Developed Countries
Highlights The recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Credit spreads would need to widen significantly more to signal that a recession is imminent. What asset classes would benefit if the curve steepens and oil prices rise? Risk assets tend to do better the year before a tax cut than they do the year after. Feature BCA's view is that global growth is on solid footing. EPS growth in the U.S. is in the process of peaking, but will be relatively robust through the end of 2018. If our view is correct, U.S. stocks will outperform bonds in the next 12 months. Nonetheless, last week investors took profits in oil, the dollar, high-yield bonds and U.S. equities as the 2/10 Treasury curve flattened to just 65 bps, the lowest reading in 10 years (Chart 1). The risk aversion occurred amid concern about global growth, waning prospects for the GOP tax cut, and higher odds of a Fed policy mistake. Moreover, financial conditions tightened last week. Chart 1BCA Expects The Curve To Steepen In The Next 12 Months Even so, the recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Junk bonds have sold off in recent weeks, along with EM credit and currencies. In general, credit trends lead the stock market. Moreover, a recent Bank of America Merrill Lynch Survey found that a record share of fund managers are overweight risk assets. Any delay in passage of the tax plan could be the trigger for a correction. BCA's U.S. Equity strategists' views on financial and energy sectors run counter to the recent market action.1 Our position is that financials will benefit from a steeper yield curve and that a drawdown in inventories and robust global oil demand will allow oil prices to rise and energy shares to outperform the S&P 500. Later in this report, we will examine how other risk assets perform as the yield curve steepens and oil prices climb. We also investigate the efficacy of using the high-yield bond market to time equity market pullbacks and recessions. In addition, with investors concerned about the GOP tax bill, we evaluate the performance of U.S. financial market assets, commodities and earnings before and after stimulative fiscal policy is enacted. Slack Is Disappearing The health of the U.S. economy in Q4 is not a concern. Data released last week was solid on October's retail sales, small business optimism and industrial production. Moreover, the November readings on the Empire State and Philadelphia Fed's manufacturing indices support BCA's view that the output gap is narrowing. However, some of the bright readings on the economy in October may reflect a snap back from Hurricanes Harvey and Irma. The November 17 readings on Q4 real GDP from both the Atlanta Fed's GDP Now (+3.4%) and the New York Fed's Nowcast (+3.8%) show the economy is running hot. Inflation-adjusted GDP growth of 3.0% or more in Q4 indicates year-over-year GDP growth is well above the Fed's view of both potential GDP growth (1.8%) and its estimate for 2017 (2.4%). Above-potential economic expansion will ultimately lead to higher inflation, given the ever tightening labor market. Despite tightening in the past week, financial conditions have eased in the past year. The implication is that GDP growth in the U.S. is set to accelerate in the coming quarters (Chart 2). The October CPI data provide the Fed with enough reason to bump up rates again next month. The annual core inflation rate ticked up to 1.8% from 1.7%. However, it is still below the roughly 2.4% pace that would be consistent with the core PCE deflator reaching the Fed's 2% target. While inflation is still below-target, there were two encouraging signs in the report. First, BCA's CPI diffusion index nudged back above the zero line. Secondly, core services (ex-shelter and medical care) are showing signs of accelerating. This sub-component of core CPI is the most correlated with wages (Chart 3, panel 4). Fed officials will get one additional reading each on CPI (December 13), the PCE deflator (November 30), and wage inflation (December 8), before the end of the December 12-13 FOMC meeting. Chart 2Easier Financial Conditions Will Boost U.S. Growth Chart 3October CPI Provides Cover For The Fed Bond Market Message The recent widening of credit spreads is not a signal that a recession is imminent. Chart 4 shows that peaks in key credit market metrics are lagging indicators of recession. While the recent spread widening is worrisome on its own, spreads would need to widen significantly more to signal that a recession is imminent. BAA quality spreads, the prepayment and liquidity risk spread (AAA corporate bond yield less 10-year Treasury) and the default risk spread (BAA minus AAA quality spread) are at or close to multi-decade lows.2 BCA does not believe that the spike in all these metrics in late 2015 was a signal that the economy was in or just exiting recession. Rather, the spread widening was related to the collapse in oil prices between mid-2014 and early 2016. BCA's Commodity & Energy Strategy service forecasts oil prices to rise as high as $70 per barrel in 2018.3 Chart 4Spreads Would Need To Widen Significantly More To Signal A Recession That said, these spreads tend to trough just prior to the onset of a recession. In longer expansions in the '60s, '80s, and '90s, bottoms in spreads occurred in mid-cycle. Credit spreads bottomed at the onset of recessions in the early 1960s, late 1960s, mid-1970s and early 1980s. The BAA quality spread and the prepayment and liquidity risk spreads bottomed six months before the onset of the 2007-2009 recession. However, the default risk spread formed a bottom in late 2004, three years before the end of a cycle (Chart 4). Spreads on lower-rated high-yield debt provide slightly earlier signals than those listed above. In the mid-1990s, spreads on BB- and CCC-rated U.S. corporate debt troughed in late 1998 as Russia defaulted, oil prices collapsed and LTCM failed. The signal came more than two years before the onset of the 2001 recession. In the mid-2000s, these spreads formed a bottom in late 2004/early 2005, three years before the 2007-2009 recession. The CCC- and BB-rated OAS spreads in this cycle initially bottomed in mid-2014 as oil price peaked. BB-rated spreads are below their mid-2014 trough, but spreads on CCC-rated debt are not (Chart 5). Chart 5HY Credit Still Outperforming Treasuries Investors question if the widening of spreads is a signal for other markets, especially the equity market. BCA finds that signals from the credit markets for equity markets are short-lived. Table 1 shows that the 13-week change in high-yield OAS is coincident to changes in S&P 500 prices. Often, stocks have already changed direction before any significant sell-off in the high-yield market. Rising spreads of more than 100 basis points tend to last for an average of 16 weeks and are accompanied by a 6% drop in the S&P 500. The only episode when a peak in spreads was not associated with a drop in equity prices occurred in 2001, as the S&P 500 rebounded in the wake of the 9/11 terrorist attacks. Table 1Stock Market Warning? Rising default rates are a necessary pre-condition for a prolonged interval of escalating spreads. Chart 6 shows the peaks in high-yield OAS spreads, along with the S&P, the VIX and Moody's trailing and forward default rates. In seven of the eight periods, spread widening occurred alongside a rising default rate. The only exception was in 2002 when spreads widened despite a fall in the default rate as accounting scandals rocked corporate America. Today, the default rate is low and falling. BCA's U.S. Bond Strategy team expects the default rate to move modestly lower in the next 12 months.4 Chart 6Spread Widening, Recessions, S&P 500 And Vol Bottom Line: The recent widening in credit spreads is one of the factors driving our cautious tactical stance on the U.S. equity market. Despite our near-term concern, BCA favors investment-grade credit and high-yield bonds over Treasuries in the next 12 months. Rising Oil And A Steeper Yield Curve BCA expects that oil prices will move 25% higher to $70/bbl in the next 12 months and that the yield curve will steepen. Above potential economic growth, tightening labor markets and rising inflation expectations will push up the long end of the Treasury curve, while the Fed lags the inflation upturn, leading initially to a steeper curve. What other asset classes would benefit if BCA's call is accurate? Chart 7 and Chart 8 show periods when oil prices rise and the yield curve steepens along with the performance of several key financial markets. Since 1970, there were five periods when oil prices moved higher and seven when the curve steepened. There are several years when both occurred at the same time, and many of these intervals also overlapped with recessions. Chart 7Lessons From Periods Of Rising Oil Prices Chart 8Lessons From Periods Of A Steepening Yield Curve The stock-to-bond ratio climbs when oil prices are rising, including the most recent episode. The S&P 500 outperformed the 10-year Treasury between 2009 and 2014 alongside oil prices, in the second half of the 1998-2008 run up in prices, and in the mid-1980s. However, during the rally in oil in the mid-to-late 1970s, stocks and bonds performed similarly. Both investment-grade and high-yield bonds outpace Treasuries as oil prices escalate. Investment-grade corporates outperformed in each of the five periods. Junk bonds struggled in the late 1980s as oil prices rose and then cruised in the 1990s, but trailed Treasuries in the first half of the 1998-2008 oil boom, finally catching up late in the cycle. The peak in both investment-grade and high-yield's performance versus Treasuries came in June 2007, providing a 12-month advance warning that oil prices had peaked for the cycle. Credit outpaced Treasuries in both oil rallies since the end of the 2007-2009 recession. Small cap performance during oil price rallies is mixed. Small caps beat large caps in the late 1970s, but underperformed in the mid-1980s. Small caps trounced large caps in the first half of the 1998-2008 energy price rally; large caps ran up and then back down again as the tech bubble swelled and then burst. Small caps only kept pace with large as energy prices soared between 2005 and 2008. Small caps eked out modest gains versus large between 2009 and 2014, and since 2016. Today, the energy sector's weight in the small cap sector is 3%, but it has ranged from 2% (2015) to 13% (2008) since 2001. Gold performs well as energy prices increase, aided in part by a weaker dollar. Gold climbed and the dollar fell during all five periods of expanding oil prices. There were several phases (mid-to-late 1980s, early 2000s and earlier this year) when the dollar mounted along with oil prices. Gold moved sideways at times as oil rose, but ultimately gold trended higher. BCA's stock-to-bond ratio generally moves lower as the curve steepens. Nonetheless, there are a few distinct but brief stages (late 1970s, mid 2000s, and 2009-10) when stocks beat bonds. There is not much difference between the performance of either investment-grade or high-yield credit in each of the six periods of curve steepening, but several shifts in a few of these cycles that overlapped with recessions are notable. Credit underperformed Treasuries in the early 1990s, early 2000s and mid-2000s as the economy entered recession, but then outperformed as the recession ended and the curve continued to steepen. Small cap performance as the curve steepens is mixed. As with credit, small caps underperform large on the way into recession as the curve steepens, but outperform after the recession ends. Recessions were not a significant factor in the performance pattern for gold and the dollar during curve steepening. Gold climbed in four of the seven periods of curve steepening, but changed little in the late 1980s/early 1990s episode. Gold declined sharply along with inflation and inflationary expectations in the early 1980s. The dollar moved significantly higher in just one of the seven periods (early 1980s) and was mixed-to-lower in the others. Bottom Line: BCA's bullish stance on the energy and financials sectors in the next 12 months is driven by our view that oil prices will continue to rally and that the Treasury yield curve will steepen as U.S. economic growth accelerates and inflation moved back to the Fed's 2% target. Stocks typically beat bonds as oil prices rally, but stocks generally underperform as the curve steepens. Gold advances under either scenario, while the dollar moves lower when the curve steepens and oil prices rise. The performance of credit and small caps in these episodes is sensitive to the business cycle. Hooray For Tax Cuts? BCA's Geopolitical Strategy team expects the GOP to pass a tax cut bill by the end of Q1 2018.5 Furthermore, the bill should provide a small but positive boost for the U.S. economy, and be neutral for EPS in the 10-year lifetime of the cuts. Chart 9 and Table 2 show that there have been seven periods since 1970 when the OECD's measure of "fiscal thrust"6 climbed. On average, stocks underperform bonds, although both are higher on average. Investment-grade corporate debt beats Treasuries, but high-yield underperforms as fiscal stimulus swells. Small caps (relative to large), gold, oil and the dollar, all are winners. Chart 9Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Treasuries are the most consistent performers when fiscal policy boosts the economy, advancing in each of the seven episodes. Small caps beat large and the S&P 500 rises in five of the seven periods. The process to propose, debate, and enact significant fiscal stimulus can be a long one, and in many cases, investors deduce that a fiscal boost is on the way well before it is passed into law. Accordingly, risk assets tend to outperform a year before a tax plan is passed. On average, stocks beat bonds, small caps do better than large caps, and both gold and oil accelerate a year before fiscal thrust starts to intensify. Corporate and high-yield bonds keep pace with Treasuries during these episodes. The S&P 500 jumps nearly 10% a year prior to an increase in fiscal thrust, while the total return on Treasuries rises by 5% and the dollar is flat (Table 3). Table 2 and 3Impact Of Fiscal Policy On Markets, The Dollar And Earnings The most consistent performers as fiscal thrust is priced in are small caps over large, oil prices, the S&P 500 and the 10-year Treasury. Each of these asset classes strengthens in five of the seven periods mentioned above. Chart 10 shows the Trump trades in the past year. The performance matches the historical experience a year before the economy receives a boost from tax and spending legislation. The tax proposal before Congress provides fiscal stimulus via tax cuts, but does not provide any economic lift from an increase in government spending. Therefore, it may be more useful to review asset class performance after personal income tax rates are lowered. The GOP plan also proposes corporate tax cuts, but the historical evidence is scant; corporate tax rates have been lowered only three times in the past 45 years. There is no clear pattern of performance for U.S. financial assets and commodities in the wake of a reduction in the top marginal personal tax rate. Chart 11 shows the performance of the primary U.S. dollar asset classes and financial markets since 1970. Stocks outperformed bonds in the year after the top marginal tax rate fell in only one of the four periods (mid-1980s). The track record for corporate bonds is also mixed at best. Investment-grade either matches or beats the performance of Treasuries in each of the four periods. High-yield outperformed in the mid-1980s, but subsequently underperformed in the wake of the early 2000s tax cut. Gold was the most consistent winner, climbing in three of the four intervals. The dollar was higher in two of the three periods since moving off the gold standard in the early 1970s. There is no consistent pattern for small caps after a decrease in personal tax rates. Chart 10Market Remains Skeptical That Tax Package Will Pass Chart 11Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Bottom Line: BCA's stance is that by the end of Q1 2018 the GOP will pass a tax cut that will provide a small lift to the economy. History shows that investing in risk assets in the year before fiscal thrust passes would provide the best returns. That said, the GOP plan only has tax cuts, and the performance of risk assets is mixed in the year following reduced personal tax rates, at best. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Later Cycle Dynamics", dated October 23, 2017. Available at uses.bcarearch.com. 2 "One component of the Baa-Treasury spread is the prepayment premium (Aaa-Treasury) to investors for the risk that if interest rates fall in the future, borrowers might retire old debt with new debt at lower rates. Another component of the Baa-Treasury spread is a liquidity premium (Aaa-Treasury) that compensates investors for the fact that private instruments are less desirable to hold relative to U.S. Treasuries when financial markets are turbulent and investors are very risk averse. The Baa-Treasury spread also contains a default risk premium (Baa-Aaa) to compensate lenders for the risk that borrowers may not repay, reflecting the amount of default risk posed and the price of risk."; Source: "What Credit Market Indicators Tells US", John V. Duca, Federal Reserve Bank of Dallas, October 1999 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Into The Fire," November 7, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism," November 8, 2017. Available at gps.bcaresearch.com. 6 The change in general government cyclically-adjusted balance as percent of potential GDP, Source: OECD.
Highlights The euro doesn't have the key attributes of a funding or a risk-off currency. This means its behavior is not fixed. While in the past it has behaved as a risk-off currency, this year it has traded as a risk-on one, correlating with key risky assets. The current episode of market volatility will not help the euro. CAD/SEK will benefit if asset-market volatility continues. A global growth deceleration helps the CAD outperform the SEK, especially as this cross trades at a discount to rate differentials. Feature As markets have begun selling off, the euro has once again become well bid. Does this reaction makes sense, or is it a move that should be faded? We are inclined to look the other way, as it is highly unlikely that the euro will benefit from market weakness this time around. The Chameleon Currency Is the euro a risk-off or risk-on currency? We believe it is neither, and that its behavior evolves over time. The reason for this is that the euro is not underpinned by one of the key attributes that offer currencies like the Swiss franc or the yen their strong defensive characteristic: a large positive net international position (NIIP). While Switzerland or Japan have NIIPs in excess of 130% of GDP and 62% of GDP, respectively, the euro area owes the equivalent of 3% of GDP more to the rest of the world than the rest of world owes the Eurozone. This means the euro does not benefit from its investors repatriating funds at home when market turbulences emerge. In other words, unlike Japan or Switzerland, local investors' home bias does not come to the euro's rescue when markets vacillate. Moreover, unlike the USD, the euro is not the key reserve currency global investors seek when turmoil grips the market. The euro represents 20% of allocated global reserves, while the USD still garners 64% of these reserves. Rightly or wrongly, investors do not yet feel that the euro area has the permanence of the U.S., nor that it possesses the military might and the same capacity to control global sea lanes that the U.S. currently enjoys. Lacking these attributes, the euro is a bit of a chameleon. When investors are negative on the outlook for the European economy, the euro is used as a funding currency for carry trades. However, sometimes it is used as the vehicle to bet on a weaker dollar or an improving global economy. These two last bets are often one and the same, as the greenback remains a countercyclical currency, enjoying strength when the global economy weakens (Chart I-1). This is because the U.S. is low-beta economy as it is much less exposed to the vagaries of EM growth - a key source of variation in the global economy and the global industrial cycle - than the euro area is (Chart I-2). This is the case as the manufacturing sector is a much lower contributor to U.S. growth than to the euro area. Chart 1The Dollar Is Countercyclical Chart I-2The U.S. Is A Low-Beta Economy This time around, the euro seems to have been used to bet on stronger global growth and a weaker dollar. This makes sense. There is no doubt that the European economic upswing is based on domestic dynamics, but foreign factors have supercharged the European recovery this year. As Chart I-3 illustrates, French exports to Germany and China have tracked the Chinese Keqiang index - a key measure of Chinese industrial activity. More interestingly, French exports to Germany and China have been correlated with Chinese monetary conditions, suggesting China's economic rebound has filtered through a wide swath of the euro area. The action of the euro only agrees with the macroeconomic observations made above. The euro and copper - a key beneficiary of Chinese reflation - have both been moving together through most of 2017 (Chart I-4). The same holds true for EM stocks. As Chart I-5 shows, the euro has tracked the performance of EM equities relative to U.S. ones since August 2015. Both these observations make sense. A stronger China should benefit EM economies more than it benefits the U.S. A stronger China should help copper as it consumes three times as much of the red metal as the U.S., the euro area, and Japan combined. And stronger EM help Europe more than they help the U.S. Chart I-3The Positive Influence Of China Chart I-4EUR/USD Moves With Copper Chart I-5EUR/USD And EM Relative Performance Yet, as we highlighted last week, cracks are emerging in the global economy that should prove particularly painful for EM economies and EM assets.1 Behind some of these weaknesses lies China itself. After having eased fiscal and monetary conditions through most of 2015 and all of 2016, Chinese authorities are using elevated core CPI and producer price readings to reverse course. Aggregate fiscal spending is slowing massively - pointing to a negative fiscal impulse - and broad money supply is growing at its slowest pace ever (Chart I-6). The tightening in monetary conditions is bearing fruit. Chinese industrial production and retail sales disappointed this month, and the Chinese surprise index has now dipped into negative territory (Chart I-7). The boost to global growth, and EM growth especially, that was caused by Chinese imports lifted by domestic investment is now receding. Chart I-6China: Aggregate Fiscal Spending Growth##br## Is Also Weak China: Broad Money Growth Is At ##br##Record Low Chinese Policy Tightening Chart I-7Chinese Surprises Have ##br## Turned Negative EM assets are not ready for this, as they are priced for perfection. EM assets, which have traded in line with U.S. high-yield bond prices since 2008, are now very expensive relative to this already expensive asset (Chart I-8). A slowdown in Chinese and EM growth is likely to represent a substantially negative shock for EM equities, especially as the slowdown in EM M1 to 9.3% already portends a contraction in EM profit growth. The breakdown in U.S. and EM high-yield bond prices could easily catalyze these risks. Copper, too, is vulnerable. With an almost insatiable love for the red metal, investors are not positioned for a reversal of its bull market (Chart I-9). However, China already has near record-high inventories of copper; slowing public spending and money growth suggest that the construction industry is likely to decelerate, limiting China's intake over the next few quarters. A negative surprise is likely to come. Chart I-8EM Stocks Offer No Protection##br## Against A Slowdown Chart I-9Too Much Love For Copper Equals ##br##High Risk Of Disappointment Falling copper prices and underperforming EM equity prices will thus drive the euro lower, as they will be key symptoms of the waning of a crucial euro support. Moreover, the euro is now overbought, and as we have highlighted before, over-owned (Chart I-10). This picture alone should support the notion that the euro is unlikely to benefit from a short squeeze as global risk aversion rises. How could it? After all, investors did not sell the euro to fund carry trades when global growth was rising and global volatility was falling. They were buying it along with carry trades. Maybe the euro was buoyed by strong GDP prints out of Europe this week, with Germany growing at a 3.2% pace on an annualized basis in the third quarter, faster than the U.S. If this response of the euro were to be durable, it should be associated with a commensurate move in interest rate differentials. Neither the gap in 5-year risk-free rates or 1-year forward, 1-year risk free rates between Europe and the U.S. have moved in favor of the euro in the wake of the release (Chart I-11). However, in the face of the existing gap between the euro and interest rate differentials, to stay stable, the euro will need an increase in the pace of positive surprises relative to the U.S. over the coming months - something that is unlikely to materialize as European financial conditions have greatly tightened relative to the U.S. Chart I-10The Euro Has Not Been Used##br## To Fund Carry Trades Chart I-11If Growth Was The Current Driver, The Euro And ##br##Rate Differentials Would Be Moving Together Instead, we believe that worries regarding the U.S. tax plan may be playing a role in the euro's strength. Investors are worried of a repeat about the Obamacare repeal debacle. Now that Senators Cruz, Rand and Cotton want to add a provision to the tax bill that would eliminate Obamacare's individual mandates, investors worry that Senators McCain, Murkowski and Collins will down the bill. This is a valid concern, but we should not forget that this is only U.S. legal process, and that reconciliation of the House version and the Senate version of the bill will need to take place before it is finalized, suggesting the final bill proposed could be very different from the version currently being discussed. Bottom Line: The euro is unlikely to benefit from a risk-off environment if the current selloff in EM and high-yield bonds continues. The euro area's net international investment position is too small to suggest that fund repatriation by local investors will result in the euro being bid. In fact, the euro has rallied on a similar impulse that pushed EM assets and copper higher: Stronger global growth and Chinese stimulus. Thus, now that the euro is over-owned and overbought, any tightening in EM financial conditions is likely to hurt it as well. Long CAD/SEK: The Rationale Last week, we opened a long CAD/SEK trade. The rationale for this position is rather straightforward. To start, the SEK is a more pro-cyclical currency than the CAD. Our Global Growth Indicator has rolled over and, if history is any guide, when this global growth gauge weakens, this leads to a period of depreciation for the stokkie relative to the loonie (Chart I-12). Stefan Ingves's renewed leadership of the Riksbank makes this risk even more salient. Throughout his tenure, Governor Ingves has emphasized that the Swedish central bank would fight imported deflation. Weakening global growth should result in some deflationary forces in Sweden, even if the domestic economy is experiencing growing resource utilization pressures. Ingves will counterbalance these dynamics by keeping the SEK down. Also, over the past 10 years, when U.S. two-year rates have been rising relative to euro area short rates, CAD/SEK has appreciated (Chart I-13). This is simply because the Canadian economy is tied to the U.S., while Sweden's is tied to the euro area. Thus when U.S. rates rise, this tends to let the Bank of Canada hike as well without putting undue pressure on CAD/USD. The same relationship is true between Swedish and European rates. As such, the current upward bias in U.S. relative to euro area rates is creating an upward drift on Canadian relative to Swedish rates. Chart I-12Growth Rolling Over Leads ##br##To A Stronger CAD/SEK Chart I-13When The Fed Tightens Versus ##br##The ECB, CAD/SEK Rises Some key domestic factors are also favoring the CAD over the SEK. Canadian real retail sales have spiked, growing a record three percentage points faster than Sweden's. Moreover, this development has occurred despite a surge in the Swedish credit impulse relative to that of Canada. The relative credit impulse is now slowly moving in favor of the Canadian economy. If this continues, since the Canadian consumer is already roaring, it will support Canadian aggregate demand relative to Sweden's. With Canadian wages set to pick up as labor shortages intensify, this could stoke additional wage and inflationary pressures (Chart I-14). The BoC is thus likely to continue to hike even if Ingves is hampered by the ECB and EM. Finally, CAD/SEK is trading at a 5% discount to our relative intermediate-term timing model (Chart I-15). This kind of a discount has historically been associated with tradeable rebounds in the loonie relative to the stokkie. We believe that a risk-off period in global capital markets is the likely catalyst required to realize the good value currently present in this cross. Chart I-14Canada Will Experience Rising Wages Chart I-15CAD/SEK Trading At A Discount to Rates This trade is obviously not devoid of risks. The most salient one remains the renegotiation of NAFTA. As Marko Papic, our Chief Geopolitical strategist argues in a Special Report, large swaths of the U.S. population are not in favor of free trade, and feel they have not gained much from globalization. Low social mobility, high income inequality, stagnant middle-class wages and growing difficulty to access debt have fueled this sentiment.2 Since U.S. President Donald Trump and not Congress is ultimately in charge of trade relations between the U.S. and the rest of the world, Trump has much leeway to please his electorate. He can therefore repudiate NAFTA. Such a development would hurt Canada. Exports to the U.S. represent 20% of Canada's GDP. A large share of these exports, especially in the auto sector, could fall under a new trade regime. This means that net exports might become a drag on Canadian growth, but it also means that a lot of capex that should have materialized in Canada will instead be realized in the U.S. This would boost USD/CAD. However, as excess investment in the U.S. is a positive for U.S. rates, it would also lift the USD against the EUR. Considering EUR/USD has a negative 67.3% correlation with CAD/SEK, this would limit the damage to our long CAD/SEK trade created by NAFTA renegotiations. Bottom Line: CAD/SEK should benefit as global growth and global risk assets hit a snag in the coming months. Moreover, the Canadian economy continues to experience growing inflationary pressures, while the Riksbank is likely to prove ultra-sensitive to any weakness in EM. With CAD/SEK trading on the cheap side, such a development is likely to result in a tactical upswing in this cross. The biggest risk to this position is related to an adverse ending to NAFTA renegotiations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Temporary Short-Term Risks", dated November 10, 2017, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Special Report, titled "NAFTA - Populism Vs. Pluto-Populism", dated November 10, 2017, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was generally positive: PPI measures beat expectations, with the headline measure coming in at 2.8% and the core at 2.4%; Core CPI beat expectations, coming in at 1.8%, while headline inflation remained steady at 2%; Continuing jobless claims decreased to 1.86 million, however initial jobless claims increased to 249,000; Net long-term TIC flows increased to USD 80.9 bn, while total net TIC flows are negative at USD -51.3 bn; NFIB Business Optimum Index and the Philadelphia Fed Manufacturing Survey underperformed expectations, coming in at 103.8 and 22.7, respectively; There was, however, a generally bearish rhetoric for the USD this week due to perceived inability of President Trump's administration to push through tax reform. Nevertheless, stronger inflation should lift the dollar in the coming months. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data was generally positive: German GDP accelerated greatly, hitting an annual rate of 2.3%, although this was in line with expectations. However, the quarterly measure of 0.8% beat expectations of 0.6%; European GDP grew in line with expectations of 2.5% on an annual basis; Industrial production increased by 3.3%, beating expectations of 3.2%; CPI across the euro area stayed steady and in line with expectations, with core inflation slowing to 0.9%. Importantly, the euro area core CPI diffusion index is decelerating sharply; As expected, French unemployment increased to 9.7% from 9.5%. The euro experienced a strong week following the release of these data points. However, as we have iterated in the past, the appreciation in the euro has tightened financial conditions, which means that inflation is unlikely to increase much from current levels. Report Links: Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has surprised to the upside in Japan: Industrial production monthly growth was not as weak as expected, only weakening -1%. Meanwhile, yearly growth came in at 2.6%, an acceleration relative to last month. Gross domestic product annual growth also outperformed expectations, coming in at 1.4%. However it is worth to point out that growth slowed from a 2.6% reading last quarter. The yen has appreciated slightly this week, with USD/JPY rising by about 0.4%. Overall we continue to bearish on the yen against the dollar, given that interest rate differentials will continue to be the main determinants of this cross. On the other hand we are more bullish on the yen against commodity currencies like the NZD, given that we expect a temporary growth downshift is likely to cause commodity and EM plays to experience some downside. Report Links: Temporary Short-Term Rates - November 10, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Consumer price inflation underperformed expectations, coming at 3%. Core inflation also surprised to the downside, coming in at 2.7%. However average hourly earnings surprised to the upside, coming in at 2.2%. It is important to note however, that this is a slowdown from last month's number of 2.3%. Moreover, retail sales growth outperformed expectations coming in at -0.3%. Nevertheless, this measure drop sharply from last month's reading of 1.3%. Overall, the GBP/USD has stayed relatively flat this week, while it has depreciated by about 1% against the euro. We believe that the upside for the pound against the dollar from here on is limited, as the BoE has very little incentive to hike any more than what is priced into the SONIA curve given that inflation seems to be stabilizing. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has suffered this week following a slew of mixed data: NAB Business Conditions improved to 21 from 14, but Business Confidence remained steady at 8; Westpac Consumer Confidence was negative at -1.7%; Wage growth remains depressed at 2% annually and 0.5% quarterly, underperforming the expected 2.2% and 0.7%, respectively; Melbourne Institute's Consumer Inflation Expectations declined to 3.7% from 4.3% in November; The participation rate dropped 10 bps to 65.1% and employment grew by only 3,700, below the expected 17,500. However, this was because the decline in part-time employment of 20,700 was offset by the increase in full-time employment of 24,300. While there were some positive developments in the labor market, wages remain depressed, pointing to ongoing underemployment within the economy. This is likely to leave the RBA to stay cautious. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The New Zealand dollar has depreciated by almost 2% this week, as commodities and junk bonds have plunged. We continue to be bearish on this currency against both the dollar and then yen, as we expect a further deterioration in EM financial conditions. This is mainly due to 2 factors: First, monetary tightening in China should cause a worsening in financial conditions, which will weigh on growth and commodity producers. Moreover, market-based expectations of U.S. interest rates could experience some upside as U.S. inflation is slated to pick up. This will put upward pressure on the U.S. dollar, and thus, weigh on commodity prices. Nevertheless, we continue to be bullish on the NZD relatively to the AUD, as the Australian economy is much more sensitive to the dynamics described above. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data has been positive: Manufacturing shipments increased by 0.5% on a monthly basis, beating expectations of -0.3% but they were weaker than the previous release of 1.6%; Foreign portfolio investment in Canadian securities increased to CAD 16.81 bn, above the expected CAD 10.68 bn and also beating the previous figure of CAD 9.77 bn. However, oil weaknesses weighed on the CAD this week. Furthermore, a lack of Canadian data meant that USD/CAD traded mostly off positive U.S. data, which further handicapped the CAD. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Swiss franc has continued to depreciate, with EUR/CHF surging by almost 1% this week. This cross is now roughly 2.5% away from the level at which it was when the Swiss National Bank took off its floor in early 2015. Overall we see very little indication that the SNB will let off their ultra-dovish monetary policy and currency intervention. Speaking with the government on Wednesday, the SNB's president Thomas Jordan said that the Franc is still "highly valued". Although there has been a slight improvement in price inflation and in economic activity, it still too tepid for central bankers to change policy significantly. Thus, the franc will continue to suffer downward pressure, due to FX market intervention. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Gross domestic product growth outperformed expectations, coming in at 0.7%. Moreover core inflation also surprised to the upside, coming in at 1.1%, and increasing from last month's reading of 1%. However headline inflation underperformed substantially, coming in at 1.2% and decreasing from last month's reading of 1.6%. The krone has depreciated slightly against the dollar, as USD/NOK has risen by almost 0.6% this week. In spite of our positive view on oil, we continue to be bullish on USD/NOK, given that this cross is more sensitive to interest rate differentials than it is to oil prices. The Norwegian economy is still plagued with plenty of slack, thus the spread between U.S. and Norwegian rates will continue to widen. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK had a dismal week due to downbeat data: Inflation slowed greatly to 1.7% from 2.1%, even underperforming the expected slowdown of 1.8%. In monthly terms, it contracted by 0.1%; Capacity Utilization fell in Q3 to 0.2% from 0.5%, indicating slack in the economy; The unemployment rate also rose to 6.3%; EUR/SEK traded near 10.0000, appreciating to levels reached last October. These data points will certainly be taken into account by the Riksbank, and a dovish tilt has most likely been priced in by the market. Close EUR/SEK trade Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The cyclical bull market in stocks will last until the end of next year. That said, global equities have become increasingly vulnerable to a correction, so fast-money investors should consider putting on a tactical hedge spanning the next few weeks. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. We ultimately expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a larger budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Feature Rising Odds Of A Stock Market Correction We remain cyclically bullish on global equities based on the expectation that global growth will stay strong over the next 12 months, which should support corporate earnings. Nevertheless, the recent price action in credit markets is disconcerting. Yesterday's relief rally notwithstanding, junk bonds have been selling off in recent weeks, as have EM credit and currencies (Chart 1). We have found that credit trends generally lead the stock market. This raises the risk of an equity correction. The fact that the bull/bear ratio has reached a 30-year high in the weekly Investors Intelligence Sentiment survey (Chart 2), and that the most recent BofA Merrill Lynch Survey shows that a record share of fund managers are overweight risk assets, only add to our worries. Chart 1Junk Bond Selloff Raises ##br##Risks Of An Equity Correction Chart 2Equity Bullish Sentiment:##br## Getting Stretched Doubts about the ability of Republicans in Congress to push through tax cuts further muddle the picture. We continue to expect a tax bill to be signed into law early next year, but the intention of President Trump and Senator Majority Leader Mitch McConnell to include a provision in the bill to rescind the individual mandate to purchase health insurance could greatly complicate this task. Moreover, as we discuss in greater detail below, the economic benefits of the tax legislation are likely to be muted, even if equity prices do rise on the back of lower corporate tax rates. This will make selling the merits of the tax plan to the American people all the more difficult. With all this in mind, we are putting on a short S&P 500 trade recommendation. We are targeting a gain of 5% and putting in a stop-loss of 2%. We will close this trade before the end of the year, so this should be seen as a purely tactical decision appropriate for fast-money investors only. Fiscal Policy Was Tightened Too Early ... Global bond yields plummeted during the Great Recession, but then quickly recovered. The U.S. 10-year Treasury yield hit 3.95% in June 2009, while the German bund yield reached 3.72% that same month. Today, output gaps are much smaller globally than they were seven years ago, yet bond yields are substantially lower (Chart 3). Chart 3ASmaller Output Gaps... Chart 3B...But Lower Bond Yields Many theories have been offered to account for this seemingly paradoxical turn of events. Was it QE? Maybe the Phillips curve broke down? Perhaps investors have steadily revised down their estimate of the neutral rate of interest? One can make compelling arguments in support of all these explanations. However, there is one reason that has received relatively little attention: fiscal policy. Chart 4 shows that fiscal policy was tightened by an average of 4.1% of GDP in the G20 economies between 2010 and 2015. This happened despite the fact that unemployment was still quite high. One could make a half-plausible case that fiscal austerity was necessary in southern Europe, where one country after another was being attacked by the bond vigilantes (although even there, the failure of the ECB to act as a lender of last resort to European sovereigns greatly exacerbated the problem). It is harder to justify the shift towards austerity in countries such as the U.S. and the U.K. which were able to issue debt in their own currencies; or to explain why Germany felt the need to tighten fiscal policy when its structural primary balance was already in surplus. In Japan's case, the 2.9% of GDP in fiscal tightening that occurred between 2013 and the 2015 was a key reason why Abenomics failed to push the country out of deflation. Faced with the reality of what was happening on the fiscal front, central banks had no choice but to step in. They did so by slashing interest rates, in some cases pushing them into negative territory. They also engaged in massive asset purchases. The tsunami of easy money helped to keep economies afloat. But in many countries, slower government debt growth was replaced by faster private-sector debt growth (Chart 5). Debt continued to rise. It just did so in a different form. Chart 4Fiscal Belt-Tightening##br## In 2010-2015 Chart 5Private Debt Growth Picked Up##br## Amid Slowing Government Debt Growth ... And Is Now Being Eased Too Late The good news is that governments are abandoning their obsession with fiscal austerity. The bad news is that they are doing it at a time when fiscal easing is no longer warranted. Standard economic theory suggests that governments should run budget deficits when unemployment is high, and surpluses when it is low. In the U.S., the unemployment rate stands at 4.1%, 0.6 percentage points below the Fed's estimate of NAIRU. And yet, President Trump and the Republicans in Congress are pushing for massive tax cuts which, according to the CBO, would add $1.7 trillion to federal debt over the next ten years, while pushing up the debt-to-GDP ratio by an extra six percentage points to 97% (Chart 6). Limited Supply-Side Benefits Proponents of the legislation argue that lower tax rates will spur growth by so much that they will pay for themselves. This is highly unlikely. Chart 7 shows that major tax cuts in the past have always led to a rising debt-to-GDP ratio, whereas tax hikes have led to a deceleration, or even outright decline, in the debt ratio. Even the much lauded 1981 Reagan tax cuts had to be partially rolled back in 1982 after the budget deficit widened sharply. Chart 6More Red Ink Chart 7Do Tax Cuts Pay For Themselves? The growth-enhancing effects of lower tax rates are likely to be smaller at present than they were in the early 1980s. The Reagan tax cuts were introduced when the economy was in the doldrums and government debt levels were much lower than they are today. Cross-border ownership of foreign assets has also increased tremendously since the Reagan era. Foreigners now own more than $10 trillion of U.S. equities, or close to 35% of the total, up from 10% in the early 1980s (Chart 8). This implies that a corporate tax cut would not only represent a massive windfall for foreigners - a bizarre outcome for a self-professed nationalist president - but would mean that a smaller share of capital gains taxes will make their way into the coffers of the U.S. Treasury. Personal income tax cuts are also likely to generate much less bang for the buck. Most empirical studies suggest that lower personal tax rates increase labor supply largely by boosting female labor participation.1 The prime-age female labor participation rate in the U.S. today is 11 points higher than it was in 1980, which limits the scope for further gains. Moreover, when Ronald Reagan cut taxes in 1981, the top personal tax rate stood at 70% (Chart 9). At such a high rate, a one percentage-point cut in the top rate increases take-home pay by 3.3% (1/30). Today, the top rate stands at 39.6%, so a one-point cut would raise after-tax income by only 1.6% (1/60.4). Thus, the incentive effect from cutting the top marginal tax rate is only half of what it was back then. And, of course, the lower the tax rate, the less incremental revenue the government gets from every additional dollar of income. A reasonable estimate is that the revenue offset from tax cuts today would be only one-quarter of whatever modest amount it was in the early 1980s. Chart 8Growing Share Of U.S. Equities##br## Is Held By Foreigners Chart 9Lower Bang For The Buck From##br## Cutting Individual Tax Rates Tax Cuts Versus Tax Reform This is not to say that tax reform is undesirable. Statutory corporate tax rates in the U.S. are quite high, but effective rates are very low, given the myriad deductions and tax-sheltering strategies (Chart 10). The combination of base-broadening and lower statutory rates would make the economy more efficient. In this respect, the set of reforms unveiled by Paul Ryan earlier this year actually had a lot going for it. Unfortunately, the half-measures in both the House and Senate bills run the risk of making the current system even worse. For example, the proposed transition from the current system where U.S. companies are taxed on their worldwide profits to one where they are taxed only on the profits they earn in the U.S. is likely to increase the incentive to use accounting gimmicks to shift more taxable income to low-tax jurisdictions abroad.2 The new "pass through" tax rate of 25% would also provide passive business owners, who are currently subject to the top marginal tax rate, with a massive tax break. Chart 10Statutory Vs. Effective Corporate Tax Rates: Please Mind The Gap In theory, full business investment expensing is a good idea, but the economic impact is likely to be modest. Companies pay less tax upfront when they can write off the value of capital expenditures immediately, but incur higher taxes in the future due to the absence of any further depreciation expenses. When interest rates are low, as they are today, the present value gain from shifting tax liabilities around in this way is bound to be small. This, along with the fact that companies can already write off a large share of capital purchases under current law in the first few years after they are made, will limit the benefits of the proposal. The full expensing of capital purchases also expires after five years under the Republican plan. This could cause companies to pull forward capital spending simply to game the tax code. Such a policy could be justified if the economy were depressed, but that is not the case today. The Tax Foundation, a free-market think tank that a number of left-leaning economists have accused of overstating the benefits of tax cuts, estimates that temporary expensing would raise the level of real GDP by only 0.18% after a decade, compared to 1.6% in the case of permanent expensing.3 From Populism To Pluto-Populism Chart 11This Is Not Populism Martin Wolf has aptly referred to Donald Trump as a "pluto-populist" - someone who talks like a champion of the poor and middle class to his adoring supporters, but actually pushes for policies that mainly benefit the wealthiest Americans.4 Many of the proposals in the Republican tax bills - including the abolition of the Alternative Minimum Tax, the phase-out of the estate tax, and the aforementioned reduction in the business pass-through tax - would further skew the distribution of income towards the rich (Chart 11). Indeed, the benefits for the wealthy grow over time under the proposed plans, even as those for the middle class dissipate, eventually reaching the point where the average middle-class household ends up paying more taxes under the House plan than they do now (Chart 12).5 And no, one cannot say that this outcome is simply the inevitable consequence of the fact that the rich pay most of the taxes. Once regressive taxes such as the payroll tax and state and local taxes are included in the tally, the rich pay about the same share of their income in taxes as the middle class (Chart 13). To make matters worse, the Republican tax bill would trigger $25 billion in Medicare cuts and $111 billion in cuts to other government programs under current PAYGO rules. More pain for middle-class voters. Donald Trump was quick to throw Ed Gillespie under the bus after he failed to win the governor's race in Virginia, tweeting that Gillespie "did not embrace me or what I stand for." But the truth is Trump has not embraced Trumpism either. We were widely scorned in the early days of the primary season for saying that Trump would secure the Republican nomination, and mocked again in 2016 for predicting that he would win the presidential election. At this point, however, the odds are high that the Republicans will lose the House next November and Trump will fail to get re-elected in 2020. Chart 12Middle-Class Tax Cuts Will Morph Into Tax Hikes Chart 13U.S. Taxation Not Very Progressive Investment Conclusions U.S. equities are overbought and ripe for a correction. As is almost always the case, lower stock prices in the U.S. will negatively impact global bourses. Fortunately, the selloff is likely to be short-lived, with strong global growth and rising earnings powering stocks into 2018. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. Nevertheless, we expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a wider budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Chart 14Inflation Higher In Countries Lacking Independent Central Banks Higher government debt levels will also increase the temptation to inflate away debt. As we discussed a few weeks ago, rising political polarization is affecting every facet of society, with the NFL just being the latest example.6 It is hard to believe that the Fed will remain above the fray. History suggests that the loss of central bank independence is often associated with higher inflation (Chart 14). Such may be America's fate as well. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Robert K. Triest, "The Effect Of Income Taxation On Labor Supply In The United States," The Journal of Human Resources, Special Issue on Taxation and Labor Supply in Industrial Countries, 25:3 (Summer 1990); and Costas Meghir and David Phillips, "Labour Supply And Taxes," IZA Discussion Paper No. 3405 (March 2008). 2 Both the House and Senate versions of the tax bill have a number of provisions to limit the ability of corporations to shift profits abroad, but at present, it is unclear how effective these measures will be. 3 Please see "Economic and Budgetary Impact of Temporary Expensing," Tax Foundation, dated October 4, 2017. 4 Martin Wolf, "Donald Trump Embodies How Great Republics Meet Their End," Financial Times, March 1, 2016. 5 This mainly occurs because the "Family Flexibility Credit" expires after 2022. The expanded Child Tax Credit is also not indexed to inflation under the House plan, implying that its value to tax filers will go down over time. In addition, the repeal of the individual mandate would cause fewer lower-income earners to buy health insurance, leading them to forego the tax subsidies that they would otherwise receive. 6 Please see , "Three Demographic Megatrends," dated October 27, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
The shares of movie & entertainment firms have been under pressure in the last several weeks, despite what has generally been a positive Q3 earnings print, driven down by speculation the AT&T/Time Warner merger may be blocked by the Department of Justice. Rumors that Disney was interested in acquiring most of Fox were not enough to lift spirits in the beleaguered index. The more important driver is the secular decline in consumer spending on media, which seems likely to continue to weigh on the industry's top line. High operating leverage, which has been a boom to EPS growth in the past, is now swinging the other way, explaining the drop in earnings growth (second panel). The industry has rerated to the downside in 2017, implying that the weak profit outlook is mostly priced in to the index (bottom panel). As such, we continue to recommend a benchmark allocation in the S&P movies & entertainment index. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB.
Highlights The current mini-upswing in the global mini-cycle started in May and is likely to end around January. On a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. The contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Feature Key to the medium-term behaviour of markets is the existence of what we call 'mini-cycles' in global activity. The evolution of these perpetual mini-cycles explains much of what has happened, what is happening, and what will happen, to financial markets both in Europe and more broadly. Chart of the WeekExpect A Trend-Reversal In The Metals Market Mini-cycles are not a hypothesis. They are an indisputable empirical fact. Just look at the global bond yield (Chart I-2), metal price inflation (Chart I-3), global inflation (Chart I-4), and the bank credit impulse (Chart I-5 and Chart I-6). The regular mini-cycles shout out at you! Furthermore, given that these clearly observed mini-cycles show the same half-cycle length of about 8 months, Investment Reductionism strongly suggests that there is a common over-arching driver. Chart I-2The Global Bond Yield Exhibits Mini-Cycles Chart I-3Metal Price Inflation Exhibits Mini-Cycles Chart I-4Inflation Exhibits Mini-Cycles Chart I-5The Global Credit Impulse Exhibits Mini-Cycles Chart I-6Individual Credit Impulses Exhibit Mini-Cycles Explaining Mini-Cycles Previously,1 we explained that the distinct mini-cycles are interconnected parts of the same never-ending feedback loop. A lower bond yield accelerates bank credit flows... which boosts economic growth... which pushes up commodity inflation and overall inflation... causing the bond market to raise the bond yield, at which point the cycle reverses. And then the alternate cycles repeat ad perpetuam (see Box I-1). Box I-1The Mathematics Of Mini-Cycles One common question we get is: why focus on bank credit analysis and not on bond-intermediated credit analysis too? The simple answer is that bank credit expands the broad money supply whereas bond-intermediated credit usually does not. When a bank issues a new loan, fractional reserve banking allows it to create money 'out of thin air'. In contrast, when a company or government issues a new bond, no new money is created, unless the primary issue is financed by the central bank - which is generally forbidden. Usually, when a bond is issued, existing money just moves from one account - that of the bond buyer - to another account - that of the bond issuer. This means that bond-intermediated credit cannot increase demand by creating new money, but only by increasing the velocity of existing money. Whereas bank credit can increase demand by increasing both the amount of money and its velocity. Therefore, changes in bank credit are the much bigger driver of the mini-cycle in economic activity. If a bank issues 100 euros of credit today, then we know that this new money will be spent in the coming days and weeks - because nobody borrows money just to sit on it. If, in the previous period, the bank had issued 90 euros which was spent, it means that economic activity in the coming period will grow by 10 euros. But if the bank had previously issued 110 euros, it means that economic activity in the coming period will contract by 10 euros. In this way, the cycles in credit and activity are interconnected. Mini-upswings in the credit impulse mini-cycle tend to signal mini-upswings in commodity inflation (Chart I-7), overall inflation and bond yields. So if we can identify turning points in the credit impulse then we can correctly position the cyclical stance of our investment strategy. Chart I-7The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The problem is that the bank credit data is slow to come out. For example, although we are in the middle of November, the last bank credit data for the euro area refers to September. This means that if the mini-cycle is turning now, we might not find out until January. Nevertheless, we can still use the mini-cycle framework. We know that the current mini-upswing started in May and that mini-upswings have an average length of 8 months. Hence, we can infer that the mini-upswing is likely to end around January. That said, upswing lengths do have some degree of variation: the current upswing might be longer or shorter than the average. How to avoid being too early or too late? Combining Mini-Cycles With Fractal Analysis To optimise our proprietary mini-cycle framework, we propose combining it with our proprietary fractal analysis framework. As regular readers know, fractal analysis measures whether herding in a specific investment has become excessive, signalling the end of its price trend. The combined mini-cycle and fractal framework works best if we use a 130-day herding indicator (fractal dimension), as it broadly aligns with the mini half-cycle length. Excessive herding signals that an investment's trend is approaching exhaustion because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when the market is split between different herds - say, short-term momentum traders and long-term value investors. This is because the herds disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity. But liquidity starts to evaporate when too many value investors join the momentum herd. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders add fuel to the trend. The tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. Earlier this year, our combined frameworks signalled that the aggressive rise in bond yields was likely to reverse (Chart I-8). Therefore, on February 2 we correctly advised: "Lean against the rise in bond yields and bank equities." Chart I-8Excessive Herding In Bonds Always Signals A Trend Reversal Today, we see the same dynamic in parts of the commodity rally - and specifically the move in the LME Index (Chart of the Week). Hence, on a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. Could Italy Be A Good Surprise? Returning to the concept of the bank credit cycle, the evolution of longer-term impulses also explains the contrasting recent fortunes of Spain and Italy. In 2013, Spain recapitalized its banking system and ring-fenced bad assets within a 'bad bank'. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. As Spanish banks' aggressive deleveraging ended, the bank credit impulse rebounded very sharply and has remained positive for several years. This undoubtedly explains why Spanish real GDP has grown by 13% since mid-2013 (Chart I-9). In contrast, Italy's banking system remained dysfunctional - which meant that its own credit impulse stayed much more muted and barely positive over the past four years (Chart I-10). But now, the Italian banking system is slowly recuperating. Italian banks' equity capital is rising, their solvency is improving, and the share of non-performing loans has fallen sharply this year. Chart I-9Spain's Peak Credit Impulse##br## Is Probably Behind It Chart I-10Italy's Peak Credit Impulse##br## Is Likely Ahead Of It So the contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Credit Slumps While Animal Spirits Soar. Why?' March 30, 2017 available at eis.bcaresearch.com Fractal Trading Model* There are no new trades this week, leaving us with six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch -##br## Interest Rate Expectations Chart II-6Indicators To Watch - ##br##Interest Rate Expectations Chart II-7Indicators To Watch -##br## Interest Rate Expectations Chart II-8Indicators To Watch -##br## Interest Rate Expectations
U.S. home sales have been soaring, with new single-family homes reaching a 10-year high in September, driven by still-low financing costs and peaking consumer sentiment. This surging housing demand which includes temporary hurricane rebuilding related sales, has already shown up in earnings; HD reported a 7.9% same store sales increase in Q3 yesterday, a stunning number relative to the current malaise in the overall retail landscape. This elevated demand, coupled with the impact of countervailing duties on Canadian imports, has pushed lumber to the stratosphere. High lumber prices benefit home improvement retailers' top lines (third panel), but serve to crimp builders' margins. With a much better profit outlook and a still reasonable valuation (bottom panel), we think the best way to gain exposure to the healthy domestic housing market is via the S&P home improvement retail index, not the S&P homebuilders. Accordingly, we reiterate our respective overweight and neutral recommendations. The ticker symbols for the stocks in these indexes are: BLBG: S5HOMI - HD, LOW and BLBG: S5HOME - PHM, DHI, LEN.
Managed health care stocks have performed exceptionally well since our early-April 2016 overweight recommendation, besting the market by roughly 24%. This begs the question: Is the time ripe to lock in impressive profits and move to the sidelines or is there more upside left? Leading profit indicators suggest that more gains are in store for the relative share price ratio. After petering out in 2016, our managed care cost proxy has plummeted by over 350bps from the recent peak (shown inverted, second panel). Given that premiums are set on a trailing cost basis, profit margins should surprise to the upside. Further, drug price deflation should prove a boon to managed care providers' bottom lines and the pharmaceutical sector's pain this year will be the managed health care industry's gain (bottom panel). Bottom Line: Melting input costs should augment managed health care profits, supporting a durable valuation expansion phase. Stay overweight and see this week's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC.
Highlights Question 1: Why is U.S. inflation still so low? Question 2: How important is the upcoming change in Fed leadership? Question 3: What are the implications of the U.S. tax cuts? Question 4: What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? Question 5: Are markets underestimating the potential impact from slower growth of central bank balance sheets? Question 6: How much longer can this powerful rally in Emerging Markets continue? Question 7: What are other investors worried about? Feature I have just returned from an extended two-week trip visiting clients in the Asia-Pacific region. The meetings were all very well attended, with even many non-dedicated fixed income investors turning up to ask tough questions about global bond markets. My impression was that given the powerful returns earned in virtually all risk assets this year (equities, credit, Emerging Markets), our clients are growing more concerned about the potential risks from tighter global monetary policy and rising interest rates than they have been for some time. Oddly enough, this is despite not fearing either a serious rise in inflation or a major growth slowdown next year. If such a thing as "nervous complacency" can exist, it seemed widely evident in most of my meetings. This week, I am taking a more personal tone than in a typical Global Fixed Income Strategy Weekly Report to summarize the key client questions from ten days of meetings, spread across six cities in five countries on two continents. Why is U.S. inflation still so low? Chart 1Tightest Global Labor Market##BR##Since The Mid-2000s Almost all of the meetings began with a discussion of the current situation in the U.S., particularly the lack of inflation. The current BCA view that U.S. inflation will accelerate in 2018 was met with some skepticism, particularly when framed in the context of the uncertain unemployment/inflation trade-off. In one meeting, outright laughter actually broke out when the term "Phillips Curve" was mentioned! Clearly, the burden of proof is on the inflation data itself. On that note, I presented several of the best BCA charts from recent months that show how the backdrop is ripe for a turnaround in global inflation. Clients were impressed when shown that nearly ¾ of the countries in the OECD had unemployment rates below the full-employment NAIRU, a level not seen since the period of strong coordinated global growth and rising inflation in the mid-2000s (Chart 1). Yet when I then presented a chart showing the actual inflation/unemployment data in the U.S. over the past 20 years, with a clear "kinked" Phillips Curve and the latest data point well on the steeper portion of that curve (Chart 2), the majority of clients were less convinced. The most cited reason was that the U.S. inflation data simply did not accelerate in 2017 when it was supposed to given the steady fall in unemployment over the preceding few years. Perhaps most surprising was that, rather than believe that the NAIRU rate may simply be lower now than in past business cycles, so many people that I met were willing to discard the entire Phillips Curve concept as a useful framework to forecast inflation. When presented with charts showing non-Phillips Curve reasons to expect higher inflation, however, there was far less skepticism. Perhaps the most compelling chart showed the typical 18-month lag between U.S. economic growth and the "momentum" of U.S. inflation (Chart 3). Upon seeing this, clients were more convinced that inflation would pick up next year in response to the current U.S. growth upturn. Chart 2U.S. Economy Has Moved Into##BR##The "Steep" Part Of The Phillips Curve Chart 3Inflation Typically Follows Economic Growth With A Long Lag I was also able to break down some of the skepticism on the U.S. inflation outlook even more after discussing the bullish oil forecast from our colleagues at Commodity & Energy Strategy. Admittedly, their view that the benchmark Brent oil price will average $65/bbl in 2018 sounds far less dramatic given that the current spot price has risen to nearly that level in the aftermath of the recent political turmoil in Saudi Arabia. Yet clients did appreciate that our bullish oil call was driven more by a view of improving global oil demand and continued production discipline by oil producers (especially for the so-called "OPEC 2.0" nations of Russia and Saudi Arabia). When shown our chart describing how oil prices persistently in the mid-$60s next would put some upward pressure on the inflation expectations component of global bond yields (Chart 4), there was virtually no disagreement from any clients that I met. There was a bit more pushback on the view that, if the BCA forecast of higher U.S. inflation and rising oil prices in 2018 comes to fruition, there is room for a substantial rise in U.S. Treasury yields from current levels. When presented a chart showing that market-based inflation expectations (both using TIPS breakevens and CPI swaps) could rise by 50-60bps just to get back to levels consistent with the Fed's inflation target (Chart 5), most clients politely nodded and basically said "show me the actual inflation first." Although there was widespread agreement with our view that it would take that kind of move in inflation expectations to prompt the Fed to fully deliver on the 100bps of rate hikes it is currently projecting to occur over the next year. Chart 4A Boost To Inflation Expectations##BR##From Higher Oil In 2018 Chart 5The Normalization Of U.S. Inflation##BR##Expectations Will Continue How important is the upcoming change in Fed leadership? The vast majority of clients that I met asked about the BCA view on the nomination of Jerome Powell as the new Fed Chair, replacing Janet Yellen. My impression was that there was not a lot of concern over the potential for serious alterations to the future path of U.S. monetary policy under new leadership. Yet it was still potentially a big enough change to ask questions about it. Most clients agreed with the BCA view that a Fed Chair Powell will not act much differently than Yellen. His voting history has aligned with hers and, by his own admission, he is a very data dependent central banker given that he is not a formally-trained economist. Only by knowing the ins and outs of the data has he been able to debate successfully with the Ph.D economists on the FOMC. Powell will likely be a data-driven Fed Chair that would not look to hike rates without higher inflation (and vice versa). Chart 6A Communications Problem##BR##For Jerome Powell? One point that I raised in all the meetings was that the Fed's communication strategy on future rate increases is the more worrisome issue for financial markets at the moment. The U.S. money market curve is still priced for only 50bps of rate increases over the next year, while the Fed "dots" are signaling 100bps of hikes. We think the Fed will deliver on its projections, which is one of the reasons we are recommending a below-benchmark duration stance in the U.S. (the upside in inflation expectations is the other reason). More importantly, the Fed's so-called "terminal rate" projection is at 2.75%, while our proxy for the market pricing of that rate - the 5-year U.S. Overnight Index Swap rate, 5-years forward - is hovering just above 2% (Chart 6). The persistent disagreement between the market and the Fed over the appropriate level of the terminal rate will become a problem later in 2018 if the Fed does indeed raise the funds rate to over 2% and continues to signal that more rate hikes will come to get the funds rate up to "neutral" (the terminal rate). If the Fed is not able to change the market's mind about the appropriate neutral level of the funds rate, then a move to the Fed's estimated terminal rate of 2.75% would push U.S. monetary policy into what will would be perceived a restrictive stance. This would have implications for the shape of the U.S. Treasury curve (a lot flatter) and for future growth expectations (a lot slower) heading into 2019. My impression from my meetings was that this possibility - that the Fed could engineer what would look to the markets like a policy mistake simply by sticking to its forecasts - was not at the forefront of clients' thinking at the moment. Yet there was no disagreement with the logic of how that could play out. The new Fed leadership under Jerome Powell may have its hands full clearly explaining their policy decisions in 2018, which could create some turbulence in global financial markets later in the year. What are the implications of the U.S. tax cuts? The details of the tax plans from the U.S. House of Representatives and the U.S. Senate were a very hot topic in all of my client meetings. Considering all the ideas being proposed, from cuts in corporate tax rates to changes in the tax treatment of debt interest costs to removing the disincentive to repatriate profits earned abroad, it is no surprise that both equity and fixed income clients had a lot of questions on future U.S. tax policy. It is difficult right now to judge the net impact of the tax changes, as not all of the proposals in the two Congressional tax plans will likely be implemented. There will be plenty of horse trading between the Republicans and Democrats (and between the Republicans themselves) before the final tax deal is done. Yet there was a lot of concern among clients in my meetings over the likelihood that the tax cuts will be implemented at all. After seeing President Trump lose the battle on health care reform earlier this year, many clients were worried that a repeat could happen for the Trump tax cut agenda. This would have negative implications for U.S. equity markets, the U.S. dollar and future Fed policy moves. I explained the views from our colleagues at Geopolitical Strategy, who strongly believe that a tax cut will eventually pass (likely in early 2018) given the need for Congressional Republicans to have something positive to present to voters heading into the 2018 U.S. midterm elections. The tax cuts will have a moderate stimulative effect on the U.S. economy that the markets were not yet fully discounting. I also presented the chart from Global Fixed Income Strategy showing that wider U.S. budget deficits usually coincide with a steeper U.S. Treasury curve, almost always because the U.S. economy is slowing down, prompting looser fiscal policy and also Fed rate cuts (Chart 7). This time is different, however, since the Trump tax cuts will be stimulating an economy currently at full employment (middle panel). This has the potential to trigger more inflation through faster economic growth and even tighter labor markets which could prompt the Fed to move more aggressively on interest rate increases next year and eventually flatten the UST curve (bottom panel). Chart 7A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve The idea of a "steeper, then flatter" Treasury yield curve in response to U.S. fiscal policy stimulus generated a lot of discussion in my meetings. Some even noted that the recent flattening of the curve was a sign that the markets were discounting a lower probability of a tax deal being reached in D.C. I described the flat curve as a consequence of inflation expectations remaining too low, as the Treasury curve was much flatter than implied by the low level of the real fed funds rate, which is one of the most reliable relationships in the bond markets (higher real rates = a flatter curve, and vice versa). My conclusion from these meetings (and from the current market pricing) is that clients are a bit skeptical that a tax deal will be reached. This suggests there is room for bond yields to rise, and the Treasury curve to bear-steepen, if our political strategists are right and the tax cuts will happen. What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? While most of the questions in my meetings focused on the U.S. outlook, several clients asked about the next move from the European Central Bank (ECB). This was both from a fixed income perspective and, perhaps even more importantly, with an eye on the future direction of the euro versus the U.S. dollar. I made the straightforward argument that with Euro Area economic growth showing strong momentum that is unlikely to slow much in 2018, and with headline Euro Area inflation likely to surprise to the upside based on our bullish oil call (Chart 8), the ECB would likely be forced to signal a tapering of its asset purchase program to zero by the end of next year. The oil view was especially important, as the ECB is expecting a slowing of headline Euro Area inflation to 1% in early 2018 based on the base effects from comparisons to the rise in oil prices seen in early 2017. If our house view on oil prices plays out, then there is potential for inflation to catch the ECB by surprise in 2018. The key will be how core inflation plays out as oil prices rise further. Core Euro Area inflation has dipped lower in recent months, even as wage growth has accelerated (bottom panel). Given tightening Euro Area labor markets, and robust domestic demand, the recent dip in core inflation is likely to bottom out sometime in the first few months of 2018. But until that happens, there is more potential for higher U.S. bond yields through faster increases in inflation expectations and Fed rate hikes (Chart 9). This will support a higher U.S. dollar versus the euro through wider interest rate differentials (bottom panel). Chart 8ECB Will Fully Taper##BR##By The End Of 2018 Chart 9UST-Bund Spread Will Widen Next Year,##BR##Supporting The USD Clients were generally in agreement with that view on relative interest rates, but the views on the direction of EUR/USD were far more mixed. My impression is that if the Fed delivers the rate hikes that we expect in 2018, EUR/USD has room to move lower as investors were not prepared for this. Are markets underestimating the potential impact from slower growth of central bank balance sheets? I received many questions on the potential impact of central banks either shrinking balance sheets (the Fed) or slowing their expansion (the ECB and Bank of Japan). The chart showing how the growth in central bank money printing since 2015 (when the ECB began buying bonds) has correlated strongly with the bull markets in virtually all global risk assets garnered a lot of attention (Chart 10). This was especially true when I showed the chart that converted the level of the major central bank balance sheets to a growth rate and plotted that versus the returns on global equities and credit markets (Chart 11). The implication - expect lower returns on global equity markets, and MUCH lower returns from corporate bond markets next year. Chart 10CB Liquidity Has Supported Risk Assets... Chart 11...But That Tailwind Will Fade Next Year On this point, there was almost no disagreement from clients. There is widespread awareness that this era of puny interest rates, spurred on by central banks buying up huge quantities of government bonds and other financial assets, was forcing investors to take on far more risk in their portfolios to achieve acceptable returns. The key is when this will all turn around. Clients were generally in agreement with my view that the final leg of this liquidity-driven global bull market in risk assets will best be played through equity markets over corporate credit. These stable, earnings-driven rallies seen in global equity markets have not yet reached a "blowoff" phase that would suggest a larger correction is imminent. Perhaps it will take a final asset allocation decision to move more money out of bonds into equities to trigger that final run-up in equity prices before tighter monetary policies and slower growth expectations begin to damage returns later in 2018 into 2019. How much longer can this powerful rally in Emerging Markets continue? This is a topic that generated a healthy amount of debate in my meetings, particularly given the bearish views on Emerging Market (EM) assets from my colleagues at Emerging Markets Strategy. Here again, clients were generally looking at EM as a way to achieve acceptable returns in their portfolios while also participating in the global economic upturn through growth-sensitive assets. The previous chart showing the impact of diminished central bank liquidity on EM credit markets got some clients a bit nervous about the outlook for EM markets. What also spooked them were the charts from our EM strategists showing accelerating Chinese inflation (Chart 12) and slowing Chinese money growth. There is obviously a connection between the two, as China's policymakers are being forced to tighten monetary policy, and clamp down on excess credit creation, in response to accelerating inflation and very high debt levels. The chart showing how our "China M3 Impulse" had turned negative this year and was pointing to slower growth in industrial metals prices and China capital goods imports (Chart 13) was particularly unnerving for even the most bullish of EM clients. Chart 12This Is Why China Is Tightening Monetary Policy Chart 13Prepare For Slower Chinese Growth In 2018 My impression is that the clients I met were fully loaded up on EM assets but were comfortable holding those positions based on expectations of solid Chinese economic growth and continued inflows into EM assets from yield-starved global investors. If BCA's view that Chinese growth will slow next year comes to fruition, combined with rising U.S. interest rates and a stronger U.S. dollar as the Fed tightens more than currently discounted by the markets, then there is potential for outflows from EM markets to accelerate, to the detriment of EM returns. What are other investors worried about? This is a question that comes up a lot at BCA meetings, as clients are always curious as to what we are hearing from other investors. Perhaps this can be chalked up to a version of "confirmation bias", where investors like to hear that their own views are shared by others in the markets. In my meetings over the past two weeks, however, I got the sense that clients are heavily exposed to risk assets, which have performed beyond their expectations, and are growing more worried about how things can go wrong. Like an end to the current low volatility regime, for example. Given the BCA views on the likelihood of global inflation increasing next year, triggering a more hawkish response from policymakers, I noted that I did not believe that clients were prepared for that outcome. This suggests that the beginning of the end of the current low volatility regime, which is seen across all asset classes (Chart 14), will occur through a pickup in bond volatility. This will take place from a rise in inflation expectations first, and a rise in policy rate expectations later. My advice to clients was that if realized bond volatility picks up, this is the signal to reduce exposure to credit and equity markets. We anticipate making such a recommendation sometime during 2018. Chart 14The Low Market Volatility Backdrop Will End When Bond Volatility Rises Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns