Developed Countries
Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Arthur Budaghyan, Senior Vice President Chief Emerging Markets Strategist Highlights The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on mainland growth. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets, including commodities and EM. The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. A narrowing interest rate differential between China and the U.S. will continue exerting downward pressure on the RMB's value versus the dollar. Our credit stress test on Turkish banks suggests their stocks are not yet cheap assuming the non-performing loan ratio rises to 15%. Stay short banks and the lira. Feature China's economic slowdown, ongoing trade wars and accumulating U.S. inflation pressures will continue propping up the U.S. dollar, thereby sustaining a perfect storm for EM financial markets. This is taking place amid the poor structural fundamentals in the developing economies and the existing overhang of investor positions in EM. Altogether this argues for more downside in EM financial markets. A strong dollar is also a bad omen for developed markets' stock indexes. The reason being that the dollar is a countercyclical variable, and the greenback's rallies usually coincide with global trade downturns that are bearish for global cyclical equity sectors (Chart I-1). Needless to say, tariffs on imports are ultimately negative for global trade, and will exacerbate the global growth slowdown that has been occurring since early this year. In fact, there is anecdotal evidence that global trade has so far temporarily benefited from mounting expectations of tariffs.1 Companies have ordered more inputs and shipped more goods in advance of higher tariffs coming into effect. This is why global shipments and manufacturing production have so far held up reasonably well, while business expectations have plummeted (Chart I-2). Consequently, global trade and manufacturing production will likely record considerable weakness later this year. Since markets are typically forward looking, asset prices will adjust beforehand. Chart I-1Global Industrial Stocks And U.S. Dollar Chart I-2Global Trade Is Heading South We are maintaining our negative stance on EM stocks, currencies, credit markets and high-yielding local bonds. China Is Easing Liquidity, But Don't Hold Your Breath Chart I-3Chinese Interest Rates And EM Stocks: ##br##Positively Correlated China's softening industrial data, growing anecdotal evidence of a worsening credit crunch in the economy, U.S. tariffs, and plunging domestic share prices have been sufficient for the authorities to ease liquidity conditions in the Chinese banking system. Not surprisingly, many investors are wondering whether the worst is over for Chinese stocks and China-related financial markets worldwide, including those in EM. At the current juncture, liquidity easing by the PBOC is a necessary but not sufficient condition to turn positive on this nation's industrial cycle as well as EM risk assets. We have the following considerations on this topic: First, China's risk-free interest rates - government bond yields - led the selloff in both EM and Chinese stocks (Chart 3). These bond yields have plunged since November, foreshadowing the slowdown in China's growth and the carnage in EM/Chinese financial markets. By and large, there has been a positive correlation between EM share prices and China's local bond yields and interbank rates as illustrated on Chart I-3. For example, EM stocks, currencies and credit markets rallied substantially in 2017 in the face of rising interest rates in China. Likewise, they dropped in the second half of 2015 as bond yields and money market rates in China plunged. The rationale behind the positive correlation between EM risk assets and Chinese interest rates is that the latter rise and EM risk assets rally when the mainland economy is improving. The opposite is also true. At the moment, Chinese risk-free bond yields will likely continue to drop as additional slowdown in growth is in the cards. This heralds a further drop in EM financial markets. Second, any major stimulus will constitute a retraction of the Chinese government's policy of deleveraging and containing financial risks. The latter is the code phrase Chinese authorities use to stop fueling bubbles and speculative excesses. Hence, any policy stimulus will for now be measured and insufficient to boost growth this year. China is saddled with massive debt and money overhangs and a bubbly property market. Ongoing enormous expansion in money supply (i.e., RMB deposits)2 (Chart I-4) and a narrowing interest rate differential over the U.S. will continue exerting downward pressure on the RMB's value (Chart I-5). Chart I-4'Helicopter Money' In China Chart I-5The RMB Will Depreciate Further Even though capital controls have tightened since 2015, the capital account is not perfectly closed. As such, shrinking interest rate deferential versus the U.S. warrants further yuan depreciation. In short, the authorities cannot reduce interest rates further and expand money/credit growth at a double-digit rate without tolerating sizable currency deprecation. If the Chinese authorities opt for a large fiscal and credit stimulus again, the nation's structural imbalances will grow further. In this scenario, the Middle Kingdom's secular growth outlook will deteriorate, and policymakers' manoeuvring room to stimulate in the future will narrow. Chart I-6China: The Industrial Cycle Is Slumping Crucially, China's enormous money and credit creation are entirely unrelated to its high savings rate. Money and credit in China have been driven by speculative behavior of Chinese banks and borrowers not households' high savings rate. We have discussed these issues in detail in our past special reports3 and will not expand on them here. Third, there has been money/credit tightening on three fronts in China - liquidity, regulatory and anti-corruption. Even though liquidity conditions in the banking system are now ameliorating, as evidenced by the plunge in interbank rates, the regulatory clampdown on the shadow banking system as well as the anti-corruption campaign targeting the financial industry are still underway. The latter policy initiatives will continue to curb credit creation by suppressing banks' and shadow banking institutions' ability and willingness to finance the real economy. In fact, it is not inconceivable that the regulatory clampdown and anti-corruption campaign will have a larger impact on credit supply than the decline in borrowing costs. Finally, policy easing and tightening works with a time lag. China's business cycles and related financial markets do not always respond swiftly to changes in policy stance. Specifically, monetary and fiscal policies were easing substantially from the middle of 2015, yet EM/China-related risk assets continued to plummet for six months until February 2016. Conversely, policy was tightening in China throughout 2017, yet EM/China-related asset markets did well in 2017. In brief, there could be a long lag between a change in policy stance and a reversal in financial markets. For now, we reckon that the cumulative effect of policy tightening of the past 18 months will continue to seep through the Chinese economy till the end of this year. Chart I-6 demonstrates that various industrial cycle indicators continue to deteriorate. Bottom Line: The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on Chinese growth and China-related risk assets, including commodities and EM. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets. More Downside The indicators that have been useful in foretelling the turmoil in EM financial markets this year are signaling that a negative stance is still warranted: One indicator that gave an early warning signal for the current EM selloff was EM sovereign and corporate bond yields. At the moment, the average of EM dollar-denominated corporate and sovereign bond yields continues to presage lower EM stock prices, as demonstrated in Chart I-7 - bond yields are shown inverted in this chart. Chart I-7Rising EM Borrowing Costs Are Bearish For Their Stocks Notably, EM share prices display lower correlation with U.S. bond yields and U.S. TIPS yields than with EM corporate and sovereign bond yields (Chart I-8). Why are EM share prices exhibiting a stronger correlation with EM bond yields rather than with U.S. Treasury yields? The basis is that EM equities are sensitive to EM - not U.S. - borrowing costs. So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate and sovereign U.S. dollar bond yields - i.e. EM borrowing costs in dollars - will decline, and EM share prices will rally (Chart I-7). But when EM corporate (or sovereign) yields rise - irrespective of whether because of rising U.S. Treasury yields or widening EM credit spreads - EM borrowing costs in dollars rise, and consequently equity prices come under considerable selling pressure. In other words, a drop in U.S. bond yields on its own is not enough for EM share prices to advance, and conversely, a rise in U.S. bond yields is not sufficient for EM stocks to drop. It is movements in EM U.S. dollar bond yields, which are comprised of U.S. Treasury yields and EM credit spreads, that matter for the direction of EM equity prices. Regarding local bond yields, EM share prices typically exhibit a strong negative correlation with EM domestic government bonds yields - the latter are shown inverted on this chart (Chart I-9). Since we expect EM currencies to depreciate further and, given the negative correlation between EM currency values and their local bond yields, the latter will continue rising. Chart I-8EM Stocks And U.S. Rates: ##br##Mixed Relationship Chart I-9EM Equities And Local Bond Yields: ##br##Strong Correlation The risky-to-safe-haven currency ratio4 continues to fall after experiencing a major breakdown early this year (Chart I-10, top panel). Historically, this ratio has been correlated with EM share prices and currently heralds further downside (Chart I-10, bottom panel). This ratio also is agnostic to the dollar's direction - it swings between risk-on versus risk-off regimes in financial markets, regardless of the general trend in the greenback. Hence, this indicator answers the question of the direction of EM share prices, regardless of the dollar's trend. Finally, key to EM performance has been corporate profits. Presently, the outlook for EM corporate profits is still negative, as suggested by the negative readings on China's money and credit (Chart I-11). Chart I-10Are Risk Assets In A Bear Market? Chart I-11EM Corporate Profits Will Likely Shrink Bottom Line: EM risk asset will continue selling off and underperforming their DM counterparts. Stay short/underweight EM risk assets. The Dollar's Trend Is Still Up The U.S. dollar is instrumental to EM financial market trends. We expect the dollar rally to persist for now - at least through the end of this year. The underlying inflation gauge measure calculated by New York Fed points to further acceleration in U.S. consumer price inflation (Chart I-12). Furthermore, America's job market is continuing to tighten. In brief, U.S. domestic demand will stay robust even as global trade slumps. These will limit the Federal Reserve's ability to back off from tightening, even if EM financial markets continue to sell off. Chart I-12U.S. Inflation Risks Are To The Upside Remarkably, a strong U.S. exchange rate is needed to cap America's growth and inflation and to boost growth in the rest of the world, especially in Asia. Given the widening growth momentum between the U.S. and Asia, the dollar will likely need to rally significantly to reverse the growth differential currently moving in favor of America. This will be especially true if more trade tariffs are imposed. Odds are that the RMB will depreciate further given the backdrop of lower interest rates in China - discussed above. That will cause a downturn in emerging Asian currencies. A strong dollar, a slowdown in Chinese/EM demand for commodities and large net long positions by investors in oil and copper all argue for a considerable drop in commodities prices in the months ahead. This is bearish for Latin American and many other EM exchange rates. Bottom Line: The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. With respect to currency positions, we recommend investors to continue to short a basket of EM currencies such as BRL, ZAR, TRY, MYR and IDR versus the dollar. CLP and KRW are also among our shorts given our bearish outlook for copper prices, global trade and Asian currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkish Banks: A Bargain Or Value Trap? 12 July 2018 Turkish bank stocks have now fallen by 40% in local currency terms and by 55% in U.S. dollar terms since their peak early this year (Chart II-1), prompting the question whether they have become a bargain or are still a value trap. Banks represent 30% of the Turkey MSCI index and are integral to the performance of this bourse. Although Turkish banks appear to be cheap with their price-to-trailing earnings ratio at 4.5 and their price-to-book value ratio at 0.62, they are still vulnerable to a substantial rise in non-performing loans (NPL) and ensuing provisioning, write-off and equity dilution. Turkey has been experiencing an enormous credit binge for years and its interest rates have risen by 600 basis points since the start of the year. Yet, current NPLs and provisions stand at a mere 3% and 2.3% of total outstanding loan, respectively (Chart II-2). Chart II-1Turkish Stocks: A Long-Term Perspective Chart II-2Turkish Banks Are Underprovisioned The creditworthiness of debtors is worse when one takes into account that Turkish companies have large foreign currency debt and a record amount of foreign debt obligations due in 2018 (Chart II-3). In our credit stress test, we assume that in the baseline scenario the non-performing credit assets (NPCA) ratio will rise to 15% (Table II-1). Taking into account that the NPL-to-total loan ratio reached 18% in 2002 after the 2001 currency crisis, we believe 15% is a reasonable estimate. Chart II-3Turkey: Record High Foreign Debt Obligations Table II-1Credit Stress Test For Turkish Banks To put this number further into perspective, India - one of the very few countries within the EM universe to have somewhat fully recognized its NPLs - currently has an NPL ratio of 15% on its public banks. Chart II-4Turkish Equities: ##br##A Cyclically-Adjusted P/E Ratio If we assume that Turkish bank stocks at the end of this cycle will trade at a price-to-book ratio of 1 after adjusting for all credit losses, then banks' stock prices are currently about 17% overvalued in the baseline scenario of 15% NPCA (Table II-1, the middle row). In all three scenarios, we assume a recovery rate of 40%. With regards to the overall equity market, Chart II-4 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is currently around 5, compared to the historical average of 8. For the bourse's CAPE ratio to drop to two standard deviations below its mean, share prices have to fall by another 20-25%. This is plausible given the outlook for more populist economic policies following the recent elections. Besides, corporate profits will contract considerably because of the monetary tightening that has occurred since early this year. The exchange rate is critical for Turkish financial markets. As such, revisiting currency valuation is also important. Our favorite measure of currency valuation is the real effective exchange rate based on unit labor costs. This takes into account both wages and productivity. Hence, it gauges competitiveness much better than the measures of real effective exchange rate based on consumer and producer prices. Using this measure, as of July 11 the lira was slightly more than one standard deviation below its historical mean (Chart II-5). For it to reach two standard deviations below its mean, it would roughly take another 15-17% depreciation, versus an equal-weighted basket of the dollar and euro. Given the current macroeconomic backdrop and the outlook for more unorthodox policies, including possible capital controls following President Erdogan's appointment of his son-in law as the key economic policymaker, the lira will likely undershoot. Meantime, foreign holdings of Turkish local bonds and stocks were not yet depressed as of June 29 (Chart II-6). Chart II-5Turkish Lira: An Undershoot Is Likely Chart II-6Foreign Ownership Is Still High Bottom Line: Provided Turkey's political outlook has deteriorated further after the recent elections, we assess that only after a 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with a 15-20% drop in stocks in local currency terms, will Turkish equities be a true bargain and warrant a positive stance. For now, dedicated EM equity and fixed income portfolios (both credit and local currency bonds) should continue to underweight Turkey. Our open directional trades at the moment remain: Short Turkish bank stocks Short TRY / long USD. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the following article Global automakers hail more ships as trade battles heat up. 2 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available on ems.bcaresearch.com 3 Please see Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available on ems.bcaresearch.com; and Emerging Markets Strategy Special Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, link is available on page 17. 4 Average of cad, aud, nzd, brl, clp & zar total return indices relative to average of jpy & chf total returns (including carry); rebased to 100 at January 2000. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Neutral In our July 3rd Weekly Report, we made good on our recent upgrade alerts and raised the S&P pharma and biotech groups to neutral from underweight, locking in relative gains of 14.5% and 13.9%, respectively. In our report, we highlighted five key drivers for our more sanguine view, namely firming operating metrics, late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar and investor and analyst capitulation. With respect to the first of these, our pharma productivity proxy (industrial production / employment) is putting in its best performance of the past several years, implying that earnings seem likely to exceed the pessimistic sell-side estimates (second panel). This seems particularly likely as the pace of improvement in drug shipments exceeds inventory growth by a fairly wide margin (third and bottom panels). Bottom Line: Lift the S&P pharma and S&P biotech indexes to a benchmark allocation and remove the S&P pharma group from the high-conviction underweight list; see our Weekly Report for more details. The ticker symbols for the stocks in the S&P biotech and S&P pharma indexes are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY and BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, NKTR, respectively.
Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Ryan Swift, Vice President U.S. Bond Strategy Highlights Chart 1Inflations Expectations Hard To Shake Low inflation expectations are proving difficult to shake. Year-over-year core PCE inflation moved to within 5 bps of the Fed's 2% target in May, but long-maturity TIPS breakeven inflation rates barely budged (Chart 1). Instead, breakevens are taking cues from commodity prices which are being held down by flagging global growth (bottom panel). The minutes from the June FOMC meeting revealed that "one participant" advocated postponing rate hikes in an attempt to re-anchor inflation expectations, but we do not expect the Fed to pursue this course. Instead, the Fed will continue to lift rates at a pace of 25 bps per quarter until a risk-off episode in financial markets prompts a delay, hoping that the incoming inflation data are strong enough to send TIPS breakevens higher in the meantime. Ultimately we think that strategy will be successful, but Fed hawkishness in the face of weakening global growth threatens the near-term performance of corporate credit. We recommend only a neutral allocation to spread product versus Treasuries, while maintaining a below-benchmark duration bias. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 60 basis points in June, dragging year-to-date excess returns down to -181 bps. Value is no longer stretched in the investment grade corporate bond market, though it is not attractive enough to compensate for being in the late stages of the credit cycle or for the looming collision between a hawkish Fed and decelerating global growth. These factors led us to reduce exposure to corporate bonds two weeks ago.1 With inflation running close to the Fed's 2% target and the 2/10 Treasury slope between 0 bps and 50 bps, our research shows that small positive excess returns are the best case scenario for corporate bonds. The likelihood that leverage will rise in the second half of this year is also a concern (Chart 2). Profit growth is only just keeping pace with debt growth and will soon have to contend with rising wage costs and the drag from recent dollar strength. The Fed's staunch hawkishness in the face of decelerating global growth is reminiscent of 2015. Then, the end result was a period of spread widening that culminated in the Fed pausing its rate hike cycle. In recent weeks we also explored how to position within the investment grade corporate bond sector, considering both the maturity spectrum and the different credit tiers.2 We concluded that in the current environment investors should favor long maturities and maintain a balanced or slightly up-in-quality bias (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 40 basis points in June, bringing year-to-date excess returns up to +76 bps. The average index option-adjusted spread widened 1 bp on the month, and currently sits at 365 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses has widened to 262 bps, just above its long-run mean (Chart 3). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 262 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in last week's report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.03% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance sheets were in much better shape than they are today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks to that forecast are to the upside. It will be critically important to track real-time indicators of the default rate such as job cut announcements, which remain low relative to history but have perked up in recent months (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in June, bringing year-to-date excess returns up to -24 bps. The conventional 30-year zero-volatility MBS spread widened 1 bp on the month, driven entirely by a 1 bp widening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The MBS option-adjusted spread has widened since the beginning of the year (Chart 4), though by much less than the investment grade corporate bond spread (panel 3). The year-to-date OAS widening has been offset by a contraction in the option cost component of spreads, and this has kept the overall nominal MBS spread flat at very tight levels (bottom panel). Going forward, rising interest rates will limit mortgage refinancing activity and this will ensure that MBS spreads remain low. In other words, while MBS valuation is not attractive, the downside is limited. Our Bond Maps show an unfavorable risk/reward trade-off in the MBS sector. This analysis, based on volatility-adjusted breakeven spreads, shows that only 7 days of average spread widening are required for the MBS sector to lose 100 bps versus duration-matched Treasuries. While this speaks to the low spread buffer built into current MBS valuations, the message from the Bond Map must be weighed against the macro outlook which suggests that the odds of significant spread widening are quite low. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in June, bringing year-to-date excess returns up to -35 bps. Sovereign debt outperformed the Treasury benchmark by 33 bps on the month, bringing year-to-date excess returns up to -210 bps. Foreign Agencies outperformed by 10 bps on the month, bringing year-to-date excess returns up to -46 bps. Local Authorities underperformed by 9 bps on the month, dragging year-to-date excess returns down to +28 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. Domestic Agency bonds underperformed by 7 bps, dragging year-to-date excess returns down to zero. The escalating tit-for-tat trade war and increasing divergence between U.S. and non-U.S. growth is a clear negative for USD-denominated Sovereign debt. Relative valuation also shows that U.S. corporate bonds are more attractive than similarly rated Sovereigns (Chart 5). Maintain an underweight allocation to Sovereign debt. Within the universe of Emerging Market Sovereign debt, we showed in a recent report that only Russian debt offers an attractive spread relative to the U.S. corporate sector.4 In contrast, the Foreign Agency and Local Authority sectors continue to offer a favorable risk/reward trade-off compared to other fixed income sectors (please see the Bond Maps). Maintain overweight allocations to these two sectors. The Bond Maps also show that the Supranational and Domestic Agency sectors are very low risk, but offer feeble return potential compared to other sectors. The Supranational and Domestic Agency sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 10 basis points in June, bringing year-to-date excess returns up to +120 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio fell 1% in June to reach 85%, close to one standard deviation below its post-crisis mean. It is also only slightly higher than the average 81% level that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. The technical picture remains favorable for Muni / Treasury yield ratios. Fund inflows increased in recent weeks, and visible supply has contracted substantially compared to this time last year (Chart 6). State & local government credit fundamentals are also fairly robust. Net borrowing is on the decline and this should ensure that municipal ratings upgrades continue to outpace downgrades (bottom panel). Despite relatively tight valuation compared to history, the Total Return Bond Map on page 16 shows that municipal bonds offer a fairly attractive risk/reward trade-off compared to other U.S. fixed income sectors, particularly for investors exposed to the top marginal tax rate. Given the favorable reading from our Bond Map and the steadily improving credit fundamentals, we recommend an overweight allocation to Municipal bonds. Treasury Curve: Favor 7-Year Bullet Over 1/20 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in June. The 2/10 Treasury slope flattened 10 bps and the 5/30 slope flattened 7 bps. At present, the 2/10 slope sits at 29 bps, its flattest level of the cycle. The yield curve has flattened relentlessly in recent months as the impact of Fed rate hikes at the short-end of the curve have not been offset by higher inflation expectations at the long end. As explained in a recent report, we think it is unlikely that curve flattening can maintain this rapid pace.5 At 2.34%, the 1-year Treasury yield is already priced for 100 bps of Fed rate hikes during the next 12 months, assuming no term premium. Meanwhile, long-maturity TIPS breakeven inflation rates remain below levels that are consistent with the Fed's 2% inflation target. While curve flattening will proceed as the Fed lifts rates, higher breakeven inflation rates at the long-end of the curve will offset some flattening pressure during the next few months. With that in mind, we continue to recommend a position long the 7-year bullet and short the duration-matched 1/20 barbell. According to our models, this butterfly spread currently discounts 41 bps of 1/20 curve flattening during the next six months (Chart 7). This is considerably more than what is likely to occur. Table 4 of this report shows the output from our valuation models for each butterfly combination across the entire yield curve, as explained in a recent Special Report.6 Table 4Butterfly Strategy Valuation (As Of July 6, 2018) TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 35 basis points in June, bringing year-to-date excess returns up to +129 bps. The 10-year TIPS breakeven inflation rate increased 4 bps on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate increased 5 bps and currently sits at 2.16% (Chart 8). Both the 10-year and 5-year/5-year TIPS breakeven inflation rates remain below the range of 2.3% to 2.5% that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We expect breakevens will return to that target range as investors become increasingly convinced that the risk of deflation has faded. Consistent inflation prints at or above the Fed's 2% target will be the deciding factor that eventually leads to this upward re-rating of inflation expectations. In that regard, the current outlook is promising. Core PCE inflation has printed above the 0.17% month-over-month level that is consistent with 2% annual inflation in four of the past five months (panel 4). Year-over-year trimmed mean PCE inflation is at 1.84% and should continue to rise based on the 2.03% reading from the 6-month trimmed mean PCE (bottom panel). Finally, our Pipeline Inflation Indicator continues to point toward mounting inflationary pressures in the economy (panel 3). Maintain an overweight allocation to TIPS relative to nominal Treasury securities. We will reduce exposure to TIPS once long-maturity TIPS breakeven inflation rates return to our 2.3% to 2.5% target range. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in June, bringing year-to-date excess returns up to -2 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and now stands at 43 bps, 16 bps above its pre-crisis low. The Bond Maps show that consumer ABS continue to offer relatively attractive return potential compared to other low-risk spread products. However, we maintain only a neutral allocation to this space because credit quality trends are moving against the sector. The household debt service ratio on consumer credit ticked down slightly in the first quarter, but its multi-year uptrend remains intact (Chart 9). Consumer credit delinquency rates follow the household debt service ratio with a lag. Meanwhile, banks are noticing the decline in credit quality and have begun tightening lending standards (bottom panel). Tighter lending standards tend to coincide with upward pressure on delinquencies and spreads. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 11 basis points in June, dragging year-to-date excess returns down to +61 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 4 bps on the month and currently sits at 74 bps (Chart 10). The gap between decelerating commercial real estate prices and tight CMBS spreads continues to send a worrying signal for CMBS (panel 3). However, delinquencies continue to decline and banks recently started to ease lending standards on nonfarm nonresidential loans (bottom panel). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in June, dragging year-to-date excess returns down to +6 bps. The index option-adjusted spread widened 2 bps on the month and currently sits at 51 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of July 6, 2018) Chart 12Total Return Bond Map (As Of July 6, 2018) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, for further details on positioning across different credit tiers. Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, for further details on positioning across the maturity spectrum. Both reports available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Threats & Opportunities In Emerging Markets", dated June 12, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
A number of factors have fallen into place, allowing an exploitable market- and industry-neutral opportunity to surface by going long the S&P homebuilding index/short the S&P REITs index. Our thesis is supported by four key pillars: Favorable macro tailwinds for residential vs. commercial real estate (prices, credit, interest rates), Firm relative demand dynamics, Supportive relative supply backdrop, Compelling relative valuations and technicals. With respect to the first of these, we show in our chart at the side that real commercial real estate (CRE) prices have overtaken the previous top, whereas house prices deflated by inflation remain significantly below the 2006 zenith. In nominal terms, CRE prices are one standard deviation above the previous high, while residential real estate prices just recently made all-time highs. The implication is that the pricey CRE sector is relatively more vulnerable to a downturn. Bottom Line: We initiated a long S&P homebuilding/short S&P REITs pair trade yesterday. Please see Monday's Special Report for more details. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively.
Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Robert Robis, Chief Fixed Income Strategist Highlights Q2 Performance Breakdown: The return for the Global Fixed Income Strategy (GFIS) recommended model bond portfolio was flat (hedged into U.S. dollars) in the second quarter of 2018, outperforming the custom benchmark index by +13bps. This pushed the 2018 year-to-date performance back into positive territory. Winners & Losers: Nearly the entire outperformance came from our overweight stance on U.S. high-yield corporates versus our underweight tilt on emerging market corporates. Successful government bond country allocation (overweight U.K. & Australia, underweight Italy) helped offset the drag on performance from our overweight stance on U.S. investment grade corporates. Scenario Analysis: Our recent decision to downgrade overall spread product exposure, even as we maintain a below-benchmark duration stance, should help boost the expected alpha of the model portfolio over the next year. Feature This week, we present the performance numbers for the BCA Global Fixed Income Strategy (GFIS) model bond portfolio in the second quarter of 2018. As a reminder to existing readers (and for new clients), the portfolio is a part of our service that is meant to complement the usual macro analysis of global fixed income markets. The model portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors, by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. In this report, we update our estimates of future portfolio performance, using the scenario analysis framework that we introduced three months ago.1 After our recent decision to downgrade global spread product exposure, our model portfolio is now expected to outperform the custom benchmark index over the next year in both our base case and plausible stress test scenarios. Q2/2018 Model Portfolio Performance Breakdown: Country & Credit Selection Pays Off The total return of the GFIS model bond portfolio was flat (hedged into U.S. dollars) in the second quarter of the year, which outperformed our custom benchmark index by +13bps.2 The first half of the quarter was driven by gains from our below-benchmark duration tilt, as the 10-year U.S. Treasury yield hit a peak of 3.13%. As yields drifted a bit lower in the latter half of Q2 in response to some cooling of global economic growth amid rising concerns on U.S. trade policy, the gains from duration reversed. At the same time, the outperformance from the spread product portion of our model portfolio started to kick in (Chart of the Week), even as credit spreads in all markets widened. Chart of the WeekSpecific Country & Credit Allocations##BR##Boosted Q2 Performance Table 1GFIS Model Bond Portfolio##BR##Q2-2018 Overall Return Attribution In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +5bps of outperformance versus our custom benchmark index while the latter outperformed by +8bps (Table 1). The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio##BR##Q2/2018 Government Bond Performance Attribution By Country Chart 3GFIS Model Bond Portfolio##BR##Q2/2018 Spread Product Performance Attribution By Sector The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Overweight U.S. high-yield B-rated corporates (+5bps) Overweight U.S. high-yield Caa-rated corporates (+2bps) Overweight Japanese government bonds (JGBs) with maturities up to ten years (+3bps) Underweight emerging market U.S. dollar-denominated corporate debt (+5bps) Underweight Italian government bonds (+4bps) Overweight U.K. Gilts (+1bp) Overweight Australian government bonds (+1bp) Biggest underperformers Overweight U.S. investment grade Financials (-2bps) Overweight U.S. investment grade Industrials (-2bps) Underweight JGBs with maturities beyond ten years (-5bps) Underweight French government bonds with maturities beyond ten years (-2bps) Two unusual trends stand out in the Q2 performance numbers: First, our overweight stance on U.S. high-yield debt was able to deliver positive alpha but a similar tilt on U.S. investment grade did not, even as U.S. corporate credit spreads widened during the quarter. It is odd for an asset class (high-yield) that is typically more volatile to outperform during a period of credit spread widening. Although that outcome did justify our view that U.S. investment grade corporates have been offering far less cushion to a period of spread volatility than U.S. junk bonds. Second, the flattening pressures on global government bond yield curves resulted in underperformance from the very long ends of curves in core Europe and Japan, even though the latter regions were the best performing bond markets in our model bond portfolio universe. This can be seen in Chart 4, which presents the benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and also adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during the second quarter.3 Chart 4Ranking The Winners & Losers From The Model Portfolio In Q2/2018 As can be seen in the chart, the best performers were government bonds in Germany, France and Japan. The fact that our excess return from those countries was only a combined +2bps, even with an aggregate overweight exposure to all three, suggests that our duration allocation within the maturity buckets of those countries was a meaningful drag on performance. Yet in terms of the overall success rate of our individual country and sector calls, the news was positive in Q2. We've been overweight U.K. Gilts and Australian government bonds, which were some of the top performers in Q2. On the other side, we have been underweight emerging market corporate debt and Italian sovereign debt, which were the worst performers in the quarter. Bottom Line: The GFIS model bond portfolio outperforming the custom benchmark index by +13bps. This pushed the 2018 year-to-date performance back into positive territory. Nearly the entire outperformance came from our overweight stance on U.S. high-yield corporates versus our underweight tilt on emerging market corporates. Future Drivers Of Portfolio Returns After Our Recent Changes Looking ahead, the performance of the model bond portfolio will have different drivers in the third quarter and beyond after the recent changes to BCA's recommended strategic asset allocations.4 We downgraded global equity and spread product exposure to neutral, based on our concern that the backdrop for global growth, inflation and monetary policy was turning less supportive for risk assets, particularly given the potential new economic shock from the "U.S. versus the world" trade tensions. In terms of the specific weightings in the GFIS model bond portfolio, we still prefer owning U.S. corporate debt versus equivalents in Europe and emerging markets. Thus, while we downgraded our recommended allocation to U.S. and investment grade corporates to neutral from overweight, we also cut our weightings to euro area corporates, as well as to all emerging market hard currency debt (see the table on page 12, which shows the model bond portfolio changes that were made back on June 26th). The latter changes were necessary to maintain the relatively higher exposure to U.S. corporate debt versus non-U.S. corporates, although it does leave the model portfolio with a small overall underweight stance to global spread product (Chart 5). Importantly, we are maintaining a below-benchmark stance on overall portfolio duration, even as we grow more cautious on credit exposure. This is because we still see potential medium-term upward pressure on bond yields coming from tightening monetary policies (Fed rate hikes, ECB tapering of bond purchases) and increasing inflation expectations. The majority of global central bankers are dealing with tight labor markets and slowly rising inflation rates. While global growth has cooled a bit from the rapid pace seen in 2017, it has not been by enough to have policymakers shift to a more dovish bias. Throughout the first half of 2018, we have been deliberately targeting a modest tracking error for our model portfolio, given the historical richness (low yields, tight spreads) of so many parts of the global bond universe. Our estimate of the tracking error is now below the 40-60bp range that we have been targeting (Chart 6), but we are willing to live with this given the higher degree of uncertainty at the moment.5 Chart 5New Spread Product Allocation:##BR##Neutral U.S., Underweight Non-U.S. Chart 6Staying Defensive With##BR##The Risk Budget Importantly, the changes to our asset allocation recommendations should help boost the expected return of the model portfolio over the next year. In our Q1/2018 portfolio review published in April, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors. For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using recent historical yield betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis based on projected returns of each asset class in the model bond portfolio universe by making assumptions on those individual risk factors. Table 2AFactor Regressions Used To Estimate##BR##Spread Product Yield Changes Table 2BEstimated Government Bond Yield##BR##Betas To U.S. Treasuries With these tools, we can forecast returns for each bond sector under different scenarios. We can then use those forecasts to predict the expected return for our model bond portfolio under those same scenarios, but with our current relative allocations. In Tables 3A & 3B. we show three differing scenarios, with all the following changes occurring over a one-year horizon. Table 3AScenario Analysis For The GFIS Model Portfolio Table 3BU.S. Treasury Yield Assumptions For The Scenario Analysis Our Base Case: the Fed delivers another 100bps of rate hikes, the U.S. dollar rises +5%, oil prices rise by +10%, the VIX index increases by five points from current levels, and U.S. Treasury yields rise by 20-40bps across the curve. A Very Hawkish Fed: the Fed delivers 150bps of rate hikes, the U.S. dollar rises by +10%, oil prices rise by +10%, the VIX index increases by ten points from current levels and there is a sharp bear flattening of the U.S. Treasury curve. A Very Dovish Fed: the Fed only hikes rates by 25bps, the U.S. dollar falls by -5%, oil prices fall by -20%, the VIX index increases by fifteen points from current levels and there is a modest bull steepening of the U.S. Treasury curve (in this scenario, the Fed puts the rate hiking cycle on hold because of a sharp selloff in U.S. financial markets). The top half of Table 3A shows the expected returns for all three scenarios under our more bullish asset allocation prior to the changes made on June 26th, while the bottom half shows the expected performance of the model portfolio after our downgrade to global spread product. Importantly, the model bond portfolio is now expected to outperform the custom benchmark index in not only the base case scenario (+25bps of outperformance) but also in the two alternative scenarios of a very hawkish Fed (+46bps) and a very dovish Fed (+6bps). Those positive outcomes are not surprising, given that all three scenarios have some degree of risk aversion (higher VIX) that would play into our now-reduced exposure to credit risk in the portfolio. Our negative view on duration risk (Chart 7) also helps boost excess returns versus the benchmark in two of the three scenarios. Interestingly, these outcomes all occur despite the fact that the portfolio is now running with a negative carry (i.e. a lower total yield versus the benchmark index) after the reduction in spread product exposure (Chart 8). Although given our views that market volatility, bond yields and credit spreads are more likely to move higher in the next 6-12 months, we think that carry considerations now play a secondary role in portfolio construction. The time to try and earn carry is during stable markets, not volatile markets. Chart 7The Model Portfolio Is Not Chasing Yield Chart 8Staying Below-Benchmark On Overall Duration Bottom Line: Our recent decision to downgrade overall spread product exposure, even as we maintain a below-benchmark duration stance, should help boost the expected alpha of the model portfolio over the next year. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start", dated April 10th 2018, available at gfis.bcareseach.com. 2 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 For Italy, Germany & France, the bars have two colors since the portfolio weights were changed in mid-May, when we cut the recommended stance on Italy to underweight and raised the allocations to Germany & France as an offset. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Time To Take Some Chips Off The Table: Downgrade Global Spread Product Exposure To Neutral", dated June 26th 2018, available at gfis.bcaresearch.com. 5 In general, we aim to target a tracking error no greater than 100bps. We think this is reasonable for a portfolio where currency exposure is fully hedged and less than 5% of the portfolio benchmark is in bonds with ratings below investment grade. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. John Canally, Chief U.S. Investment Strategist Highlights Late in the business cycle, investors should remain overweight risk assets generally, as long as margins are still rising. A 2015-style deceleration in the Chinese economy cannot be ruled out if it suffers a serious shock to its external sector. The bar remains high for Q2 2018 EPS, but investors are already focused on 2019 and the impact of trade policy on corporate results. Economic surprise is rolling over as inflation surprise climbs. Feature U.S. equities prices rose last week as U.S.-China tariffs kicked in. The U.S. dollar and 10-year Treasury yields dipped, while oil and gold held steady to start the first quarter. Despite the relative calm, investors remain concerned about the impact of trade policy and rising labor and raw materials costs on corporate margins. BCA expects S&P 500 margins to peak later this year. In the next section of this report, we examine the performance of a broad range of asset classes after the economy reaches full employment. Higher labor and input costs, along with the impact of global trade disputes, will be key topics of discussion as the Q2 earnings seasons kicks off this week. We provide a preview later in this report. Market participants are also worried that the weakness in Chinese equities and the decline in the CNY are signaling a repeat of late 2015-early 2016. We explore those concerns in the second section below. Although the June jobs report (see below) was mixed relative to consensus expectations, the Citigroup Economic Surprise Index (CESI) is poised to turn negative. In the final section of this week's report, we discuss how investors should positions as CESI troughs and how to prepare for the inevitable bounce higher. The rise in the U.S. unemployment rate to 4% in June is not the start of a new trend. The labor market continues to tighten and the FOMC is noticing (Chart 1, panels 1 and 2). Chart 1Don't Be Fooled By The Uptick##BR##In The U.S. Unemployment Rate The June Establishment Survey revealed a 213k rise in payrolls, along with upward revisions to the previous two months. The three-month average, at 211k, remains well above the underlying trend in labor force growth. In contrast, the Household Survey showed a more modest 102k increase in jobs in the month. Moreover, the number of people entering the workforce surged by 601k, which caused the unemployment rate to rise from 3.8% to 4%. We doubt this signals a trend change in the unemployment rate. The Household Survey is quite volatile relative to the Establishment Survey, suggesting that employment gains in the former are likely to catch up next month. The surge in the labor force in June could reflect the possibility that the tight labor market is finally drawing people into the workforce who were not previously looking for work. The participation rate rose by 0.2 percentage points to 62.9% (panel 4). However, this rate bounces around from month-to-month and is still in its post-2015 range. Moreover, the typical wave of college and high school students entering the workforce at this time of the year may have distorted the labor force figures due to seasonal adjustment problems. The real story is that the underlying labor market continues to tighten. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. Average hourly earnings edged up by 0.2% m/m in June. The y/y rate held at 2.7% in the month, but the trend in wage growth remains up (panel 3). Moreover, the June non-manufacturing ISM report highlighted that economic momentum remains very strong, and the respondents' comments noted widespread building cost pressures related to labor shortages, rising commodity prices and a shortage of transportation capacity. China: It's Not 2015...Yet Investor concerns escalated last week over emerging markets and specifically China. Market participants are worried that the weakness in Chinese equities and the decline in the CNY are signaling a repeat of late 2015-early 2016. BCA's Foreign Exchange Strategy's view1 is that Beijing is letting the CNY depreciate at a faster pace against the U.S. dollar for two reasons. First, it is a means to reflate the economy because the proposed U.S. tariffs on Chinese goods would inflict a non-negligible blow to China that would need to be softened if it materializes. Secondly, letting the yuan depreciate sends a message to the U.S.: China can weaponize its currency if necessary. Meanwhile, our China Investment Strategy service remains cautious on Chinese equities, but notes that the recent selloff in domestic stocks may be overdone (we remain neutral on the investable market).2 Chart 2China's Borrowing Costs Have Climbed... A 2015-style deceleration in the Chinese economy cannot be ruled out if it suffers a serious shock to its external sector, which would be very problematic for financial markets given our view that China has a higher pain threshold for stimulus than in the past. But tight monetary policy was a key driver of China's 2015 slowdown, and while monetary conditions have tightened since late-2016, they remain easier than what prevailed four years ago (Chart 2). There are key differences between 2015 and today from a U.S./global perspective as well. In late 2015, the dollar had moved up by 27% from its mid-2014 low, business capital spending was in freefall, credit spreads widened and oil dropped by over 50% year-over year. None of those conditions are currently in place. The key difference between 2015 and today is that three years ago there was no threat of a trade war with China, or the widespread imposition of protectionist measures more generally. Late Cycle Asset Return Performance Some of our economic and policy analysis over the past year has focused on previous late-cycle periods, especially those that occurred at the end of long expansions such as the 1980s, 1990s and the 2000s.3 Specifically, we analyzed the growth, inflation and policy dynamics after the point when the economy reached full employment (i.e. when the unemployment rate fell below the CBO estimate of full employment - NAIRU). This week we look at asset class returns during late-cycle periods. We wanted to use as broad a range of asset classes as possible, although data limitations mean that we can only analyze the late-cycle periods at the end of the 1990s and the mid-2000s (Chart 3). To refine the analysis, we split the late-cycle periods into two parts: before and after S&P 500 profit margins peak. One could use other signposts to split the period, such as a peak in the ISM or a peak in the S&P 500 index itself. However, using the S&P operating profit margin proved to be a more useful break point across the cycles in terms of timing trend changes in risk assets. Table 1 (and Appendix) presents total returns for the following periods: (1) the full late-cycle period - i.e. from the point at which full employment is reached until the next recession; (2) from the point of full employment to the peak in the S&P margin; (3) from the peak in margins to the recession; and (4) during the subsequent recession. All returns are annualized for comparison purposes, and the data shown are the average of the late 1990s and mid-2000 late-cycle periods. Chart 3Profit Margins Peak Late##BR##In The Late Cycle Period Table 1Historical Returns; Average Of##BR##Late 1990s And Mid-2000s We must be careful in interpreting the results because no two cycles are exactly the same, and we only have two cycles in our sample of data. Nonetheless, we make the following observations: Treasury bond returns are positive across the board, which seems odd at first glance. However, in both cycles the selloff occurred before the late-cycle period began. Yields then fluctuated in a range, and then began to fall after margins peaked. Global factors also contributed to Greenspan's "conundrum" of stable bond yields in the years before the Great Recession. We do not expect a replay this time around given the low starting point for real yields and the fact that the Fed is encouraging an overshoot of the inflation target. Bonds are unlikely to provide positive returns on a 6-12 month horizon. Similar to Treasuries, investment-grade (IG) corporate bond returns were positive across the board for the same reason. However, IG underperformed Treasuries after margins peaked and into the recession. High-yield (HY) bonds followed a similar pattern, but suffered negative returns in absolute terms after margins peaked. U.S. stocks began to sniff out the next recession after margins peaked. Small caps outperformed large caps in the recessions, but after margins peaked relative performance was mixed. We are avoiding small caps at the moment based on poor fundamentals and valuations. Growth stocks had a mixed performance versus value before and after margins peaked, but tended to outperform in the recessions. Dividend aristocrat returns performed well relative to the overall equity market after margins peaked and into the recession on average, but the performance is not consistent across the two late cycles. EM stocks performed well before margins peak, and poorly during the recessions. However, the performance is mixed in the period between the margin peak and the recession. We recommend an underweight allocation because of poor macro fundamentals and tightening financial conditions. In theory, Hedge funds are supposed to be able to perform well in any environment, but returns have been a mixed bag after margins peaked. The return performance of Private Equity, Venture Capital and Distressed Debt were similar to the S&P 500, albeit with more volatility. Avoid them after margins peak. Structured product is one of the few categories that performed well across all periods and cycles. The index we used includes MBS, CMBS and ABS. Farmland and Timberland returns are attractive across all periods and cycles, except for Timberland during recessions where the return performance was mixed. Oil and non-oil commodities tended to perform poorly during recession, but returns were inconsistent in the other phases shown in the table. Gold was also a mixed bag. The return analysis underscores that investing late in an economic cycle is risky because risk assets can begin to underperform well before evidence accumulates that the economy has fallen into recession. Using the peak in the S&P 500 operating profit margin as a signal to lighten up appears promising. Based on this approach, investors should remain overweight risk assets generally, including stocks, corporate bonds, hedge funds, private equity and real estate, as long as margins are still rising. Investor should scale back in most of these areas as soon as margins peak, although they can hold onto Farmland, Timberland, structured products, real estate (including REITs) for a while after margins peak because it may not be as important to exit these areas before the next recession begins. For fixed income, investor should be looking to raise exposure but move up in quality after margins peak. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. S&P 500 margins are still rising at the moment which, on its own, suggests that investors should be fully-exposed to all risk assets. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market (e.g. trade war, economic China slowdown, and EM economic and financial vulnerabilities). We are not yet ready to go underweight on risk assets, but the risk/reward balance at the moment suggests that risk tolerance should be no more than benchmark. Still Going Strong The consensus predicts a 21% year-over-year increase in the S&P 500's EPS in Q2 2018 versus Q2 2017, and 22% in calendar year 2018. Expectations are high; at the start of 2018, analysts projected 11% growth in Q2 and 12% in 2018. Energy, materials, technology and financials will lead the way in Q2 earnings growth, while real estate and utilities will struggle. Excluding the energy sector, the consensus expects a robust 18% increase in profits. The stout profit environment for Q2 2018 and the year ahead reflects sharply higher oil prices compared with Q2 2017, and the impact of last year's Tax Cut and Jobs Act on share buybacks and management confidence. However, global growth, which was a tailwind for S&P 500 results in 2017 and early 2018, has stalled. Moreover, rising costs for raw materials and labor will erode margins, but not until later this year. S&P 500 revenues are forecast to rise by 8% in Q2 2018 versus Q2 2017, matching the Q1 2018 year-over-year increase. The consensus expects a year-over-year gain in Q2 sales in all 11 sectors. Trade policy will continue to be at the forefront as managements discuss Q2 outcomes and provide guidance for 2H 2018 and beyond. In addition, capacity constraints, labor shortages and rising input costs will be key topics. Elevated corporate debt levels4 and climbing interest rates also will be debated as CEOs and CFOs provide guidance to Wall Street for Q3 2018 and beyond. Their counsel is more vital than the actual Q2 results. The markets probably have already priced in a robust 2018 earnings profile linked to the Tax Cut and Jobs Act, and are looking ahead to 2019 and 2020 (Chart 4). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 22% increase expected this year. Chart 4High Bar For 2018... But Focus Will Quickly Turn To 2019 At 9%, the consensus estimate for S&P 500 EPS growth in 2020 is too high (Chart 4). BCA's view5 is that the next recession in the U.S. will commence in 2020. Since 1980, S&P 500 profits have dwindled by 28%, on average, in the first year of a recession. Chart 5 (panel 1) shows that elevated readings on the ISM manufacturing index still provide a very favorable backdrop for S&P 500 profit growth in 2018. However, the top panel also illustrates that the index rarely stays above 60 (it was 60.2 in June), especially late in the business cycle. The ISM is a good proxy for S&P 500 forward earnings (panel 2) and sales (panel 3). The implication is that while the near-term environment for S&P 500 earnings and sales is solid, there is not much more upside. Chart 5Domestic Backdrop For S&P Profits In ''18 Still Looks Solid... Global growth is peaking despite the rosy domestic economic environment. At close to 3%, the consensus view of U.S. GDP growth in 2018 is still accelerating thanks to pro-cyclical fiscal, monetary and legislative policies in the U.S.6 However, in early April, analysts estimates for 2019 GDP growth in the U.S. reached a zenith at 2.5% and have since rolled over (Chart 6). The FOMC projects real GDP growth at 2.8% in 2018 and 2.4% in 2019.7 Meanwhile, global GDP growth estimates for 2018 began flattening near 3.5% in early April 2018, about a month after President Trump announced the first round of tariffs. Estimates for 2019 economic growth peaked in mid-May, near 3.25% (Chart 6). Chart 6Consensus GDP Estimates For U.S., World Are Rolling Over BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. The trade-weighted dollar is up by 2.5% year-to-date, and by 7% from its recent (February 2018) trough. Nonetheless, the dollar is down by 2% year-over-year and should not have a major impact on Q2 results. Furthermore, based on the minimal references to a robust dollar (only eight in the past eight Beige Books), the dollar probably will not be an issue for corporate profits in Q2 2018 (Chart 7). The handful of recent references is in sharp contrast with a surge in comments during 2015 and early 2016. The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. The implication is that a robust dollar may get a few mentions during the earnings season, but those mentions will be drowned out by concerns over global trade. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically-focused corporations versus globally-oriented ones. Economic growth trends, discussed above, also play a role. Chart 8 shows that sales of domestically-oriented firms in the U.S. are still in a clear uptrend (panel 2). However, revenues of U.S. companies with a global focus stalled in recent quarters, even before the first round of tariffs were announced (panel 4). Margins at domestically-focused firms are still accelerating (panel 1), while margins at global businesses are topping out, albeit at a higher level than domestic ones. Moreover, since the start of 2017, the weaker dollar has allowed profit and sales gains of global corporations to rebound and outpace those companies with only domestic concerns. BCA expects that margins for S&P 500 companies will peak later this year. Investors are skeptical that S&P 500 margins can advance in Q2 2018 for the eighth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate and raw materials costs escalate. Bottom Line: BCA expects that the earnings backdrop will support equity prices in 2018 (Chart 9). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on the upcoming 2019 and 2020 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 9). In late June,8 we downgraded our 12-month recommendation on global equities and credit from overweight to neutral. Chart 7The Dollar Should Not Be##BR##A Big Concern In Q2 Earnings Season Chart 8Global Sales,##BR##Margins Stalled... Chart 9Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Look Out Below Citi's Economic Surprise Index (CESI) is poised to turn negative (Chart 10) after hitting a four-year high in late 2017. Since then, a harsh winter and early spring in the U.S., coupled with elevated expectations following the introduction of the tax bill, saw most economic data fall short of expectations. Moreover, a slowdown in global growth and uncertainty around U.S. and global trade policy negatively affected U.S. economic data in the spring and early summer months. Chart 10Citi Economic Surprise Poised To Turn Negative In our late March 2018 report,9 we noted that there have been six other episodes since 2011 when the CESI behaved similarly. These phases lasted an average of 96 days; the median number of days from peak to trough was 66 days. Moreover, in our March 2018 report we stated that a trough in CESI may be a month or two away, but there are no signs that has occurred. Table 2 illustrates the performance of key U.S. dollar-based investments, commodities and the dollar itself as the CESI moves from zero to its ultimate trough. We identified eight periods since 2010 when the CESI moved lower from zero. Table 2U.S. Stocks, Credit And Commodities As Economic Surprise Turns Negative On average, these episodes lasted 43 days, with the longest (81 days) in early 2015 and the shortest (13 days) in January-February 2013. During these phases, U.S. equities posted minimal gains and underperformed Treasuries (Chart 11). Moreover, investment-grade and high-yield credit tracked Treasuries, and there was little difference between the performance of small cap and large cap equities. Gold and oil struggled, while the dollar barely budged. Chart 11U.S. Financial Assets, Commodities And The Dollar As Economic Surprise Troughs While the CESI is rolling over, the Citigroup Inflation Surprise index is on the upswing (Chart 12). We identified seven stages when the CESI rolled over while the Citi Inflation Surprise Index: 2003-2004, 2007-2008, 2009, 2011, 2012-13, 2014 and this year. The late 2007 period is most similar to today; the other five episodes occurred either during early cycle (2003-2004, 2009 and 2011) or mid-cycle (2012-13 and 2014). In late 2007, the U.S. economy was in the late stages of an expansion, the unemployment rate was below full employment and the Fed was raising rates. The stock-to-bond ratio fell, credit underperformed Treasuries and gold and oil rose. Furthermore, small caps outperformed large caps, and the dollar fell (Chart 13). Chart 12Episodes Of Rising Inflation Surprise##BR##When Economic Surprise Is Falling Chart 13U.S. Financial Assets,##BR##Commodities And The Dollar As... Our work10 shows that these periods were associated with higher wage and compensation metrics, and higher realized core inflation. Moreover, these phases tended to occur when the economy was at full employment and the Fed funds rate was above neutral. The implication is that inflation indices are poised to move higher in the coming year, and prompt the Fed to continue to boost rates gradually at first, but then more aggressively starting in mid-2019. Bottom Line: The disappointing run of economic data is not over. Treasury bond yields will likely dip as the CESI troughs. However, the weakness in the economic data does not signal recession. We expect that the Inflation Surprise Index will continue to grind higher, while unemployment dips further into excess demand territory and oil prices rise. After the CESI forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb.11 Fed policymakers have signaled that they will not mind an overshoot of their 2% inflation target. However, because core PCE inflation is already at the Fed's target, the central bank will be slower to defend the stock market in the event of a swoon. 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 Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Appendix 1 Please see BCA Research's Foreign Exchange Strategy Weekly Report "What Is Good For China Doesn't Always Help The World", published June 29, 2018. Available at fes.bcaresearch.com. 2 Please see BCA Research's China Investment Strategy Weekly Report "Standing On One Leg", published July 5, 2018. Available at cis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Equity Strategy Weekly Report "Till Debt Do Us Part", published May 8, 2018. Available at uses.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report "Third Quarter 2018: The Beginning Of The End", published June 29, 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Policy Line Up," published March 12, 2018. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180613.pdf 8 Please see BCA Research's U.S. Investment Strategy Weekly Report "Sideways," published June 25, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report "Waiting", published March 26, 2018. Available at usis.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report "Wait A Minute", published May 28, 2018. Available at usis.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Solid Start," published January 8, 2018 and "The Revenge Of Animal Spirits," published October 30, 2017. Both available at usis.bcaresearch.com.
Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Peter Berezin, Chief Global Strategist U.S. Housing Will Drive The Global Business Cycle... Again Highlights Housing is the main channel through which changes in U.S. monetary policy affect the real economy. The U.S. housing sector is in good shape, which means that the Fed will be able to raise rates more than the market anticipates. The Fed's tightening efforts are coming at a time when cyclical factors are raising the neutral rate of interest. Higher U.S. rates will push up the dollar, which will adversely affect emerging markets. Stay overweight developed market equities relative to their EM peers, while underweighting deep cyclical sectors relative to defensives. Feature U.S. Housing Back In The Spotlight The Global Financial Crisis began in the U.S. and quickly spread to the rest of the world. The U.S. housing market was at the epicenter of the last crisis and it could be the main source of global financial turbulence once again. Unlike ten years ago however, the problem is not that U.S. housing has become too vulnerable to a downturn. Rather, the problem, as we explain below, is that housing has become too resilient. Housing starts were slow to recover after the Great Recession. To this day, they are still 40% below their 2006 peak (Chart 1). As a result, the homeowner vacancy rate stands at only 1.5%, the lowest level since 2001. Mortgage lenders remain guarded. The ratio of mortgage debt-to-disposable income is 31 percentage points below where it stood in 2007. Mortgage-servicing costs, expressed as a share of disposable income, are near all-time lows. FICO scores among new borrowers are well above pre-crisis levels. The Urban Institute's Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, remains in extremely healthy territory (Chart 2). Chart 1No Oversupply Of U.S. Homes Chart 2Mortgage Lenders Are Being Prudent Housing And The Monetary Transmission Mechanism Chart 3Residential Investment Collapsed ##br##In Response To Higher Interest Rates##br## In The Early 80s... While Business Investment ##br##Was Barely Affected Housing is the main channel through which the Federal Reserve affects the real economy. When the Fed hiked rates in the early 1980s, residential investment collapsed but business investment barely contracted (Chart 3). "Housing is the business cycle," as Ed Leamer likes to say. To quote Leamer's timely 2007 Jackson Hole paper:1 Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession. Since World War II we have had eight recessions preceded by substantial problems in housing and consumer durables. Housing did not give an early warning of the Department of Defense Downturn after the Korean Armistice in 1953 or the Internet Comeuppance in 2001, nor should it have. By virtue of its prominence in our recessions, it makes sense for housing to play a prominent role in the conduct of monetary policy. Neutral Rate: Structural Versus Cyclical Chart 4Market Expectations Versus The Fed Dots The market is pricing in only 90 basis points in rate hikes between now and the end of 2020 (Chart 4). Yet, if U.S. housing is in as good shape as it appears, what is stopping the Fed from hiking rates much more than investors currently anticipate? The answer, one presumes, is that most investors share Larry Summers' view that the neutral rate of interest is very low. We have a great deal of sympathy for Summers' position. In fact, we ourselves have argued many times that a variety of secular factors are pushing down the neutral rate of interest. These include slower potential GDP growth, the shift to a capital-lite economy, and high levels of income inequality. That said, it is critical to distinguish between the secular and cyclical determinants of the neutral rate. While secular factors are pushing down the neutral rate, cyclical factors are pushing it up. Credit And Household Wealth On The Upswing Credit is one such cyclical factor. Private credit is now growing faster than GDP. The ratio of nonfinancial private debt-to-GDP has increased by an average of 1.2 percentage points during the past three years, which is close to its historic trend (Chart 5). Not all the new credit is used to finance domestic spending - some of it can flow into imports as well as the purchase of financial assets - but if one assumes that every additional dollar of credit boosts domestic demand by 50 cents, today's pace of credit growth is adding 0.6% of GDP to aggregate demand relative to a situation where the ratio of credit-to-GDP is stable.2 In addition, housing and equity wealth have been rising much more quickly than GDP. Household real estate wealth fell from a peak of 182% of GDP in 2006 to 115% of GDP in 2012. It has since clawed its way back to 142% of GDP, equivalent to where it stood in 2002. Equity wealth reached nearly 150% of GDP earlier this year, on par with the prior peak set in 2000. Historically, there has been a robust relationship between the ratio of household net worth-to-disposable income and the personal savings rate (Chart 6). At present, the former stands at an all-time high. This helps explain today's low savings rate. All things equal, a lower savings rate implies more desired spending which, in turn, implies a higher neutral rate of interest.3 Chart 5Rising Household Credit And Wealth Chart 6High Net Worth Explains Today's Low Savings Rate Loose Fiscal Policy Warrants A Higher Neutral Rate U.S. fiscal policy has also become extremely stimulative. The IMF estimates that the cyclically-adjusted primary budget deficit will reach 4.2% of GDP in 2019, a deterioration from a deficit of 1.7% of GDP in 2015. That is more accommodative than Japan, which is set to have a deficit of 2.7% of GDP next year; or the euro area, which is expected to record a surplus of 0.8% of GDP (Chart 7). Assuming a fiscal multiplier of one, fiscal policy will add a whopping 5% more to aggregate demand in the U.S. than in the euro area next year. If one combines this fact with all the other reasons we have listed for why the neutral rate is higher in the U.S. than the euro area, the market's expectation that the ECB will be hard-pressed to raise rates by very much over the next few years is probably not far from the mark.4 An Overheated Economy Will Lift The Neutral Rate The fact that the U.S. jobless rate has fallen below most estimates of full employment means that the Fed may have to bring rates above their neutral level for a while to cool the economy. An overheated economy may also push up the neutral rate itself, at least temporarily. Chart 8 shows that labor's share of income rose during the late 1990s, as businesses were forced to pay higher wages to attract workers. Workers tend to spend more of every dollar of income than companies. Thus, any shift in the distribution of income towards the former raises aggregate demand. Chart 7U.S. Fiscal Policy Is More Stimulative Than Abroad Chart 8Tight Labor Market And Rising Labor Share Of Income: ##br##A Replay Of The 1990s? Today, employers are complaining about a "shortage" of qualified workers. While the business press usually takes such comments at face value, the word "shortage" is highly misleading. Except in a few isolated cases, the number of workers a company employs is much smaller than the number of qualified workers it could theoretically hire. Even the internet giants compete for the same well-educated, tech-savvy workers. When companies say they cannot find good workers, what they usually mean is that they do not want to raise wages to entice good workers to move from competing firms. Fortunately for potential job-switchers, that is starting to change. The difference between wage growth among job switchers and job stayers in the Atlanta Fed's Wage Growth Tracker has risen to close to where it was in 2000 (Chart 9). Surveys suggest that companies are increasingly willing to raise wages (Chart 10). Higher wages and falling unemployment will boost spending, raise consumer confidence, and probably further supercharge the housing market. Chart 9Things Are Perking Up For Job Switchers Chart 10Surveys Show Employers More Willing To Raise Compensation Investment Considerations The 30-year U.S. prime mortgage rate has risen from a low of 3.78% last September to 4.55% at present, but still remains more than 2.5 percentage points below where it stood in 2006. In real terms, today's mortgage rate is significantly lower than the average rate since 1980 (Chart 11). For the first time in a decade, the Federal Reserve wants to slow GDP growth to prevent the economy from overheating. This means the Fed must tighten financial conditions. If housing does not buckle as the Fed raises rates, the tightening in financial conditions must come through a stronger dollar, higher corporate borrowing costs, and lower equity prices. We remain long the dollar and recently downgraded global equities from overweight to neutral. We also recommended that clients cut exposure to credit. Chart 12 shows that a rising dollar usually corresponds to wider high-yield corporate bond spreads. Chart 11U.S. Mortgage Rates Are Still Low Chart 12Rising Dollar Usually Corresponds ##br##To Wider High-Yield Spreads The rest of the world will feel the repercussions of Fed tightening, perhaps even more so than the U.S. itself. Emerging market equities almost always fall when U.S. financial conditions are tightening (Chart 13). One can believe that EM stocks will go up; one can also believe that the Fed will do its job and tighten financial conditions in order to prevent the U.S. economy from boiling over. One cannot believe that both these things will happen at the same time. As a share of GDP, dollar-denominated debt in emerging markets is now back to late-1990s levels (Chart 14). Local-currency debt has also mushroomed (Chart 15). This puts emerging market policymakers in the unenviable position of having to decide whether to hurt domestic borrowers by hiking rates or keeping rates low and risking a steep devaluation of their currencies. Neither outcome would be good for EM assets. As such, equity investors should overweight developed market stocks over their EM peers. An underweight in global cyclical sectors relative to defensives is also appropriate at this juncture. Chart 13Tightening U.S. Financial Conditions ##br##Do Not Bode Well For EM Stocks Chart 14EM Dollar Debt Is High Chart 15EM Local Credit Is High Too Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). Thus, credit growth affects GDP and, by extension, the change in credit growth (the so-called credit impulse) affects GDP growth. 3 Conceptually, one can see the relationship between the savings rate and the neutral rate of interest in the Solow Growth Model. For example, the neutral real rate of interest, r*, in the Model is equal to (a/s) (n + g + d), where a is the capital share of income, s is the savings rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. An increase in the savings rate reduces the neutral rate. 4 Please see Global Investment Strategy Weekly Report, "The U.S. Needs A Stronger Dollar," dated May 4, 2018. 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