Sentiment is stretched, but not excessively so. The share of bullish respondents in the AAII's weekly poll of individual investors stood at 29.7% this week (Chart 25). This marked the 18th consecutive week that optimism has been below its long-term average. Market Vane's survey of traders and Yale's Investor Confidence index paint a more complacent picture, as do other measures such as the VIX and margin debt (Chart 26). Nevertheless, as long as earnings continue to grow and monetary policy remains in expansionary territory, sentiment can remain elevated without being a significant threat to stocks. Overweight The Euro Area And Japan Over The U.S. Regionally, earnings revisions have been more positive in Europe and Japan than in the U.S. so far this year. Net profit margins are also lower in Europe and Japan, which gives these two regions more room for catch-up. Moreover, unlike the Fed, neither the ECB nor the BoJ are likely to raise rates anytime soon. As we discuss in greater detail in the currency section of this report, this should lead to a weaker euro and yen, giving European and Japanese exporters a further leg up in competitiveness. Lastly, valuations are more favorable in the euro area and Japan than in the U.S., even if one adjusts for differing sector weights across the three regions (Chart 27). Chart 26...There Are Signs Of Complacency Chart 27U.S. Valuations Seem Stretched Relative ##br##To Other Bourses Mixed Outlook For EM Earnings growth in emerging markets has accelerated sharply. Bottom-up estimates imply EPS growth of 20% in 2017 and 11% in 2018 for the EM MSCI index. Our EM strategists believe this is too optimistic, given the prospect of a stronger dollar, high debt levels across the EM space, poor corporate governance, and the lack of productivity-enhancing structural reforms. These problems warrant a slight underweight to emerging markets in global equity portfolios. Nevertheless, considering the solid backdrop for global growth, EM stocks should still be able to deliver positive real total returns over the next 12 months. Within the EM space, we favor Russia, central Europe, Korea, Taiwan, India, Thailand, and China. Chinese H-shares, in particular, remain quite attractive, trading at only 7.1-times forward earnings and 1.0-times book value. Favor Cyclicals Over Defensives ... For Now Looking at global equity sectors, upward revisions have been largest for industrials, materials, financials, and real estate. Revisions for energy, health care, and telecom have been negative. We expect cyclical stocks to outperform defensives over the next 12 months. Energy stocks will move from being laggards to leaders, as oil prices rebound. Financials should also do well, as steeper yield curves, increased M&A activity, and falling nonperforming loans bolster profits. Equity Bear Market Will Begin Late Next Year As growth begins to falter in the second half of 2018, stocks will swoon. U.S. equities are likely to fall 20% to 30% peak to trough, marking the first sustained bear market since 2008. Other stock markets will experience similar declines. Global equities will eventually recoup most of their losses at the start of the 2020s, but the recovery will be a lackluster one. As we have argued extensively in the past, global productivity growth is likely to remain weak.3 Population aging will deplete savings, leading to higher real interest rates. The next recession could also propel more populist leaders into power. None of these things would be good for stocks. Against today's backdrop of lofty valuations, global stocks will deliver a total real return in the low single-digit range over the next decade. Fixed Income Bonds Have Overreacted To The Inflation Dip We turned structurally bearish on government bonds on July 5th, 2016. As fate would have it, this was the very same day that the U.S. 10-year Treasury yield dropped to a record closing low of 1.37%. The dramatic bond selloff that followed was too much, too fast. We warned at the start of this year that bond yields were likely to climb down from their highs. At this point, however, the pendulum has swung too far in the direction of lower yields. Chart 28 shows that almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained resilient, suggesting that investors' views of global growth have not changed much. This helps explain why stocks have been able to rally to new highs. The fall in inflation expectations has been largely driven by the decline in commodity prices. Short-term swings in oil prices should not affect long-term inflation expectations, but in practice they do (Chart 29). If oil prices recover in the second half of this year, as we expect, inflation expectations should shift higher as well. This will translate into higher bond yields. Chart 28Inflation Expectations Declined This Year, ##br##But Real Yields Remained Resilient Chart 29Low Oil Prices Drag Down##br## Inflation Expectations U.S. Treasurys Are Most Vulnerable Tightening labor markets should also boost inflation expectations. This is particularly the case in the U.S., where the economy is quickly running out of surplus labor. Some commentators have argued that the headline unemployment rate understates the true amount of economic slack. We are skeptical that this is the case. Table 2 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message from the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Table 2Comparing Current Labor Market Slack With Past Cycles 12-MONTH If the U.S. has reached full employment, does the absence of wage pressures signal that the Phillips curve is dead? We don't think so. For one thing, wage growth is not that weak. Our wage growth tracker has risen from a low of 1.2% in 2010 to 2.4% at present (Chart 30). In fact, real wages have been rising more quickly than productivity for the past three years (Chart 31). Unit labor cost growth is now just shy of where it was at the peaks of the last two business cycles (Chart 32). Chart 30Stronger Labor Market ##br##Is Leading To Faster Wage Growth Chart 31Real Wages Now Increasing Faster##br## Than Productivity Chart 32Unit Labor Cost Growth Close ##br##To Previous Two Peaks The evidence generally suggests that the Phillips curve becomes "kinked" when the unemployment rate falls towards 4%. In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 4.5% to 3.5% does. The experience of the 1960s is illustrative in that regard. Chart 33 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation took off. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. The Fed is keen to avoid a repeat of that episode. In a recent speech, New York Fed President and FOMC vice chairman Bill Dudley warned that "If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation ... Then the risk would be that we would have to slam on the brakes and the next stop would be a recession." If U.S. growth remains firm and inflation rebounds in the second half of this year, as we expect, the Fed will get the green light to keep raising rates in line with the "dots." The market is not prepared for that, as evidenced by the fact that it is pricing in only 27 basis points in rate hikes over the next 12 months. We are positioned for higher rate expectations by being short the January 2018 fed funds contract. The ECB And The BoJ Will Not Follow The Fed's Lead Could better growth prospects cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl? We doubt it. Investors are reading too much into Mario Draghi's allegedly more "hawkish" tone. There is a huge difference between removing emergency measures and beginning a full-fledged tightening cycle. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 34). Chart 33Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% Chart 34Euro Area: Labor Market Slack##br## Is Still High Outside Of Germany At this point, the market is pricing in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 25 months at present (Chart 35). Investors now expect real yields in the U.S. to be only 16 basis points higher than in the euro area in five years' time.4 This is below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 36). Chart 35ECB: Markets Are Pricing In Too Much Tighteninh Chart 36The Neutral Rate Is Lowest In The Euro Area As for Japan, while the unemployment rate has fallen to a 22-year low of 2.8%, this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Bank Of England's Dilemma Gilts are a tougher call. The equilibrium rate is higher in the U.K. than in most other developed economies. Inflation has risen, although that has largely been a function of a weaker currency. Fiscal policy is turning more accommodative, which, all things equal, would warrant a more bearish view on gilts. The big wildcard is Brexit. Chart 37 shows that the U.K. is the only major country where growth has faltered this year. Worries over Britain's future relationship with the EU have likely contributed to the slowdown. Ongoing Brexit angst will keep the Bank of England on hold, justifying a neutral weighting on gilts. Stay Short Duration ... For Now In summary, investors should keep global duration risk below benchmark levels over the next 12 months. Regionally, we recommend underweighting U.S. Treasurys, overweighting Japan, and maintaining a neutral position towards euro area and U.K. government bonds. Reflecting these recommendations, we are closing our short Japanese, German and Swiss 10-year bond trade for a gain of 5.3% and replacing it with a short 30-year U.S. Treasury bond position. As global growth begins to slow in the second half of next year, global bonds will rally. However, as we discussed at length in our Q2 Strategy Outlook, the rally will simply represent a countertrend move in what will turn out to be a structural bear market.5 The 2020s, in short, could end up looking a lot like the 1970s. Spread Product: Still A Bit Of Juice Left While we prefer equities to high-yield credit on a risk-adjusted basis over the coming months, we would still overweight spread product within a global asset allocation framework. The option-adjusted spread of the U.S. high-yield index offers 200 basis points above the Treasury curve after adjusting for expected defaults, roughly in line with the mid-point of the historical data (Chart 38). Corporate defaults are likely to trend lower over the next 12 months, spurred by stronger growth and a rebound in oil prices. Chart 37U.K. Is Lagging Its Peers Chart 38Default-Adjusted Junk Spreads Are At Historical Average As with all our other views, the picture is likely to change sharply in the second half of next year. At that point, corporate spreads will widen, warranting a much more defensive stance. Currencies And Commodities The Dollar Bull: Down But Not Out Our long-standing dollar bullish view has come under fire over the past few months. The Fed's broad trade-weighted dollar index has fallen 4.6% since December. Momentum in currency markets can be a powerful force, and so we would not be surprised if the dollar remains under pressure over the coming weeks. However, over a 12-month horizon, the greenback will strengthen, as the Fed raises rates more quickly than expected while most other central banks stand pat. When all is said and done, the broad-trade weighted dollar is likely to peak next summer at a level roughly 10% higher than where it is today. That would still leave it substantially below prior peaks in 1985 and 2000 (Chart 39). The U.S. trade deficit has fallen from a peak of nearly 6% of GDP in 2005 to 3% of GDP at present (Chart 40). Rising shale production has reduced the demand for oil imports. A smaller trade deficit diminishes the need to attract foreign capital with a cheaper currency. Chart 39The Dollar Is Below Past Peaks Chart 40The U.S. Trade Deficit Has Halved Since 2005 Sentiment and speculative positioning towards the dollar have swung from extremely bullish at the start of the year to being more neutral today (Chart 41). In contrast, long euro speculative positions and bullish sentiment have reached the highest levels in three years. Our tactical short euro/long dollar trade was stopped out this week for a loss of 1.6%. However, we continue to expect EUR/USD to fall back towards parity by the end of the year. We also expect the pound to weaken against the dollar, but appreciate slightly against the euro. Now that the Bank of Japan is keeping the 10-year JGB yield pinned to zero, the outlook for the yen will be largely determined by what happens to yields abroad. If we are correct that Treasury yields - and to a lesser extent yields in Europe - rise, the yen will suffer. Commodity Currencies Should Fare Well Higher commodity prices should benefit currencies such as the Canadian and Aussie dollars and the Norwegian krone. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. While shale output continues to rise, this is largely being offset by falling production from conventional oil fields. Consequently, oil inventories should fall in the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 42). Chart 41USD: Sentiment And Positioning ##br##Are Not Lopsided Anymore Chart 42Falling Oil Inventories Should Lead ##br##To Higher Crude Prices The outlook for industrial metals is not as upbeat as for oil, but metal prices should nevertheless rebound over the coming months. We suspect that much of the recent weakness in metal prices can be attributed to the regulatory crackdown on shadow banking activity in China. Many Chinese traders had used commodities as collateral for loans. As their loans were called in, they had no choice but to liquidate their positions. Today, speculative positioning in the commodity pits has returned to more normal levels (Chart 43). This reduces the risk of a further downdraft in commodity prices. BCA's China strategists expect the Chinese authorities to relax some of their tightening measures. This is already being seen in a decline in interbank lending rates and corporate bond yields (Chart 44). Chart 43Commodities: Long Speculative Positions Returning ##br##To More Normal Levels Chart 44China: Some Relief##br## After Recent Tightening Action? One key reason why the authorities have been able to let interest rates come down is because capital outflows have abated. Compared to late 2015, economic growth is stronger and deflationary pressures have receded. The trade-weighted RMB has also fallen by 7.5% since then, giving the economy a competitive boost. As such, the seeming can't-lose bet on further yuan weakness has disappeared. We still expect the RMB to depreciate against the dollar over the next 12 months, but to strengthen against most other currencies, including the euro and the yen. If the yuan remains resilient, this will limit the downside risk for other EM currencies. Nevertheless, at this point, much of the good news benefiting EM currencies has been priced in. Across the EM universe, in addition to the Chinese yuan, we like the Mexican peso, Taiwan dollar, Indian rupee, Russian ruble, Polish zloty, and Czech koruna. Lastly, a few words on the most timeless of all currencies: gold. We expect bullion to struggle over the next 12 months on the back of a stronger dollar and rising bond yields. However, once the Fed starts cutting rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For example, please see Box 4.1: Financial Linkages and Spillovers in "Spillovers and Cycles in the Global Economy," IMF World Economic Outlook, (April 2007). 2 Please see Global Investment Strategy Weekly Report, "The Message From Our Stock Market Timing Model," dated May 5, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; Global Investment Strategy - Strategy Outlook, "First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters), First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters)," dated January 6, 2017; and Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 U.S. minus euro area 5-year/5-year forward real bond yields. Real bonds yields are calculated as a difference between nominal yields and the CPI swap rate. Euro area yields refer to a GDP-weighted average of Germany, France, the Netherlands, Belgium, Austria, Italy, and Spain. 5 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Fed Policy Loop: Low inflation is preventing rate hike expectations from being revised higher, prolonging the current rally in spread product. We expect rate hike expectations to move up as inflation recovers, eventually leading to a correction in spread product. Such a correction will prove fleeting as long as inflation stays below target. High-Yield: High-yield valuation is consistent with its historical average, after accounting for expected default losses. Current valuation levels should translate into excess returns of just over 200 bps during the next 12 months. Aaa Spread Product: Non-agency CMBS offer the most spread pick-up of any Aaa-rated sector. However, we prefer to focus our Aaa-rated spread product allocation in Agency CMBS and credit card backed consumer ABS. Feature Chart 1The Fed Policy Loop In Action One of this publication's main themes during the past few years has been the Fed Policy Loop.1 In essence, the Loop describes the feedback mechanism between monetary policy and financial markets, a relationship that results from both investors' sensitivity to the Fed's policy stance and the Fed's reliance on financial conditions as a predictor of economic growth. In practice, the Loop works as follows: Easier Fed policy causes spread product to outperform Treasuries. Tighter credit spreads lead to easier financial conditions, which the Fed interprets as a sign that economic growth will accelerate. An improved economic outlook causes the Fed to step up the pace of tightening. Tighter Fed policy causes spread product to underperform Treasuries. Wider credit spreads lead to tighter financial conditions, which the Fed interprets as a sign that economic growth will moderate. A worse economic outlook causes the Fed to slow its expected pace of tightening. Rinse, repeat. Chart 2 provides a graphical description of the Loop, and its most recent iteration can be seen in Chart 1 above. Chart 1 shows that corporate bonds outperformed Treasuries leading up to the March rate hike, but then rate expectations rose too far. In mid-March the market was discounting a fed funds rate of 1.86% by the end of 2018. These overly stringent rate hike expectations caused corporate bonds to underperform, and this underperformance led rate hike expectations to be revised lower. The market now expects a fed funds rate of only 1.47% by the end of 2018, and these depressed rate expectations have fueled the rally in corporate bonds that started in mid-April. Normally at this stage of the Fed Policy Loop we would expect rate hike expectations to move higher until they eventually prompt a correction in corporate spreads. However, extremely disappointing core inflation prints during the past three months have caused the market to keep its rate hike expectations depressed. This has extended the most recent rally in spread product. This is why we have consistently pointed to core inflation and the cost of inflation protection embedded in long-maturity bond yields as the main factors to watch to determine how much life is left in the corporate bond trade. As long as inflation stays below target, the Fed absolutely needs it to rise. It will therefore be quick to respond to any tightening of financial conditions/widening of credit spreads. Table 1 shows average monthly excess returns for investment grade corporate bonds relative to duration-matched Treasuries. These returns are split into buckets based on the reading from the St. Louis Fed's Price Pressures Measure (PPM). The PPM is a composite of 104 economic indicators designed to measure the probability that inflation will exceed 2.5% during the next 12 months. As can be seen, average monthly excess returns are strongest when inflation pressures are low, but they gradually decline as inflation heats up and the Fed's reaction function becomes less supportive for markets. At present, the PPM gives a reading of only 4.8%. Table 1Investment Grade Corporate Bond Excess Returns* Under Different ##br## Ranges Of Price Pressures Measure** (January 1990 To Present) Similarly, Table 2 shows that it is difficult to get a long-lasting correction in an environment with low inflation pressures and a responsive Fed. This table shows the results of a "buy the dips" trading strategy where if the average junk spread widens by 20 basis points we buy the junk index versus duration-matched Treasuries and hold it for a period of 1, 2 or 3 months. Just as in Table 1, this strategy works well when inflation pressures are muted, but starts to fail as inflation ramps up. Table 2High-Yield Corporate Bond Returns* Achieved By Holding The Junk Index ##br## Following A 20 BPs Widening In High-Yield Corporate OAS** Under Different Ranges Of ##br## The St. Louis Fed Price Pressures Measure*** (February 1994 To Present) Beatings Will Continue Until Morale Improves So when will the Fed staunch the current rally? That depends on how quickly inflation rebounds,2 and also on how much emphasis Fed policymakers place on financial conditions versus the actual inflation data. At the moment, most indexes are sending the message that financial conditions are easier than average and that the Fed should continue to tighten (Chart 3). However, as was noted above, inflation gauges are sending the opposite signal (Chart 3, panel 2). For now, the Fed is downplaying low inflation as transitory. It decided to leave its median projected rate hike path unchanged at the June FOMC meeting. But the Fed's refusal to capitulate in the face of weaker inflation has caused the yield curve to flatten, the cost of inflation protection to plummet (Chart 3, bottom panel) and investors to grow increasingly concerned about a policy mistake (Chart 4). Chart 3Financial Conditions Are Supportive Chart 4Should The Fed Keep Tightening? This brings up an interesting flaw in the financial conditions approach to policymaking. Most indexes of financial conditions are at least partially driven by long-maturity Treasury yields (lower yields = easier financial conditions, and vice-versa). This makes some sense. Lower yields do in fact indicate that the financing back-drop is more supportive and tend to translate into higher growth in the future (Chart 5). Chart 5Financial Conditions Lead Economic Growth However, what if lower long-maturity Treasury yields are the result of excessively tight Fed policy? This would appear to be the case at the moment. Investors are revising their long-run inflation forecasts lower on the view that the Fed is not doing enough to allow prices to rise. In such a situation it would be incorrect to interpret lower Treasury yields as a signal that policy needs to tighten further. On the contrary, tighter policy would only exacerbate the downtrend in yields. For this reason we do not include the level of yields in the financial conditions component of our Fed Monitor (Chart 3, top panel). As a result, this financial conditions indicator is not as deep in "easing territory" as most other indicators. However, it is still above the zero line, suggesting that policy should be biased tighter at the margin. Bottom Line: Low inflation is preventing rate hike expectations from being revised higher, prolonging the current rally in spread product. We expect rate hike expectations to move up as inflation recovers, eventually leading to a correction in spread product. Such a correction will prove fleeting as long as inflation remains below the Fed's target. The key risk is that inflation stays low but the Fed continues to focus exclusively on "easy" readings from financial conditions indexes, and proceeds on its current tightening path. In that scenario cries of "policy mistake" will grow louder and spread product will sell off, converging with lower rate hike expectations. We view this scenario as a low-probability tail risk. Junk Valuation Update At 378 bps, the average spread on the Bloomberg Barclays High-Yield index is only 55 bps above its post-crisis low, but still more than 100 bps above the level where it tends to settle in the late stages of the economic cycle when the Fed is tightening policy (Chart 6, top panel). Higher debt levels than are typical for this stage of the cycle suggest that somewhat wider spreads are justified,3 but the idea that junk spreads are extremely tight compared to history does not hold up to scrutiny. Chart 6High-Yield Default-Adjusted Spread Our preferred measure of junk valuation, the default-adjusted high-yield spread, paints an even rosier picture. The second panel of Chart 6 shows an ex-post measure of the default-adjusted spread (the option-adjusted spread of the high-yield index less actual default losses over the subsequent 12 months). The most recent reading from this indicator is based on our forecast of default losses for the next 12 months, and is shown as a dashed line. The message from the default-adjusted spread is that, assuming our default loss forecast is correct, junk bonds currently offer compensation for default risk that is in line with the historical average. That level of compensation would be consistent with an excess return of just over 200 bps during the next 12 months (Chart 6, panel 3), and is contingent on the speculative grade default rate falling to 2.68%, in line with Moody's baseline forecast (Chart 6, bottom panel). We expect a decline in the default rate to materialize in the coming months as commodity sector defaults continue to work their way out of the data. Moody's did not record any commodity-related defaults in May, the first month this has occurred since January 2015. The risk going forward is that defaults start to emerge in the increasingly stressed retail sector. So far, Moody's has recorded two retail defaults this year. However, more are probably on the way. This will be especially true if inflationary pressures start to mount and the Fed tightens policy, giving banks less incentive to extend credit. We will be monitoring the situation in retail closely going forward. Bottom Line: High-yield valuation is consistent with its historical average, after accounting for expected default losses. Current valuation levels should translate into excess returns of just over 200 bps during the next 12 months. Aaa Roundup As can be inferred from the previous two sections, we are still reasonably comfortable taking credit risk in U.S. bond portfolios. However, this week we also look at the compensation offered by Aaa-rated spread product. For investors who desire some Aaa-rated allocation outside of the Treasury market, Chart 7 provides a snapshot of where the most additional spread is available. The first thing that jumps out is that Agency bonds offer very little spread compared to other Aaa-rated instruments. Agency residential mortgage-backed securities also offer relatively little compensation, unless one is willing to extend into premium coupons (4% and above). Agency CMBS, auto ABS and credit card ABS all offer more spread than Aaa-rated corporate bonds. Non-agency CMBS offer much more attractive spreads than the other Aaa sectors, but we see potential for capital losses in that segment, as is discussed below. Agency MBS Only agency MBS carrying coupons of 4% or above offer interesting compensation relative to other Aaa-rated sectors, and even there we see potential for spread widening in the coming months. Nominal MBS spreads are already very tight compared to history (Chart 8) and appear even tighter relative to trends in net issuance (Chart 8, panel 2). While refinancing activity will likely stay depressed (Chart 8, panel 3), we see potential for option-adjusted spreads to follow net issuance higher, even as the compensation for prepayment risk (option cost) remains low. A similar scenario played out in 2007 (Chart 8, bottom panel). The Fed's exit from the MBS market, which could occur as early as September, represents an additional upside risk for spreads. Chart 8MBS Spreads Biased Wider Chart 9Avoid Non-Agency CMBS CMBS As noted above, non-agency CMBS look very attractive compared to other Aaa-rated spread products. But we see potential for spread widening in this sector. Commercial real estate lending standards are tightening and property prices are decelerating, both should pressure non-agency CMBS spreads wider (Chart 9). Agency CMBS offer somewhat lower spreads than their non-agency counterparts. But this sector should be more insulated from spread widening. For one thing, Agency CMBS are mostly backed by multi-family loans. Multi-family property prices have been stronger than those in the retail or office segments (Chart 9, panel 3), and multi-family properties have also experienced much lower delinquencies (Chart 9, bottom panel). Consumer ABS Chart 10Credit Cards Greater Than Autos While Chart 7 shows that Aaa-rated auto ABS offer a slight spread advantage over Aaa-rated credit card ABS, we are inclined to view credit card ABS more favorably. Rising auto loan net loss rates pose a risk for auto ABS spreads, while credit card charge-offs remain historically low (Chart 10). Auto lending standards have also moved deep into "net tightening" territory, while credit card lending standards have dipped back into "net easing" territory. The small extra compensation available in auto ABS relative to credit card ABS does not seem to be worth the extra risk. Bottom Line: Non-agency CMBS offer the most spread pick-up of any Aaa-rated sector. However, we view the risk of a further widening in non-agency CMBS spreads as substantial. We prefer to focus our Aaa-rated spread product exposure in Agency CMBS and credit card backed consumer ABS. Both sectors offer reasonably attractive spreads, and should remain insulated from capital losses going forward. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 2 Our view is that core inflation will rebound fairly quickly. For further details please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 3 For further details please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The rollover in the economic surprise index is not sending a near-term recession signal and should trough in the next month or so, as decent economic data begins to surpass now lowered expectations. Investors should be prepared for a mild recession in 2019, but odds of a recession are low in the next 12-18 months. Oil prices will move higher from the mid $40s per barrel as investors start to see the inventory drawdowns we expect in the coming months. We expect that the Fed will stick to its plan to begin shrinking its balance sheet in September and hike rates again in December. Still, a stubbornly low inflation rate in the next few months would likely see the Fed postpone any further tightening until early 2018. Small cap stocks have underperformed large caps this year, but investors should not interpret this as a sign of that start of sell-off in risk assets. Feature The Citi Economic Surprise Index (CESI) is not sending a near-term recession signal and should trough in the next month as decent economic data begin to surpass lowered economic expectations. The index is nearly two standard deviations below its mean after peaking in early March in the wake of the election and has been falling for 71 days. It typically takes 90 days for the surprise index to find a footing after readings above 40. Moreover, the mean reverting nature of the index suggests a rebound at two standard deviations, absent a recession that we do not foresee (Chart 1). Chart 1Economic Surprise Index Approaching A Turning Point CESI is composed of two components, whose composition and recent behavior are crucial to interpreting the weakness in the overall surprise metric. A positive reading on the "consensus change" index, which tracks economists' forecasts, means that expectations have improved relative to their one-year average. A positive reading on the "data change" component suggests that economic releases have been stronger than their one-year average. The overall surprise index combines these two elements/factors (Chart 2). Chart 2Post Election, Economic Expectations For Soft Data Hit An Eight Year High Lofty expectations, rather than poor data, account for much of CESI's weakness in the past three months. This is most pronounced in the soft economic surprise index, where outlooks moved sharply in the wake of the U.S. election when forecasters were swept up in Trump euphoria. By early March 2017, the economic consensus index for soft data was at its highest in seven years, topping out just shy of the all-time record set in late 2009. Prognosticators also ratcheted up their forecasts for the hard data, but not by nearly as much. The inevitable result of elevated expectations, combined with economic reports that signaled that overall growth remained close to 2%, was a prolonged spell of economic disappointment. This type of divergence between heightened expectations and weakness in the overall surprise index has occurred several times in the past 13 years (2004, 2010, 2011, 2012 and 2017). Each episode took place before a bottom in the economic surprise index and our view is that this time is no different (Chart 2). Despite the dismal surprise index, forecasts for U.S. and global GDP in 2017 and 2018 have held up, which is a positive sign for profits (Chart 3). The stability of these forecasts is in sharp contrast to 2012, 2013, 2015 and 2016 when global growth estimates sunk at the same time as the economic surprise index. As we stated in our recent report,1 GDP growth in 1H 2017 in the U.S. is on track to match the Fed's modest 2.1% target for the year. Moreover, in years when Q1 GDP is weak, 2H growth is faster than 1H growth 70% of the time. Chart 3U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well Falling oil prices are another worry for investors concerned that global growth is on the wane. We take a different view and expect oil prices to increase in the coming months. In a recent report,2 our Energy Sector Strategy team noted that investors are confused about conflicting supply signals in oil markets. Traders do not see the physical shortage that the IEA/EIA/OPEC and BCA's top-down supply & demand analyses argue should prevail (Chart 4). Investors are cautious amid the uncertainty. We view the investment environment as overly pessimistic and anticipate that oil prices (and oil-focused upstream equities) will improve as inventory withdrawals escalate in the coming months. The latest 3.5% year-over-year reading on LEI for May points to low odds of a near-term recession (Chart 2, panel 3). However, BCA's Global Investment Strategy service has raised the possibility of a U.S. recession commencing in 2019. Financial markets would move ahead of a recession, thus investors should begin to adjust their portfolios3 for a recession scenario in the latter half of 2018, as economic and profit growth begins to weaken. Until then, we favor stocks over bonds, but we remain vigilant for any signs of imbalances that typically precipitate a recession. Our Global Investment Strategy service points out that in the post-war era the unemployment rate's three-month moving average has never risen by more than one-third of a percentage point without a recession. A good leading indicator of the unemployment rate is the weekly unemployment claims data, and they suggest continued tightening in the labor market (Chart 5). Chart 4We Expect The Oil Balance To Tighten Later This Year Chart 5Claims Not Even Close To Sending A Recession Signal A tighter labor market will lead to the familiar vicious cycle of a more aggressive Fed, a margin squeeze, slower and eventually falling profits, rising corporate defaults and layoffs. The resulting economic downturn would be mild compared with the 2007-2009 recession because the current imbalances are not as severe as those in 2007. Even so, with valuations stretched, the pain of the recession may be most felt in the financial markets, with a likelihood of a 20-30% equity bear market. Bottom Line: Despite signs to the contrary, the sweet spot that has buoyed risk assets remains in place: a beneficial combination of moderate economic growth, healthy corporate profit growth, stable margins, low inflation and a Fed prepared to only gradually hike rates. We remain overweight stocks versus bonds in the next 6-12 months. Threats to this risk-asset friendly environment include a further drop in core inflation, an over-aggressive central bank, and signs that negative economic shocks are leading to a significant markdown of global growth prospects. Is The Fed's Inflation Target Credible? The recent drop in oil prices has undermined our short-duration recommendation. But more than that, investors are questioning whether the Fed even has the ability to reach its inflation goals, following the surprising May CPI report and the softening in some of the wage data. Is it possible that the U.S. is following Japan's roadmap where even an over-heated labor market is insufficient to generate any meaningful inflation? The sharp flattening of the Treasury curve indicates that the bond market has already rendered its judgement. As we noted last week, the energy component pulled down the headline CPI rate again in May, but the softening of inflation this year is widespread in the index. This is contrary to Fed Chair Yellen's assertion that recent weak readings are due largely to special factors, such as wireless telecommunications prices. The deceleration in inflation began around the start of the year. The 3-month rate of change of the headline index fell by more than five percentage points between January and May, of which energy accounts for 3.3 percentage points. The deceleration in the core rate was a less severe, but still substantial, 2.8 percentage points. Table 1 presents the components of the CPI that made the largest contribution to the deceleration in core inflation. Motor vehicles, owners' equivalent rent, apparel, recreation, wireless telecom and medical care services accounted for 1.2 percentage points as a group. However, many other sectors contributed in a small way to the overall deceleration of core inflation in the first five months of the year. Table 1Key Drivers Of Core Inflation Deceleration In 2017 Some special factors were at play. The moderation in rent inflation likely reflects the bottoming of the vacancy rate. Discounting in the auto sector is not a surprise given weak sales. Wireless prices can be viewed as a special case as well. Nonetheless, the breadth and suddenness of the deceleration in core inflation across such diverse sectors, some unrelated to labor markets, commodity prices, the weak dollar or on-line shopping, is startling. The disinflation this year in the Fed's preferred measure, the PCE price index, is not as extended but the data lag the CPI by roughly a month. A diffusion index made up of the components of the PCE index is still in positive territory, unlike the CPI's diffusion index (Chart 6). Nonetheless, the CPI data suggest that core PCE inflation will edge lower when the May data are released at the end of June. There has also been a moderation in some of the wage inflation data, such as average hourly earnings (Chart 7). The slowdown has been fairly widespread across manufacturing and services. The good news is that the soft patch appears to be over; 3-month rates of change have firmed almost across the board (retail is a major exception). Chart 6CPI, PCE Diffusion##BR##Indices Are Mixed Chart 7Wages Have Accelerated##BR##Over Past Three Months There is no slowdown evident at all in the better-constructed Employment Cost Index (ECI) as of the first quarter (Chart 8). The related diffusion indexes also remain constructive. The ECI is adjusted to avoid compositional effects that can distort the aggregate index. We conclude from these and other wage measures that the Phillips curve is still operating. Admittedly, the curve appears to be quite flat, which means it is difficult to generate inflation even when the labor market overheats. Nonetheless, the relationship between the ECI and measures of labor market tightness, such as the quit rate, the "jobs plentiful" index and NFIB compensation plans, does not appear to have broken down (Chart 9). The percentage of U.S. states with unemployment below the Fed's estimate of full employment is above 70%. Anything over 60% in the past has been associated with wage pressure (Chart 10). The percentage jumped from 58% in March to 71% in April, blasting through the 60% threshold. Chart 8No Slowdown##BR##In ECI Data Chart 9Labor Market Tight Enough##BR##To Push Up Inflation The bottom line is that, while we are concerned about the breadth of the soft patch in the consumer price data, we are in agreement with the Fed that the labor market is tight enough to gradually push up inflation. We are willing at this point to chalk up the recent drop in core inflation partly to randomness in the data, and partly to lagged effects of the slowdown in real GDP growth in the first half of 2016 (Chart 11). The PPI for services and for core goods are not suggesting there is deflationary pressure in the pipeline (Chart 8). Chart 10Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Chart 11Inflation Lags Economic Growth By 18 Months What Will The Fed Do? The CPI data have rattled some on the FOMC. Federal Reserve Bank of Dallas President Kaplan, for example, believes that the Fed needs to be patient to ensure that the inflation pullback is temporary. However, the June FOMC Statement and Yellen's press conference suggested that the consensus is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment. FOMC Vice Chairman Dudley echoed this view in comments he made last week to the press. The Fed has been quick to ease or back away from planned rate hikes at the first hint of trouble since the Lehman shock. However, it appears that the reaction function has changed, now that the labor market is at full employment. This is especially the case because financial conditions have eased further since the June rate hike. Unemployment will edge further below the full-employment level if the FOMC does not slow the economy. Policymakers know that the Fed has had little success in the past when it tried to nudge unemployment higher in order to relieve inflation pressure and achieve a soft landing; these attempts almost always ended in recession. Dudley added that "...pausing policy now could raise the risk of inflation surging and hurting the economy." Other FOMC members are worried that financial stability risk will rise if the low-rate environment extends much further. The bottom line is that we expect the Fed will stick with the game-plan for now. The FOMC will begin shrinking the balance sheet in September, but will wait until December for the next rate hike. That said, a stubbornly low inflation rate in the coming months would likely see the FOMC postpone the next rate increase into next year. Where Next For Bonds? Our fixed-income strategists see three possible scenarios for the bond market:4 Base Case: Weak recent inflation readings are nothing more than a lagged response to last year's deceleration in economic growth. U.S. growth accelerates in the second half, unemployment falls further and both wage growth and inflation pick up. Oil inventories begin to contract and prices head higher. The FOMC is vindicated in its inflation view and proceeds with the current rate hike and balance sheet adjustment agenda. Investors receive a "wake up call" from the Fed, bond prices get hit and recent curve-flattening trend reverses. Fed Capitulates: The U.S. labor market continues to tighten, but core PCE inflation is still close to 1½% by the September FOMC meeting. We would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. Long-maturity real yields would fall in this scenario, although long-term inflation expectations could rise to the extent that the Fed's more dovish tilt will weaken the dollar and generate more inflation in the medium term. Nominal yields may not end up moving much in this scenario. A Policy Mistake: If core inflation remains low between now and the September FOMC meeting and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would price-in a policy mistake scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. In terms of likelihoods, we would characterize Scenario 1 as our base case scenario, Scenario 2 as unlikely and Scenario 3 as a tail risk. The bottom line is that short-duration positions have been a "pain trade" in recent weeks, but it appears to us that the rally is overdone. We remain short-duration. No Signal From Small Caps Chart 12Small Caps Are No Longer Expensive The underperformance of small cap stocks since December is not sending a signal about the broader equity market. In fact, small cap relative performance has a mixed track record calling the peak in large cap equities. We maintain our view from a 2014 report:5 There is no basis for concluding that small cap underperformance heralds a fragile economy, stock market weakness or heightened risk aversion. Investors should note the sector/compositional, domestic/international, cyclical/defensive, and valuation discrepancies between small and large cap stocks before drawing any conclusions about the signals from small caps. The S&P 500 small cap index has more exposure to financials, industrials and materials than its large cap cousins, and has lower weights in energy, staples and healthcare. This mix makes small caps more cyclically oriented. Moreover, small caps have less exposure to overseas economies and, therefore, less sensitivity to fluctuations in the U.S. dollar. Plus, our small cap valuation indicator has moved even further into undervalued territory since our discussion of small cap equities in this publication on April 246 (Chart 12). Chart 13Small Caps Are Not Great##BR##Market Prognosticators Small-cap stocks outperformed large cap by 12% from November 8 through December 8, 2016, but have lagged since, as investors unwound the Trump trade. The implication is that the recent sell-off in small caps is not a signal that the broader market is poised for a downturn. Instead, it reflects the market's view that Trump's pro-small business agenda has stalled. Moreover, history shows that the relative performance of small caps versus large caps is not a good predictor of the future performance of risk assets versus bonds. The small-to-large ratio sent plenty of mixed signals in the '80s and '90s when the economy was in a long expansion, fostered by low inflation and a gradualist Fed (Chart 13, panels 1 and 2). On the other hand, local peaks and troughs in small cap performance provided solid signals for turns in stock versus bond performance from the early '70s through the mid-80s, a period characterized by soaring inflation that is not present today (Chart 13, panel 1). Small-cap outperformance starting in late 2008 did presage an upturn in the stock-to-bond total return ratio in 2009, and captured a few of the risk on/risk off periods from 2010 through 2012, while the Fed engineered QE2, Operation Twist and QE3. More recently, the relative performance of small versus large has been range-bound and has not provided a consistent signal for turns in the overall market (Chart 13, panel 3). Bottom Line: The underperformance of small caps to large is a reaction to the market's perception that Trump's pro-small business agenda will disappoint, not a sign that U.S. growth is waning. While several planned policies of the Trump administration have been delayed, a legislative agenda that appears to be pro-business is in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation noted above. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Can The Service Sector Save The Day?", June 5, 2017, available at usis.bcaresearch.com. 2 Please see Energy Sector Strategy Weekly Report, "Views From The Road", June 21, 2017, available at nrg.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report "The Timing Of The Next Recession", June 16, 2017, available at gis.bcaresearch.com. 4 Please see U.S. Bond Strategy Weekly Report "Three Scenarios For Treasury Yields In 2017", June 20, 2017, available at usbs.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report "On The Road Again", June 2, 2014, available at usis.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report "Spring Snapback", April 24, 2017, available at usis.bcaresearch.com.
Dear client, This week, we are sending you an abbreviated Weekly Report as we co-authored a Special Report on Wednesday with our sister Geopolitical Strategy service. In our Special Report, available on our website, we argue that Italy's flirtation with leaving the euro area is rooted in its positive experience with devaluations in the 1990s. However, we note that this time is different and devaluing the euro through exit will not be a panacea, as financial market linkages would cause a deep domestic recession that could be brought forward by the mere reality of a referendum on the topic. As such, we think that Italy is unlikely to leave the Euro Area, but that it will remain a drag on the Eurozone - one that will force the European Central Bank to stay a bit more dovish than warranted by conditions in the broader Euro Area. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature Chart I-1The Dollar At A Critical Spot Since the end of last week, the dollar has staged a small rebound. This rebound was of the utmost importance as it materialized at an important level. Had DXY punched below the 96 level, the dollar could have sold off toward 93 in a matter of weeks. However, if the dollar can remain above 96, the greenback is likely to have formed a trough for the remainder of 2017 as it will rest above an important congestion zone that has been in place since early 2015 (Chart I-1). What are the odds of the greenback moving back to 93? We think that right now the balance of probability is in favor of a continued rebound. A call on DXY is first and foremost a call on the euro, as EUR/USD represents 60% of this index. We'll thus focus on the dynamics in this pair. Currently, nominal short rate differentials remain in the dollar's favor. As Chart I-2 illustrates, interbank rate spreads between the Euro Area and the U.S. are broadly supportive of the USD. Additionally, in both the late 1990s and in 2005-06, this spread had been much more negative than at present. BCA still expects the spread to grow more negative as the Federal Reserve continues on its intended policy path, while we also believe it will take a few more years before the ECB can begin lifting rates.1 Real rate differentials paint a similar picture. The euro's strength in the second quarter has emerged in spite of a move in real rate spreads in favor of the USD. As Chart I-3 shows, this divergence has mostly reflected dynamics at the short end of the yield curve, but over the past month and a half the real interest rate difference at the 10-year maturity has also diverged from the EUR/USD's path. Chart I-2EUR/USD Short Rate Differentials ##br##Can Grow Deeper Chart I-3EUR/USD Has Dissociated##br## From A Key Driver Technically, the dollar is beginning to look attractive against the euro as well. Our positioning indicator - based on sentiment, net speculative positions, and the euro's advanced/decline line - shows that investors are already positioned the most euro bullish since 2012 (Chart I-4). Our intermediate-term technical indicator is also at highly overbought levels, highlighting the euro's limited upside potential. Most importantly though, these moves have happened as the Euro Area economic surprise index massively beat the U.S. one (Chart I-4, bottom panel). This means that Europe's economic outperformance has been driving the euro's strength, unlike in 2015 when the surge in the European surprise index relative to the U.S. was reflective of the euro's 2014 collapse. This paints a picture where much good European news has been priced into EUR/USD during the recent rally. At current levels, the mean-reverting nature of the relative surprise index suggests that European surprises are unlikely to continue to beat U.S. ones by such a margin going forward. This means that the already overbought euro is likely to lose a key support. Finally, as we highlighted two weeks ago, global analysts have already ratcheted up their year-end estimates for EUR/USD (Chart I-5). Not only are their forecasts at levels that have in recent years been indicative of a peak, but the speed and magnitude of their adjustments has also been exceptional. This corroborates that the positive momentum in the Eurozone vis-à-vis the U.S. has already been internalized by market participants. If anything, this favorable relative economic momentum must only grow going forward for the euro to rally further. However, European LEIs have already rolled over relative to the U.S. as the latter looks set to exit its soft patch in the coming months (Chart I-6). Chart I-4Good News Already ##br##In The Euro Chart I-5Investors Have Already##br## Bought The Euro Chart I-6The Economic Tailwinds For The ##br##Euro Are Beginning To Fade Bottom Line: DXY has rebounded at a crucial level. If it can stay above 96, this would suggest that its correction is over. We are willing to make this bet as the euro - the key component of the DXY - has dissociated from rate differentials on strong optimism toward the economic outlook for Europe - at the exact time that investors have become more incredulous of the Fed's intentions. Due to these dynamics, EUR/USD is now massively overbought and at risk of a further pullback. Cutting Loose Short USD/JPY Last week, we closed our short USD/JPY position at a 4.2% gain. We did so because we see an increasingly less-supportive environment for the yen. To begin with, the U.S. Treasury notes' fair-value model used by our U.S. Bond Strategy service highlights that U.S. bond yields are currently quite expensive, and could be set to rise anew (Chart I-7). Because JGBs possess a very low beta relative to U.S. yields, an environment where global rates rise tends to be associated with rate differentials moving in favor of USD/JPY, often prompting a rally in the latter. Also, the Bank of Japan is keenly aware that it will be very difficult to achieve its 2% inflation target. The yen's recent strength has exerted a significant tightening in Japanese financial conditions that will drag down inflation (Chart I-8). Hence, the BoJ will continue to be among the most dovish central banks in the world. Additionally, while Japanese industrial production has been strong, it looks set to soften in the coming months, which will give further reason to the BoJ to talk down the yen: Japanese industrial production is very much a function of financial conditions. We are entering a window where the recent tightening in Japanese financial conditions should begin to bite industrial production. The growth rate of the Japanese shipments-to-inventories ratio has rolled over, historically a precursor of a slowdown in industrial production (Chart I-9). Chart I-7T-Notes Are Expensive Chart I-8Japanese FCI Points To Lower Inflation Chart I-9Japanese IP Will Turn Finally, the annual growth rate of Japan's industrial production is heavily influenced by China's economic dynamics, as EM represents 43% of Japanese exports. Two months ago, the Keqiang index - a barometer of strength for the Chinese economy based on credit growth, railway freight volumes, and electricity production - hit its highest level since June 2010, levels only recorded in early 2007, early 2005, and early 2004. Even though we do not anticipate it to crater, we do expect its recent rollover to deepen further in response to the recent wave of policy tightening in China. This should result in some weakness for Japan's industrial production. In practice there is little additional actions the BoJ can implement to ease policy further. However, because investors are currently so negative on the prospects for further Fed rate increases, with only 40 basis points priced in over the next 24 months, a re-assurance by the BoJ that easy policy is here to stay could put upward pressure on USD/JPY. While we remain worried about EM assets, we think that shorting the AUD or the NZD against the yen represents better portfolio protection than shorting USD/JPY. Bottom Line: USD/JPY has a generous amount of upside from here. Investors are too pessimistic regarding the Fed's ability to increase rates over the next 24 months. Meanwhile, the recent tightening in Japanese financial conditions is a headache for the BoJ, as it points to weaker inflation and a slowdown in industrial production. Hence, we expect the BoJ will try to talk down the yen over the coming months. EUR/NOK At An Interesting Spot Chart I-10If Brent Doesn't Fall Below,##br## EUR/NOK Is A Short The price action in EUR/NOK caught our eye this week. EUR/NOK is at a critical level and has rallied as investor optimism toward the Euro Area economy continues to grow. Meanwhile, oil prices have collapsed to US$45/bbl. Since Norway is an economy heavily geared to oil-price gyrations, this bifurcation created an ideal combination to generate a EUR/NOK rally. However, by discounting these developments, EUR/NOK has now entered massively overbought territory. Additionally, as Chart I-10 illustrates, the cross has only traded at higher levels at the depth of the financial crisis in the first quarter of 2009 and the early days of 2016. In both instances, Brent was trading below US$40/bbl. A selling opportunity could soon emerge. Our Commodity And Energy Strategy service continues to expect a deepening of the adjustment in global oil inventories as the OPEC 2.0 deal remains in vigor and compliance stays in place.2 This means a move below US$40/bbl for Brent is very unlikely, and the upside in EUR/NOK is extremely limited. While in the coming weeks a move in Brent to between US$44/bbl and US$42/bbl could happen, we think this limited downside points to an attractive risk-reward ratio to shorting this cross. We are currently long CAD/NOK and short EUR/CAD, with the latter having greater potential downside than EUR/NOK. However, due to Canada's deep integration with the U.S. economy, the EUR/CAD trade is often affected by dynamics in the U.S. dollar. Shorting EUR/NOK is thus a cleaner play on oil and removes much of the risk associated with the greenback's fluctuations. Finally, yesterday, the Norges Bank policy release displayed less dovish tone than anticipated by the market. This kind of surprise would create an additional support to being short EUR/NOK. Bottom Line: EUR/NOK looks set to weaken. Over the past 10 years, it has only traded above current levels when Brent prices were below US$40/bbl. Based on our commodity team's analysis, such a move is very unlikely. Thus, any short-term weakness in oil prices should be used to sell EUR/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 6, 2017, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report titled "Time For "Whatever It Takes" In Oil?", dated June 2, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The divergence between global bond yields and equity prices is not as puzzling as it may first appear. Thus far, lower inflation has dampened the need for central banks to tighten monetary policy. This has caused bond yields to fall, lifting stocks in the process. Looking out, the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment. The "blow-off" phase for the U.S. economy is likely to last until mid-2018. The dollar and Treasury yields will move higher over this period. The euro and the yen will suffer the most against a resurgent greenback, the pound less so. China's economy will remain resilient, helping to boost commodity prices. This will support the Canadian and Aussie dollars. Stronger global growth will provide a tailwind to emerging markets. However, at this point, most of the good news is already reflected in EM asset valuations. Feature Stocks And Bonds: A Curious Divergence Chart 1Global Growth: Increasing Optimism One could be forgiven for thinking that equity and bond investors are living on different planets. Global bond yields have been trending lower thus far this year, while stocks have been setting new highs. Are bonds signaling an imminent slowdown which equity investors are willfully ignoring? Not necessarily. Almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained reasonably steady, suggesting that growth worries are not foremost on investors' minds. The fact that consensus global growth estimates for 2017 and 2018 have continued to grind higher is consistent with this observation (Chart 1). A quiescent inflation picture has given investors more confidence that the Fed will not need to raise rates aggressively. This has pushed down bond yields, weakened the dollar, and fueled the rally in stock prices. The decline in headline inflation, in turn, has been largely driven by lower commodity prices. In the U.S., several one-off factors - including Verizon's decision to move to unlimited data plans, a temporary lull in health care inflation, and a drop in airline fares - have helped keep core inflation in check. The U.S. Economy: It Gets Better Before It Gets Worse Looking out, global growth is likely to remain firm. This should ultimately translate into higher inflation, particularly in the U.S., where the economy has already achieved full employment. Granted, as we discussed last week,1 the U.S. business cycle expansion is getting long in the tooth. However, history suggests that the transition between boom and bust is often accompanied by a revelry of sorts where things get better before they get worse. Call it a "blow-off" phase for the business cycle. The example of the late 1990s - the last time the U.S. unemployment rate fell below NAIRU for an extended period of time - comes to mind. Chart 2 shows that final domestic demand accelerated to 8.3% in nominal terms in Q1 of 2000. Personal consumption growth surged, reaching 8.4% in nominal terms and 5.7% in real terms. Obviously, there are many differences between now and then. However, there is at least one critical similarity: The unemployment rate stood at 4.3% in January 1999. This is exactly where it stands today. And if it keeps falling at its current pace, the unemployment rate will dip below its 2000 low of 3.8% by next summer. As was the case in the past, an overheated labor market will lead to faster wage growth. In the U.S., underlying wage growth has accelerated from 1.2% in 2010 to 2.4% at present (Chart 3). Chart 2The Late 1990s: An End-Of-Cycle Blow-Off Chart 3Stronger Labor Market Is Leading To Faster Wage Growth Granted, this is still well below the levels seen in 2000 and 2007. However, productivity growth has crumbled over the past decade while long-term inflation expectations have dipped. Real unit labor costs - a measure of compensation which adjusts for shifts in productivity growth and inflation - are rising at a faster rate than in 2007 and close to the pace recorded in 2000 (Chart 4). In fact, real wage growth in the U.S. has eclipsed business productivity growth for three straight years (Chart 5). As a result, labor's share of national income is now increasing. Chart 4Real Unit Labor Cost Growth: Back To Its 2000 Peak Chart 5Real Wages Now Increasing Faster Than Productivity What happens to aggregate demand when the share of income going to workers rises? The answer is that at least initially, demand goes up. Companies typically spend less of every marginal dollar of income than workers. This is especially the case in today's environment where the distribution of corporate profits has become increasingly tilted towards a few winner-take-all firms which, for the most part, are already flush with cash (Chart 6). Thus, a shift of income towards workers tends to boost overall spending. In addition, an overheated labor market typically generates the biggest gains for workers at the bottom of the income distribution. Wages for U.S. workers without a college degree have been rising more quickly than those with a university education for the past few years (Chart 7). Such workers often live paycheck-to-paycheck and, hence, have a high marginal propensity to consume. Chart 6A Winner-Take-All Economy Chart 7Tighter Labor Market Boosting Wages Of Less Educated Workers Let's Get This Party Started The discussion above suggests that U.S. aggregate demand could accelerate over the next few quarters. There is some evidence that this is already happening (Chart 8). Despite a moderation in auto purchases, real PCE growth is still tracking at 3.2% in the second quarter according to the Atlanta Fed's GDPNow model. And with the personal saving rate still stuck at an elevated 5.3%, there is scope for consumer spending to grow at a faster rate than disposable income. Chart 9 shows that the current saving rate is well above the level one would expect based on the ratio of household net worth-to-disposable income. Chart 8Solid Near-Term Outlook For U.S. Consumers Financial conditions have eased over the past six months thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart 10). Historically, an easing in financial conditions has foreshadowed faster growth (Chart 11). This could make the coming blow-off phase even more explosive than in past business cycles. Some commentators have noted that while financial conditions have eased, bank lending has slowed significantly. If true, this would imply that easier financial conditions are not boosting credit growth in the way one might expect. The problem with this argument is that it takes a far too limited view of the U.S. financial system. Although bank lending to companies has indeed slowed, bond issuance has soared. In fact, total nonfinancial corporate debt rose by $212 billion in the first quarter according to the Fed's Financial Accounts database, the largest increase in history (Chart 12). Chart 10Financial Conditions Have Been Easing... Chart 11...Which Will Support Growth Chart 12Nonfinancial Corporate Debt Surged In Q1 All Good Things Must Come To An End Unfortunately, the burst of demand that often occurs in the late stages of business cycle expansions contains the seeds of its own demise. Initially, when consumer spending accelerates, firms tend to react by expanding capacity. This translates into higher investment spending. However, as labor's share of income keeps rising, an increasing number of firms start incurring outright losses. This causes them to dismiss workers and cut back on investment spending. Such a souring in corporate animal spirits is not an immediate risk for the U.S. economy. Hiring intentions remain solid and businesses are still signaling that they expect to increase capital spending over the coming months (Chart 13). Profit margins are also quite high by historic standards, which gives firms greater room for maneuver. This will change over time, however. Margins are already falling in the national accounts data (Chart 14). History suggests that S&P 500 margins will follow suit. This raises the risk that capex and hiring will start to slow late next year, potentially sowing the seeds for a recession in 2019. We remain overweight global equities on a cyclical 12-month horizon, but will be looking to significantly pare back exposure next summer. Chart 13Corporate America Feeling Great Again Chart 14Economy-Wide Margins Have Slipped The Dollar Bull Market Is Not Over Yet Chart 15Historically, A Rising Labor Share Has Pushed Up The Dollar Until U.S. growth does decelerate, the path of least resistance for bond yields and the dollar will be to the upside. Chart 15 shows the strikingly close correlation between labor's share of income and the value of the trade-weighted dollar. As noted above, the initial effect of accelerating wage growth is to put more money into workers' pockets. This results in higher aggregate demand and, against a backdrop of low spare capacity, rising inflation. Historically, such an outcome has prompted the Fed to expedite the pace of rate hikes, leading to a stronger dollar. This time is unlikely to be any different. The market is currently pricing in only 21 basis points in Fed rate hikes over the next 12 months. This seems far too low to us. Other things equal, a stronger dollar implies a weaker euro and yen. Improved export competitiveness will lead to better growth prospects and higher inflation expectations in the euro area and Japan. Unless the ECB and the BoJ respond by tightening monetary policy, short-term real rates will fall. This, in turn, could put further downward pressure on the euro and the yen. The ECB And The BoJ Will Not Follow The Fed's Lead Many commentators have argued that better growth prospects will cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl. We doubt it. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 16). If anything, the market has priced in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 28 months at present (Chart 17). Investors now expect real rates in the U.S. to be only 23 basis points higher than in the euro area in five years' time. This is well below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 18). Chart 16Euro Area: Labor Market Slack Is Still High Outside Of Germany Chart 17ECB: Markets Are Pricing In Too Much Tightening Chart 18The Neutral Rate Is Lowest In The Euro Area As for Japan, while it is true that the unemployment rate has fallen to 2.8% - a 22-year low - this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Pound Will Rebound Against The Euro, But Weaken Further Against The Dollar Chart 19Pound: Unloved And Underappreciated While we continue to maintain a strong conviction view that the euro and yen will weaken against the dollar, we are more circumspect about other currencies. Bank of England Governor Mark Carney played down speculation this week that the BoE would raise rates later this year, noting in his annual speech at London's Mansion House that "now is not yet the time to begin that adjustment." U.K. growth has been the weakest in the G7 so far in 2017, partly because of growing angst over the forthcoming Brexit negotiations. Nevertheless, U.K. inflation remains elevated and fiscal policy is likely to be eased in the November budget, as Chancellor Hammond confirmed in a BBC interview on Sunday. Sterling is already quite cheap based on our metrics (Chart 19). Our best bet is that the pound will weaken against the dollar over the next 12 months but strengthen against the euro and the yen. We are currently long GBP/JPY. The trade has gained 7.2% since we initiated it in August 2016. CAD Has Upside We went long CAD/EUR in May. Despite the downdraft in oil prices, the trade has managed to gain 2.6% thus far. We are optimistic on the Canadian dollar over the coming months. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 20). The Bank of Canada has also turned more hawkish. Senior Deputy Governor Carolyn Wilkins suggested last week that interest rates are likely to rise later this year. The market is now pricing in a 84% chance of a rate hike in 2017, up from only 18% earlier this month. The Canadian economy continues to perform well (Chart 21). Retail sales are growing briskly, the unemployment rate is close to its lowest level in 40 years, and goods exports are recovering thanks to a weak loonie and stronger growth south of the border. While the bubbly housing market remains a source of concern, this is as much a reason to raise interest rates - to prevent further overheating - as to cut them. Chart 20Falling Oil Inventories Should Lead To Higher Crude Prices Chart 21Canadian Economy: Chugging Along China Will Drive The Aussie Dollar And EM Assets After a very strong start to the year, Chinese growth has slipped a notch. Housing starts slowed in May, as did gains in property prices. M2 growth decelerated to 9.6% from a year earlier, the first time broad money growth has fallen into the single-digit range since the government began publishing such statistics in 1986. Still, the economy is far from falling off a cliff, as evidenced by the fact that the IMF upgraded its full-year 2017 GDP growth forecast from 6.6% to 6.7% last week. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Export growth is accelerating thanks to a weaker currency and stronger global growth. The PBoC's trade-weighted RMB basket has fallen by over 8% since it was introduced in December 2015. Retail sales continue to expand at a healthy clip. The percentage of households that intend to buy a new home has also surged to record-high levels. This should limit the fallout from the government's efforts to cool the housing market. The rebound in exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 22). A better profit picture should support business capital spending in the coming months. The government also remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system last Friday. This was the single biggest one-day intervention since January, when demand for cash was running high in the lead up to the Chinese New Year celebrations. Fiscal policy has also been eased (Chart 23). So far, the "regulatory windstorm" of measures designed to clamp down on financial speculation has largely bypassed the real economy. Medium and long-term lending to nonfinancial corporations - a key driver of private-sector capital spending - has actually accelerated over the past eight months (Chart 24). Chart 22China: Higher Selling Prices Fuelling A Rebound In Profits Chart 23Fiscal Spending Is On The Mend Chart 24China: Credit To The Real Economy Is Accelerating The key takeaway for investors is that Chinese growth is likely to slow over the next few quarters, but not by much. Considering that fund managers surveyed by BofA Merrill Lynch in June cited fears of a hard landing in China as the biggest tail risk facing financial markets for the second month in a row, the bar for positive surprises out of China is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the Aussie dollar and other commodity plays. Strong Chinese growth should provide a tailwind for EM assets. However, EM stocks and currencies have already had a major run, which limits further upside. The fact that serial-defaulter Argentina could issue a 100-year bond this week in an offering that was three times oversubscribed is a testament to that. The fundamental problems plaguing many emerging markets - high debt levels, poor governance, and lackluster productivity growth - remain largely unaddressed. Until they are, the long-term outlook for EM assets will continue to be challenging. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights While the yield curve is a critical indicator for developed economies, its significance in China should be put in proper perspective, as the country's market-based financial intermediation is much less important compared with the West. The inverted Chinese yield curve indicates tighter interbank liquidity in recent months, but the impact on the economy should be limited. The PBoC will at minimum pause its liquidity tightening campaign, which will provide a window for bonds to rally. Go long Chinese onshore corporate bonds. The near term impact of MSCI's A Share inclusion should be negligible for the broader market. Valuation indicators of the select 222 large-cap names are much more attractive compared with their domestic peers, which may well provide a catalyst for some catch-up rally. Feature Chart 1China's Inverted Yield Curve The Chinese authorities' tightening measures on the financial sector have significantly pushed up interest rates across the curve, particularly in the short end, leading to rapid yield-curve flattening. By some measures, long-dated interest rates are currently lower than short rates, generating an inverted yield curve (Chart 1). Some have viewed an inverted Chinese yield curve as a harbinger of an impending material growth slowdown. While the yield curve is undoubtedly a critical indicator for developed economies, its significance in China should be put in proper perspective. In short, bank loans still play a dominant role in financial intermediation, the interest rates on which are still largely determined by the policy lending rate. Therefore, a simple comparison of the Chinese yield curve to its counterparts in the West misreads the situation and is overly alarmist. Moreover, we suspect that the phase of maximum strength of policy tightening is over, at least in the near term. Therefore, Chinese interest rates are likely to fall in the coming three to six months. This week we recommend a long position in Chinese onshore corporate bonds. Why The Yield Curve Matters Less For China To be sure, the yield curve is among the most relevant and watched indicators in some developed economies. In the U.S., for example, an inverted yield curve, defined as U.S. 10-year Treasury yields resting below three-month Treasury yields, has historically been a reliable indicator in predicting economic recessions (Chart 2). Evidence from other developed economies such as Japan and Europe is less compelling, but a flat/inverted yield curve is still generally regarded as a market signal for growth problems. Chart 2U.S. Yield Curve Inversion Predicts Economic Recession The reasons for the linkage between yield curve inversion and economic recessions have been the subject of lengthy debates among academia, policymakers and investors. From a financial market perspective, it is generally accepted that an inverted yield curve occurs when the bond market anticipates a significant slowdown in growth and/or decline in inflation, which bids down long-term yields, while policymakers fail to respond in a timely manner, which holds short-term rates at elevated levels. Yield curve inversion is typically followed by aggressive monetary easing as central banks wake up to the economic reality predicted by the bond market. Economically, the costs of funding in most developed countries are tightly linked with interest rates in the bond markets. One of banks' key functions as financial intermediaries is to transform maturity - i.e. to "borrow short and lend long," and therefore interest rates of bank loans are tied to government bond yields at the longer end, while their costs of funding are linked to the shorter end. Therefore, an inverted yield curve typically compresses banks' interest margins, which tends to hinder credit origination and slow down business activity. For example, Chart 3 shows that U.S. mortgage interest rates historically have been tightly linked with 10-year Treasury yields, while interest rates of banks' deposit base and interbank rates for "wholesale" funding are both determined by short-term Treasury yields, which is in turn determined by the fed funds rate. In China, the yield curve plays a much smaller role than in the developed world, simply because the country's market-based financial intermediation is much less important. Traditionally both lending rates and deposit rates of commercial banks were rigidly set by the People's Bank of China, and there was little lending/borrowing activity outside the formal commercial banking system. The situation has been gradually changing in recent years as a result of financial reforms. Banks are given flexibility to set their own interest rates, and non-bank lending, or shadow banking activity that is more driven by market interest rates, has expanded. However, commercial banks still play a dominant role. Chart 3U.S. Bank Loan Rates Follow Treasury Yields Closely Chart 4China: Bank Loans Still Dominate Bank loans currently account for over 70% of China's total non-equity social financing, both in terms of flow and total outstanding stock (Chart 4). Commercial banks' average lending rate still closely tracks the PBoC policy benchmark. Banks' prime lending rate moves in lock step with PBoC interest rate adjustments, and average interest rates on new mortgages are also primarily determined by the policy rate (Chart 5). Banks' cost of funding is also primarily determined by retail deposit interest rates, which are in turn set by the PBoC. Retail deposits account for about 80% of total loanable funds for large banks, or 70% for smaller banks (Chart 6). Repo and interbank transactions, which are subject to the central bank's liquidity tightening, only account for 14% of smaller lenders' source of funds, or a mere 2% for large lenders. Chart 5Chinese Bank Loan Rates ##br##Still Track PBoC Benchmarks Chart 6Retail Deposits Are Still The Dominant Funding Source ##br##For Commercial Banks The important point is that market signals from China's juvenile and volatile financial markets should be taken with a healthy dose of skepticism, and a simple comparison with the West is often misleading. For example, a significant decline in stock prices in developed economies may well herald a growth recession in their respective economies. In China, however, domestic stock prices have routinely gone through massive boom and bust cycles without any tangible impact on the broader economy, as the equity markets play a marginal role for both the corporate sector in terms of raising capital and for households in managing their wealth. In recent years, China's financial sector reforms have been gradually introducing market forces in setting interest rates, but the process is far from advanced enough to have a meaningful and direct impact on the cost of funding for both the corporate sector and banks. Overall, the inverted Chinese yield curve indicates tighter interbank liquidity in recent months, but the impact on the economy should be limited. PBoC Tightening: Passing The Phase Of Maximum Strength Moreover, it is noteworthy that yield-curve flattening has been a global phenomenon rather than a China-specific development (Chart 7). What's different is that in other countries the flatter yield curve has been mostly due to falling yields of longer-dated bonds, while in China it has been entirely driven by a sharp increase in short-term yields due to the PBoC's liquidity tightening.1 Looking forward, the PBoC will maintain close scrutiny on the financial sector to keep financial excesses in check. However, we believe the phase of maximum strength of liquidity tightening is likely over, at least in the near term. There is no case for genuine monetary tightening, as inflation is extremely low and growth momentum is already softening. It is very unlikely that the PBoC will tighten monetary conditions further, amplifying deflationary pressures in the process.2 The PBoC's tightening measures have already significantly reduced the pace of leverage buildup and excesses in the financial system. Banks' exposure to non-bank financial institutions has tumbled, net issuance of commercial banks' negotiable certificates of deposits has turned negative of late, and overall off-balance-sheet lending by financial institutions, or shadow banking activity, has slowed sharply in recent months (Chart 8). In other words, the tightening campaign has achieved the intended consequences, diminishing the odds of further escalation. Chart 7Synchronized Yield Curve Flattening Chart 8Financial Excesses Are Being Reined In Global developments are also conducive for some loosening by the PBoC. Last week's rate hike by the Federal Reserve has further pushed down both U.S. interest rates and the dollar. The spread between Chinese 10-year government bond yields and U.S. Treasurys has widened sharply of late, which is helping stabilize the RMB (Chart 9). All of this has reduced pressure on the PBoC to follow the Fed with additional domestic tightening. Already, the PBoC has stepped in to ease liquidity pressure in the interbank system in recent weeks. After massive liquidity withdrawals early this year, the PBoC has been injecting liquidity into the interbank market through various open market operations in the past two months, according to our calculations - likely a key reason why interbank rates have stopped rising of late (Chart 10). Chart 9China - U.S. Interest Rate Spread Versus##br## Exchange Rate Chart 10The PBoC Is Stepping In ##br##To Ease Interbank Liquidity Pressure Chart 11Onshore Corporate Bonds ##br##Are Attractive Chinese corporate bonds will benefit the most, should the authorities stop further tightening (Chart 11). Onshore corporate spreads have widened sharply since late last year amid the PBoC crackdown, and are now substantially higher than in other countries. Chinese corporate spreads should recover without further escalation in liquidity tightening, and will also benefit from the ongoing profit recovery in the corporate sector. We expect both quality spreads and government bond yields to drop in the next three to six months, lifting corporate bond prices. Bottom Line: The PBoC will at minimum pause its liquidity tightening campaign, which will provide a window for bonds to rally. Go long Chinese onshore corporate bonds. A Word On The MSCI A-Share Inclusion MSCI Inc. announced this week its decision to include Chinese A shares in its widely followed emerging market and world equities indexes. The company will add 222 China A large-cap stocks to its EM benchmark at a 5% partial inclusion factor, which will account for about 0.73% of EM market cap. This marks a major milestone in China's capital market development and financial sector liberalization. Increasing participation of foreign institutional investors will also over the long run help improve China's corporate governance and regulatory practices - all of which are instrumental for improving the efficiency of domestic capital market as well as the efficiency of capital allocation. Table 1Valuation Of China A-Share Universe The near-term market impact, however, should be negligible. After all, the inclusion will take effect June next year. In addition, foreign investors already have access to these A share companies through the existing Stock Connect channels between Chinese domestic exchanges and Hong Kong. Moreover, potential capital inflows from global managed assets benchmarked to MSCI indexes in the initial step will be marginal. It is estimated that a total of US$18 billion, or RMB 125 billion, foreign capital may follow the MSCI decision into the A share market, a tiny fraction of A-shares' almost RMB 40 trillion market cap. That said, the valuation indicators of the select 222 large-cap names look attractive compared with their domestic peers, with median trailing P/E and P/B ratios at 23 and 2 times, substantially lower than other major domestic indexes (Table 1). MSCI inclusion may well provide a catalyst for some catch-up rally. We will follow up on this issue in the following weeks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports, "A Chinese Slowdown: How Much Downside?," dated June 8, 2017, and "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations