Developed Countries
Highlights This week, Commodity & Energy Strategy is publishing a joint report with our colleagues at BCA's Energy Sector Strategy. Driven by the leadership of the Kingdom of Saudi Arabia (KSA) and Russia, OPEC 2.0 formalized the well-telegraphed decision to extend its production cuts for another nine months, carrying the cuts through the seasonally weak demand period of Q1 2018. The extension is will be successful in bringing OECD inventories down to normalized levels, even assuming some compliance fatigue (cheating) setting in later this year. Energy: Overweight. We are getting long Dec/17 WTI vs. short Dec/18 WTI at tonight's close, given our expectation OPEC 2.0's extension of production cuts, and lower exports by KSA to the U.S., will cause the U.S. crude-oil benchmark to backwardate. Base Metals: Neutral. Despite "catastrophic flooding" in March, 1Q17 copper output in Peru grew almost 10% yoy to close to 564k MT, according to Metal Bulletin. This occurred despite strikes at Freeport-McMoRan's Cerro Verde mine, where production was down 20.5% yoy in March. Precious Metals: Neutral. Our strategic gold portfolio hedge is up 2.61% since it was initiated on May 4, 2017. Ags/Softs: Underweight. The USDA's Crop Progress report indicates plantings are close to five-year averages, despite harsh weather in some regions. We remain bearish. Feature Chart 1Real OPEC Cuts Of ~1.0 MMb/d##BR##For Over 400 Days OPEC 2.0's drive to normalize inventories by early 2018 will be accomplished with last week's agreement to extend current production cuts through March 2018. In total, OPEC has agreed to remove over 1 MMb/d of producible OPEC oil from the market for over 400 days (Chart 1), supplemented by an additional 200,000-300,000 b/d of voluntary restrictions of non-OPEC oil through Q3 2017 at least, perhaps longer if Russia can resist the temptation to cheat after oil prices start to respond. Many of the participants in the cut, from both OPEC and non-OPEC, are not actually reducing output voluntarily, but have had quotas set for them that merely reflect the natural decline of their productive capacity, limitations that will be even more pronounced in H2 2017 than in H1 2017. With production restricted by the OPEC 2.0 cuts, global demand growth will outpace supply expansion by another wide margin in 2017, just as it did last year (Chart 2). As shown in Chart 3, steady demand expansion and the slowdown in supply growth allowed oil markets to move from oversupplied in 2015 to balanced during 2016; demand growth will increasingly outpace production growth in 2017, creating sharp inventory draws (Chart 4) that bring stocks down to normalized levels by the end of 2017 (Chart 5). Chart 3Production Cuts And Demand##BR##Growth Will Draw Inventories Chart 4Higher Global Inventory##BR##Withdrawals Through Rest Of 2017 Chart 5OECD Inventories To Be##BR##Reduced To Normal The extension of the cut through Q1 2018 will help prevent a premature refilling of inventories during the seasonally weak first quarter next year. The return of OPEC 2.0's production to full capacity in Q2 2018 will drive total production growth above total demand growth for 2018, returning oil markets from deliberately undersupplied during 2017 to roughly balanced markets in 2018, with stable inventory levels that are below the rolling five-year average. 2018 inventory levels will still be 5-10% above the average from 2010-2014, in line with the ~7% demand growth between 2014 and 2018. Compliance Assessment: Only A Few Players Matter In OPEC 2.0 OPEC's compliance with the cuts announced in November 2016 has been quite good, with KSA anchoring the cuts by surpassing its 468,000 b/d cut commitment. In addition to KSA, OPEC is getting strong voluntary compliance from the other Middle Eastern producers (except Iraq), while producers outside the Middle East lack the ability to meaningfully exceed their quotas in any case. OPEC's Core Four Remain Solid. The core of the OPEC 2.0 agreement has delivered strong compliance with their announced cuts. Within OPEC, the core Middle East countries Kingdom of Saudi Arabia, Kuwait, Qatar, and UAE have delivered over 100% compliance of their 800,000 b/d agreed-to cuts. We expect these countries to continue to show strong solidarity with the voluntary cuts through March 2018 (Chart 6). Iraq And Iran Make Small/No Sacrifices. Iraq and Iran were not officially excluded from cuts, but they were not asked to make significant sacrifices either. We estimate Iran has little-to-no capability to materially raise production in 2017 anyhow, and KSA is leaning on Iraq to better comply with its small cuts. Chart 7 shows our projections for Iran and Iraq production levels through 2018. Chart 6KSA, Kuwait, Qatar & UAE Carrying##BR##The Load Of OPEC Cuts Chart 7Iran And Iraq Production##BR##Near Full Capacity Iraq surged its production above 4.6 MMb/d for two months between OPEC's September 2016 indication that a cut would be coming and the late-November formalization of the cut. Iraq's quota of 4.35 MMb/d is nominally a 210,000 b/d cut from its surged November reference level, but is essentially equal to the country's production for the first nine months of 2016, implying not much of a real cut. Despite the low level of required sacrifice, Iraq has produced about 100,000 b/d above its quota so far in 2017 at a level we estimate is near/at its capacity anyway. KSA and others in OPEC are not pleased with Iraq's overproduction and have pressured it to comply with the agreement. We forecast Iraq will continue producing at 4.45 MMb/d. Iran's quota represented an allowed increase in production, reflecting the country's continued recovery from years of economic sanctions. We project Iran will continue to slowly expand production, but since the country is almost back up to pre-sanction levels, there is little remaining easily-achievable recovery potential. South American & African OPEC Capacity Eroding On Its Own. Chart 8 clearly shows how production levels in Venezuela, Angola and Algeria started to deteriorate well before OPEC formalized its production cuts, with productive capacity eroded by lack of reinvestment rather than voluntary restrictions. The quotas for these three countries (as well as for small producers Ecuador and Gabon) are counted as ~258,000 b/d of "cuts" in OPEC's agreement, but they merely represent the declines in production that should be expected anyway. With capacity deteriorating and no ability to ramp up anyway, these OPEC nations will deliver improving "compliance" (i.e. under-producing their quotas) in H2 2017, and are happy to have the higher oil prices created by the extension of production cuts by the core producers within OPEC 2.0. Libya and Nigeria Exclusions Unlikely To Result In Big Production Gains. Both Libyan and Nigerian production levels have been constrained by above-ground interference. Libyan production has been held below 1.0 MMb/d since 2013 principally by chronic factional fighting for control of export terminals, while Nigerian production--on a steady natural decline since 2010--has been further limited by militants sabotaging pipelines in 2016-2017. While each country has ebbs and flows to the amount of oil they are able to produce, we view both countries' problems as persistent risks that will continue to keep production below full potential (Chart 9). Chart 9Libya And Nigeria Production Could Go Higher##BR##Under Right (But Unlikely) Circumstances For Nigeria, we estimate the country's crude productive capacity has eroded to about 1.8 MMb/d from 2.0 MMb/d five years ago due to aging fields and a substantial reduction in drilling (offshore drilling is down ~70% since 2013). Within another year or two, this capacity will dwindle to 1.7 MMb/d or below. On top of this natural decline, we have projected continued sabotage / militant obstruction will limit actual crude output to an average of 1.55 MMb/d for the foreseeable future. Libyan production averaged just 420,000 b/d for 2014-2016, a far cry from the 1.65 MMb/d produced prior to the 2011 Libyan Revolution that ousted strongman Muammar Gaddafi. Since Gaddafi was deposed and executed, factional strife and conflict has persisted. Each faction wants control over oil export revenues and, just as importantly, wants to deny the opposition those revenues, resulting in a chronic state of conflict that has limited production and exports. If a détente were reached, we expect Libyan oil production could quickly rise to about 1.0 MMb/d of production within six months; however, we put the odds of a sustainable détente at less than 30%. As such, we forecast Libyan crude production will continue to struggle, averaging about 600,000 b/d in 2017-2018. Non-OPEC Cuts Hang On Russia In November, ten non-OPEC countries nominally agreed to restrict production by a total of 558,000 b/d, but Russia--with 300,000 b/d of pledged cuts--is the big fish that KSA and OPEC are relying on. Mexico's (and several others') agreements are window dressing, reframing natural production declines as voluntary action to rebalance markets. Through H1 2017, Russia has delivered on about 60-70% of its cut agreement, with compliance growing in Q2 (near 100%) versus Q1 (under 50%). From the start, Russia indicated it would require some time to work through the physical technicalities of lowering production to its committed levels, implying that now that production has been lowered, Russia could deliver greater compliance over H2 2017 than it delivered in H1 2017. We are a little more skeptical, expecting some weakening in Russia's compliance by Q4, especially if the extended cuts deliver the expected results of bringing down OECD inventories and lifting prices. Russia surprised us with stronger-than-expected production during 2016. Some of the outperformance was clearly due to a lower currency and improved shale-like drilling results in Western Siberia, but it is unclear whether producers also pulled too hard on their fields to compensate for lower prices, and are using the OPEC 2.0 cut as a way to rest their fields a bit. We have estimated Russian production returning to 11.3 MMb/d by Q4 2017 (50,000 b/d higher than 2016 average production) and holding there through 2018 (Chart 10), but actual volumes could deviate from this level by as much as 100,000-200,000 b/d. Mexico, the second largest non-OPEC "cutter," is in a position similar to Angola, Algeria, and Venezuela. Mexican production has been falling for years (Chart 11), and the nation's pledge to produce 100,000 b/d less in H1 2017 than in Q4 2016 is merely a reflection of this involuntary decline. As it has happened, Mexican production has declined by only ~60,000 b/d below its official reference level, but continues to deteriorate, promising higher "compliance" with their production pledge in H2 2017. Chart 10Russia Expected##BR##To Cheat By Q4 Chart 11Mexican Production Deterioration##BR##Unaffected By Cut Pledges Kazakhstan and Azerbaijan are not complying with any cuts, and we don't expect them to. Despite modest pledges of 55,000 b/d cuts combined, the two countries have produced ~80,000 b/d more during H1 2017 than they did in November 2016. We don't expect any voluntary contributions from these nations in the cut extension, but Azerbaijan's production is expected to wane naturally (Chart 12). While contributing only a small cut of 45,000 b/d, Oman has diligently adhered to its promised cuts, supporting its OPEC and Gulf Cooperation Council (GCC) neighbors. We expect Oman's excellent compliance will be faithfully continued through the nine-month extension (Chart 13). Chart 12Kazakhstan And Azerbaijan Not Expected##BR##To Comply With Any Cut Extension Chart 13Oman Has Faithfully Complied##BR##With Cut Promises To Date OPEC Extension Will Continue To Support Increased Shale Drilling Energy Sector Strategy believed OPEC's original cut announced in November 2016 was a strategic mistake for the cartel, as it would accelerate the production recovery from U.S. shales in return for "only" six months of modestly-higher OPEC revenue. As we cautioned at the time, the promise of an OPEC-supported price floor was foolish for them to make; instead, OPEC should have let the risk of low prices continue to restrain shale and non-Persian Gulf investment, allowing oil markets to rebalance more naturally. However, despite our unfavorable opinion of the strategic value of the original cut, since the cut has not delivered the type of OECD inventory reductions expected (seemingly due to a larger-than-expected transfer of non-OECD inventories into OECD storage), we view the extension of the cut as a necessary, and logical, next step. OPEC 2.0's November 2016 cut agreement signaled to the world that OPEC (and Russia) would abandon KSA's professed commitment to a market share war, and would instead work together to support a ~$50/bbl floor under the price of oil. Such a price floor dramatically reduced the investment risk for shale drilling, and emboldened producers (and supporting capital markets) to pour money into vastly increased drilling programs. Now that the shale investment genie has already been let out of the bottle, extending the cuts is unlikely to have nearly the same stimulative impact on shale spending as the original paradigm-changing cut created. The shale drilling and production response has been even greater than we estimated six months ago, and surely greater than OPEC's expectations. The current horizontal (& directional) oil rig count of 657 rigs is nearly twice the 2016 average of 356 rigs, is 60% higher than the level of November 2016 (immediately before the cut announcement), and is still rising at a rate of 25-30 rigs per month (Chart 14). The momentum of these expenditures will carry U.S. production higher through YE 2017 even if oil prices were allowed to crash today. Immediately following OPEC's cut, we estimated 2017 U.S. onshore production could increase by 100,000 - 200,000 b/d over levels estimated prior to the cut, back-end weighted to H2 2017, with a greater 300,000-400,000 b/d uplift to 2018 production levels. Drilling activity has roared back so much faster than we had expected, indicative of the flooding of the industry with external capital, that we have raised our 2017 production estimate by 500,000 b/d over our December estimate, and raised our 2018 production growth estimate to 1.0 MMb/d (Chart 15). Chart 14Rig Count Recovery Dominated##BR##By Horizontal Drilling Chart 15Onshore U.S. Production##BR##Estimates Rising Sharply Other Guys' Decline Requires Greater Growth From OPEC, Shales, And Russia We've written before about "the Other Guys' in the oil market, defined as all producers outside of the expanding triumvirate of 1) U.S. shales, 2) Russia, and 3) Middle East OPEC. While the growers receive the vast majority of investors' focus, the Other Guys comprise nearly half of global production and have struggled to keep production flat over the past several years (Chart 16). Chart 17 shows the largest offshore basins in the world, which should suffer accelerated declines in 2019-2020 (and likely beyond) as the cumulative effects of spending constraints during 2015-2018 (and likely beyond) result in an insufficient level of projects coming online. This outlook requires increasing growth from OPEC, Russia and/or the shales to offset the shrinkage of the Other Guys and simultaneously meet continued demand growth. Chart 16The Other Guys' Production##BR##Struggling To Keep Flat Risks To Rebalancing Our expectation global oil inventories will draw, and that prices will, as a result, migrate toward $60/bbl by year-end is premised on the continued observance of production discipline by OPEC 2.0. GCC OPEC - KSA, Kuwait, Qatar, and the UAE - Russia and Oman are expected to observe their pledged output reduction, but we are modeling some compliance "fatigue" all the same. Even so, this will not prevent visible OECD oil inventories from falling to their five-year average levels by year-end or early next year. Obviously, none of this can be taken for granted. We have consistently highlighted the upside and downside risks to our longer term central tendency of $55/bbl for Brent crude, with an expected trading range of $45 to $65/bbl out to 2020. Below, we reprise these concerns and our thoughts concerning OPEC 2.0's future. Major Upside Risks Chief among the upside risks remains a sudden loss of supply from a critical producer and exporter like Venezuela or Nigeria, which, respectively, we expect will account for 1.9 and 1.5 MMb/d of production over the 2017-18 period. Losing either of these exporters would sharply rally prices above $65/bbl as markets adjusted and brought new supply on line. Other states - notably Algeria and Iraq - highlight the risk of sustained production losses due to a combination of internal strife and lack of FDI due to civil unrest. Algeria already appears to have entered into a declining production phase, while Iraq - despite its enormous potential - remains dogged by persistent internal conflict. We are modeling a sustained, slow decline in Algeria's output this year and next, which takes its output from 1.1 MMb/d in 2015 down to slightly more than 1 MMb/d on average this year and next. For Iraq, where we expect a flattening of production at ~ 4.4 MMb/d this year and a slight uptick to ~ 4.45 MMb/d in 2018, continued violence arising from dispersed terrorism in that country in the wake of a defeat of ISIS as an organized force, will remain an ongoing threat to production. Longer term - i.e., beyond 2018 - we remain concerned the massive $1-trillion-plus cutbacks in capex for projects that would have come online between 2015 and 2020 brought on by the oil-price collapse in 2015-16 will force prices higher to encourage the development of new supplies. The practical implication of this is some 7 MMb/d of oil-equivalent production the market will need, as this decade winds down, will have to be supplied by U.S. shales, Gulf OPEC and Russia, as noted above. Big, long-lead-time deep-water projects requiring years to develop cannot be brought on fast enough to make up for supply that, for whatever reason, fails to materialize from these sources. In addition, as shales account for more of global oil supplies and "The Other Guys" continue to lose production to higher depletion rates, more and more shale - in the U.S. and, perhaps, Russia - and conventional Persian Gulf production will have to be brought on line simply to make up for accelerating declines. This evolution of the supply side is significantly different from what oil and capital markets have been accustomed to in previous cycles. Because of this, these markets do not have much historical experience on which to base their expectations vis-à-vis global supply adjustment and the capacity these sources of supply have for meeting increasing demand and depletion rates. Lower-Cost Production, Demand Worries On The Downside Downside risks, in our estimation, are dominated by higher production risks. Here, we believe the U.S. shales and Russia are the principal risk factors, as the oil industry in both states is, to varying degrees, privately held. Because firms in these states answer to shareholders, it must be assumed they will operate for the benefit of these interests. So, if their marginal costs are less than the market-clearing price of oil, we can expect them to increase production up to the point at which marginal cost is equal to marginal revenue. The very real possibility firms in these countries move the market-clearing price to their marginal cost level cannot be overlooked. For the U.S., this level is below $53/bbl or so for shale producers. For Russian producers, this level likely is lower, given their production costs are largely incurred in rubles, and revenues on sales into the global market are realized in USD; however, given the variability of the ruble, this cost likely is a moving target. While a sharp increase in unconventional production presently not foreseen either in the U.S. or Russian shales will remain a downside price risk, an increase in conventional output - chiefly in Libya - remains possible. As discussed above, we believe this is a low risk to prices at present; however, if an accommodation with insurgent forces in the country can be achieved, output in Libya could double from the 600k b/d of production we estimate for this year and next. We reiterate this is a low-risk probability (less than 25%), but, in the event, would prove to be significant additions to global balances over the short term requiring a response from OPEC 2.0 to keep Brent prices above $50/bbl. Also on the downside, an unexpected drop in demand remains at the top of many lists. This is a near-continual worry for markets, which can be occasioned by fears of weakening EM oil-demand growth from, e.g., a hard landing in China, or slower-than-expected growth in India. These are the two most important states in the world in terms of oil-demand growth, accounting for more than one-third of global growth this year and next. We do not expect either to meaningfully slow; however, we continue to monitor growth in both closely.1 In addition, we continue to expect robust global oil-demand growth, averaging 1.56 MMb/d y/y growth in 2017 and 2018. This compares with 1.6 MMb/d growth last year. OPEC 2.0's Next Move Knowing the OPEC 2.0 production cuts will be extended to March 2018 does not give markets any direction for what to expect after this extension expires. Once the deal expires, we expect production to continue to increase from the U.S. shales, and for the key OPEC states to resume pre-cut production levels. Along with continued growth from Russia, this will be necessary to meet growing demand and increasing depletion rates from U.S. shales and "The Other Guys." Yet to be determined is whether OPEC 2.0 needs to remain in place after global inventories return to long-term average levels, or whether its formation and joint efforts were a one-off that markets will not require in the future. Over the short term immediately following the expiration of the production-cutting deal next year, OPEC 2.0 may have to find a way to manage its production to accommodate U.S. shales without imperiling their own revenues. This would require a strategy that keeps the front of the WTI and Brent forward curves at or below $60/bbl - KSA's fiscal breakeven price and $20/bbl above Russia's budget price - and the back of the curve backwardated, in order to exert some control over the rate at which shale rigs return to the field.2 As we've mentioned in the past, we have no doubt the principal negotiators in OPEC 2.0 continue to discuss this. Toward the end of this decade, such concerns might be moot, if growing demand and accelerating decline curves require production from all sources be stepped up. Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see the May 18, 2017, issue of BCA Research's Commodity & Energy Strategy article entitled "Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts," in which we discuss the outlook for China's and India's growth. Together, these states account for more than 570k b/d of the 1.56 MMb/d growth we expect this year and next. The article is available at ces.bcaresearch.com. 2 A backwardated forward curve is characterized by prompt prices exceeding deferred prices. Our research indicates a backwardated forward curve results in fewer rigs returning to the field than a flat or positively sloped forward curve. We explored this strategy in depth in the April 6, 2017, issue of BCA Research's Commodity & Energy Strategy, in an article entitled "The Game's Afoot In Oil, But Which One?" It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016
Communications equipment stocks have diverged negatively from the broad tech sector and now trade broadly in line with telecom carrier stocks - a key end-market, with a slight lag. The latest signal from telecom services stocks is bearish, and we recommend a downgrade to a below-benchmark allocation in the S&P communications equipment group. While valuations look compelling, the risk of further near-term losses and a longer-term value trap remains high; all three key communications equipment end-markets point to additional demand weakness ahead. First, a full blown price war has engulfed the telecom services industry, driving outright deflation. In the absence of revenue growth, telecom capex is unlikely to reaccelerate. Secondly, delays/uncertainty with regard to U.S. fiscal policy and the Trump administration's strict budget control warns that the government's purse strings will remain tight for some time, representing another source of drag. Finally, export markets are unlikely to offset domestic cooling, as soaring Chinese & European telecom equipment exports suggest that U.S. manufacturers are losing competitiveness, and market share. Meanwhile, deflationary industry specific forces such as virtual networking will also contribute to margin pressure. We recommend shifting to underweight. Please see yesterday's Weekly Report for more details. The ticker symbols for this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV.
Highlights Geopolitical risks remain overstated in 2017, but China and Italy could scuttle the party; June elections in France and the U.K. are not market-movers; But early Italian election is a risk that could prompt the ECB to stay easy, close long EUR/USD for a gain; U.S. budget reconciliation process may be arcane, but is vital to understand upcoming tax reform process; Investors should expect details of tax reform by Q4 2017, but legislation may only pass in Q1 2018. Feature We turned the traditional adage of "sell in May and go away" on its head last month in a report titled "Buy In May And Enjoy Your Day!"1 So far so good (Chart 1). The fundamental reasons behind the breakout is the narrowing of the global equity risk premium on the back of easy monetary policy and a recovering global economy (Chart 2) two trends that our colleagues at the Global Alpha Sector Strategy highlighted last September.2 Since then, geopolitical risks cited as likely to end the party have been largely overstated.3 We continue to worry about Chinese financial sector reforms, U.S. politics, Sino-American tensions, signs of growing U.S. mercantilism, prospects of early Italian elections, and especially the developments in North Korea. But these remain risks for 2018, rather than 2017.4 Chart 1Blow-Off Phase Has Resumed Chart 2Global ERP Has Room To Fall There are still some "loose ends" to tie up from the first quarter, including the upcoming French legislative and U.K. general elections. On the former, there is nothing to say other than that investors should indeed prepare for a "French Revolution," by which we mean a supply-side revolution.5 Current seat projections based on the latest polling have pro-market, centrist, Europhile parties controlling between 85-92% of the National Assembly following the two-round elections in mid-June (Diagram 1).6 Diagram 1French National Assembly Seat Projection Yes. In France. Skeptical commentary will surely rain on the centrist parade by pointing out that anti-establishment presidential candidates won nearly 50% of the vote in the first round of the presidential election (true), that Marine Le Pen will be back even stronger in 2020 (false), or that the electoral system is designed to suppress the populist vote (yes, so what?). We are not as perceptive nor profound as the witty op-ed writers. Our far simpler conclusion is that the French National Assembly will elucidate the revealed preference of the French electorate, given the electoral rules that are quite familiar to all French voters. And that preference appears to be for pro-market, and quite possibly painful, structural reforms. We remain long French industrials relative to German ones, but our clients may find alternative ways to play the upcoming free-market revolution in France. On the British front, Tory PM Theresa May is facing her first genuine crisis. The impact of the Manchester terrorist attack on the election is difficult to forecast. However, May's "dementia tax" gaffe has clearly given Labour new life in the polls (Chart 3). What most commentators saw as a clear shoo-in for the Conservative Party has now become a competitive, if not exactly tight, race. Chart 3Labour Gains... Chart 4...But Tories Keep Devouring UKIP We would note that despite Labour's rise in the polls, May's strategy of suppressing the UKIP vote by campaigning from the nationalist right is paying off. As Chart 4 illustrates, UKIP voters appear to be switching to the Tories en masse: UKIP has gone from support of 20% in April 2016 to under 5% today. Given Britain's first-past-the-post electoral system, May's strategy of swallowing the UKIP whole is a savvy move. It will eliminate the probability that UKIP siphons votes away from the Tories in competitive constituencies. Our own, highly conservative, estimate gives the Tories a minimum of 11 gained seats (Table 1). This is based on constituencies that voted for Brexit but where Labour and the Liberal Democrats won by less than 5% in the last election. Table 1Minimal Scenario Gives Tories 11 New Seats For Their Majority We do not think that the election will have much impact on the Brexit process. Political risks peaked in January when May announced that she planned to take the U.K. out of the EU Common Market. We pointed out at the time that this decision made it highly unlikely that the U.K. and EU negotiations would take an acrimonious turn.7 The market agreed with us, with the pound bottoming in mid-January. We continue to believe that the Brexit process will have no investment relevance for global assets. As for U.K. equities and the pound, a larger-than-expected seat grab by the Tories (375+) at the upcoming election would likely strengthen the pound further, which in turn could weigh on the FTSE 100 (with the FTSE 250 being less affected). A disappointing result, one where the Conservative Party fails to reach 350 seats, could create temporary headwinds for the pound. The one risk that remains on our horizon is faster-than-expected deleveraging in China. As we mentioned in our report last week, China's financial crackdown raises near-term risks (Chart 5).8 We do not think that policymakers are looking to enact wide scale financial sector reform, which would entail a surge in realized non-performing loans, bankruptcies, and defaults ahead of the Fall Party Congress. However, Chinese investors and businesses may already be looking ahead to 2018. Chart 5Policymakers Are Inducing Financial Risk... Chart 6...At A Time When Vulnerability Is Growing China's reserves-to-M2 ratio - an IMF-proposed measure that captures Chinese reserves of liquid assets against those that its residents could potentially liquefy as part of wide scale capital flight - has continued to decline (Chart 6). Measures of quarterly net portfolio flows and capital flight show that the Q4 2016 outflows accelerated sharply after a slowdown in outflows in the previous two quarters (Chart 7), although we have no information for Q1 2017. More recently, there has been a stunning surge in Bitcoin prices. The crypto-currency is up 65% since the start of May, which cannot be attributed to Euro Area fears given the victory of Europhile Emmanuel Macron in the French election. Could it be related to policy uncertainty in China? We think yes (Chart 8). China remains our pick for the risk that is most likely to scuttle our sanguine view on global risk assets in 2017. Chart 7Chinese Outflows Restarted In Q4 2016 Chart 8Chinese Uncertainty Is Bitcoin's Gain The final risk to investors that we have been tracking this year is inaction by U.S. Congress on the tax reform front. We have received many client questions regarding when investors should expect to see tax reform legislation and when (and how) it is expected to pass. We turn to this question in the rest of this report. Market Relevance Of The Budget Reconciliation Process The U.S. legislative process is complicated, arcane, and highly mutable. We have tried to spare our clients as much of the headache of U.S. congressional procedure as possible.9 However, the budget reconciliation process underpins current efforts to reform both the 2010 Affordable Care Act (Obamacare) and enact tax reform. To understand how, when, and whether the GOP-controlled Congress will pass these pieces of legislation, it is necessary for investors to learn the basics of the reconciliation process in particular, and the budget process more broadly. Budget reconciliation - or simply, reconciliation - simplifies the process of passing a budget and was introduced by the Congressional Budget Act of 1974.10 To understand why reconciliation matters, we first have to explain how the U.S. Congress sets the budget. The U.S. Budget Process The U.S. budget process (Diagram 2) begins with the U.S. president submitting the White House budget request to Congress. This is a largely ceremonial act as Congress has the power over the appropriations process. Diagram 2U.S. Budget Process: A Tentative Timeline Congress takes into account the president's request as it formulates a budget resolution, which both houses of Congress pass but which is not presented to the president and does not actually constitute law. The resolution sets out the guidelines for the budget process, which is supposed to ultimately produce an appropriations bill. It is this bill, also referred to as a budget bill, which appropriates funding for the various federal government departments, agencies, and programs. Under a revised timetable in effect since 1987, the annual budget resolution is supposed to be adopted by both chambers of Congress by April 15, giving legislators sufficient time to then pass a budget bill by the start of the fiscal year on October 1. However, there is no obligation to do so. In fact, Congress failed to pass a budget resolution for most of President Obama's two terms in office due to a high degree of polarization between the Democrats and Republicans. As such, the government was funded via "continuing resolutions," which merely extended pre-existing appropriations at the same levels as the previous fiscal year. Reconciliation Process Where does the reconciliation process fit? It was originally introduced to simplify the process of changing the law on the books in order to bring revenue and spending levels into line with the budget resolution. The crucial feature of the process, and the reason we are focusing so much on it, is that it limits the debate in the Senate to 20 hours, thus automatically preventing any Senator from filibustering the ultimate legislation that emerges from the reconciliation process. No filibuster, no need to reach 60 Senate votes to invoke cloture, an act that ends the debate in the chamber. In the current context, where the Republican Party controls 52 seats, this means that the Republicans can use the reconciliation process to pass legislation that would otherwise be "filibustered" in the Senate. The reconciliation procedure is a very powerful legislative tool by which Congress can pass controversial legislation, as long as such legislation has an impact on government revenues or spending levels. Tax legislation, obviously, would impact government revenues. George W. Bush used the reconciliation procedure to lower taxes in 2001 and 2003. His father, George H. W. Bush used reconciliation to raise taxes in 1990 (and thus roll back some of the Ronald Reagan 1986 tax reform). The 1996 welfare reform - the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 - was also passed via the reconciliation process. Obamacare was not passed via the reconciliation procedure. The main portion of the bill - including almost all of its key provisions - was passed at the beginning of the 111th Congress in 2009 when the Democrats held 58 seats in the Senate following the momentous 2008 election.11 It was the subsequent amendments to the original bill that required the reconciliation process due to the death of Massachusetts Senator Ted Kennedy, particularly several crucial funding provisions. The one unifying feature of all reconciliation bills is that they must have an impact on the budget, essentially by changing the revenue or spending levels of the federal government. If the bill introduces extraneous provisions that deviate from the budgetary requirement, then these can be struck out by invoking the so-called "Byrd rule." Waiving the Byrd rule requires an affirmative vote of three-fifths of the Senate, which is 60 votes. As such, it essentially requires the 60-seat majority needed to also invoke cloture, making the entire reconciliation process redundant. Bottom Line: The budget reconciliation process allows U.S. Congress to pass legislation without the a 60-seat Senate majority. However, procedural rules require the provisions of a reconciliation bill to deal exclusively with legislation that impact government revenue or spending levels. Timing Since the introduction of the procedure in 1974, there have been 24 reconciliation bills, three of which were vetoed by the president. The reconciliation process begins with the passing of the budget resolution, which sets out the "reconciliation instructions." However, since the procedure was introduced, it has rarely progressed along the intended timeline. The very first reconciliation act in 1980 was introduced in a budget resolution that passed well after the April 15 deadline, in mid-June. And the ultimate appropriations bill, the Omnibus Reconciliation Act of 1980, was only signed into law in early December 1980, so essentially two months after the start of FY1981 on October 1. Investors should therefore understand that the U.S. budget process has no real firm deadlines. The schedule is highly malleable. A reconciliation bill also does not have to be passed with the actual budget. Despite being initiated by the budget resolution, reconciliation runs parallel to the budget process. For example, Congress has already set appropriations for FY2017, but the reconciliation bill on Obamacare - set by the FY2017 budget resolution - is still in negotiations. Diagram 3 illustrates that half of all reconciliation bills were passed after the start of the fiscal year for which they were introduced in a budget resolution. And five reconciliation bills were passed in the calendar year of the fiscal year for which they were supposed to reconcile the budget, basically mid way through the fiscal year. Diagram 3Timing Of Reconciliation Procedures This is important in the current context because investors are waiting for tax reform legislation which is supposed to be passed via the budget reconciliation process for FY2018. However, the GOP-controlled Congress has not even finished the budget process for FY2017. In fact, the budget resolution for FY2017 only passed the House on January 13, 2017. As we learned above, U.S. budget process guidelines call for the budget resolution to have been passed by April 15, 2016. As such, the Obamacare repeal and replace bill, if it were to ultimately pass the Senate, would certainly be the most delayed reconciliation bill ever. In fact, we could see the current Congress passing the FY2017 reconciliation bill in the waning days of FY2017! Congressional rules only allow one budget resolution to be active at any one time. In fact, as soon as a new budget resolution is passed, the old reconciliation instructions are made void. As such, investors have to wait for the Republicans to decide what they plan to do with the Obamacare reconciliation bill before they begin contemplating tax reform. Bottom Line: Republicans in Congress decided to issue reconciliation instructions as part of the FY2017 budget resolution, which passed in January. As such, investors have to wait until that process ends - with either Obamacare repeal or failure of the bill - before Congress can produce a FY2018 budget resolution with reconciliation instructions for tax reform. We suspect that the FY2018 budget resolution will be passed sometime between the end of the August Congressional recess, on September 5, and December. But that is just a guess (Diagram 4). It could happen earlier, in July, if Obamacare is dealt with over the next month. Diagram 4Tentative U.S. Political Timeline Reconciliation Rules And Tax Reform Changing America's complex tax laws is precisely the sort of legislative action that reconciliation was designed to facilitate. That said, investors are still not sure whether the Trump administration and Congress will be able to agree on comprehensive tax reform that includes lowering top rates for corporations, or whether they will merely agree to cut household taxes on households. Some clarity will emerge once the Republican-controlled Congress passes the FY2018 budget resolution, which will contain reconciliation instructions for either comprehensive tax reform (most likely) or merely household tax reform (unlikely). At that point, the length of the reconciliation process will depend on how much agreement there is surrounding tax reform. Diagram 3 shows that tax cuts - such as those in 2001 and 2003 - take relatively little time to pass. Tax reform, on the other hand, could take a while longer given multiple competing interests. If comprehensive, we would expect tax reform to be passed by the end of Q1 2018. Would that mean that tax cuts would only be effective from January 1, 2018? Or, even less bullish, from the start of FY2019? No. The GOP would have the option of making tax cuts retroactive and thus can avoid a huge market disappointment if tax cuts come later in the next year. It is even legally possible for tax laws passed in 2018 to take effect on January 1, 2017 - though it is admittedly more of a stretch than doing it this year.12 Can reconciliation be used to pass budget-busting tax reform, as we have argued investors should expect? You bet! From 1980 to the 1990s the reconciliation procedure was primarily used - and in fact designed - to reduce the deficit through reductions in mandatory spending, revenue increases, or both. It has since become a tool to expand deficits. This was most famously done by the Bush era reconciliation bills in 2001 and 2003, which introduced large tax cuts. The aforementioned Byrd rule forces any provision of a bill that increases the deficit beyond the years covered by the reconciliation bill to "sunset." In the case of the 2001 and 2003 bills, this meant that Bush-era tax cuts expired in 2011 (estate tax) and 2013 (which investors will remember as the "fiscal cliff"). The sunset period does not have to be ten years, it could conceivably be a lot longer, in effect making tax reform permanent, as far as most investors' time horizons are concerned. Following the Democratic Party sweep in the 2006 midterm elections, the Democrat-controlled Senate changed reconciliation rules to prohibit any deficit-increasing measures, regardless of the sunset clause loophole. However, the Republicans changed the rules back in 2015, after they re-took the Senate in the 2014 midterm election. This is crucial for two reasons: first, it means that the current procedural rules on the books allow deficits to be blown out via the reconciliation procedure and second, it establishes that the current cohort of Republicans in Congress is fiscally profligate, despite media punditry to the contrary. Bottom Line: The reconciliation process was designed to facilitate precisely the type of legislation that Republicans will try to pass via tax reform. According to the current procedural rules, such legislation can increase the budget deficit, as long as it sunsets at the conclusion of the budgetary period set out by the legislation (normally 10-years, but it could be longer). We suspect that tax reform will take until Q1 2018 to pass, but Republicans will be able to make its effects retroactive to January 1, 2017. The Big Picture - What Does It All Mean For Fiscal Policy? We expect the Republican-held Congress to attempt to pass comprehensive tax reform over the next four quarters. If the GOP fail to agree on "revenue offsets" for corporate tax cuts, we could see the Republican Congress electing to pass simple tax cuts for households, as the Bush-era tax cuts of 2001 and 2003 did. To facilitate such legislation politically, the Republicans will rely on "dynamic scoring," the macroeconomic modeling tool based on the work of economist Arthur Laffer (of the "Laffer curve" fame). The idea is that the headline government revenue lost through tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, factors that actually add to revenues. In other words, "tax cuts pay for themselves." It is true that the Congressional Budget Office (CBO) will balk at dynamic scoring. But we doubt that "egghead, socialist economists" will stand in the way of tax reforms. As we discussed above, the CBO's score will ultimately only force the Republicans to "sunset" tax reform legislation, not scuttle it. The market disagrees with us. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 9). Chart 9Market Has Voted: No Fiscal Stimulus We think the market is making a serious mistake by taking the Republican mantra of "revenue neutral" - meaning that any tax cuts would need to be offset by other revenue-raising measures - tax reform seriously. This is easier said than done. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - will all face resistance from vested interests. We suspect that the GOP will produce some revenue offsets, but not enough to have a revenue-neutral tax reform. The path of least resistance, therefore, will be to bust the budget and then force the measures to expire over the life of the budget-setting window. White House budget director Mick Mulvaney has already floated the idea of extending the 10-year budget scoring window to 20 years. This would allow tax reform measures, even if they are characterized by the CBO as profligate, to expire in two decades. That's practically a lifetime away, as far as any investor is concerned. What is the investment significance of a stimulative tax reform package? Our colleague Peter Berezin has recently pointed out that it is ironic that fiscal stimulus is coming to America only when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year, as the Fed responds to greater fiscal thrust with tighter monetary policy.13 We encourage our clients to read BCA Special Report "Beware The 2019 Trump Recession," penned by Martin Barnes in March, which details the likely path that assets and the economy will take over the next two years.14 In the short term, the market will continue to fret that tax reform is doomed and that Republicans are committed to austerity. However, budget-busting tax reform could begin to be priced in by the market well before the reconciliation bill is ultimately passed. We suspect that the outlines of tax reform will emerge this summer. The market may realize that stimulus is coming as soon as the FY2018 budget resolution, containing tax reform instructions, is passed in Q3 or Q4 2017. Such a realization later this year could augur a violent snap-back in the USD. Currently, the two-year real interest rate differentials between the euro area and the U.S. have widened by 58 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 10). We have been long EUR/USD since March 22,15 in expectations that investors would be busy covering their euro hedges that they put on in the lead up to the French elections, the outcome of which we have had a high conviction on since November.16 However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will ultimately subside (Chart 11). Chart 10Widening Real Rate ##br##Differentials Support The Dollar Chart 11Speculators Are Long The Euro##br## For The First Time In Three Years We are therefore closing our USD short versus both the euro and the pound, for gains of 3.48% and 3.34% respectively. As we expected, the ECB is going to look to guide investors towards a "dovish" tapering of its QE program. Speaking before the European Parliament's committee on economic affairs, ECB President Mario Draghi confirmed that "very accommodative financing conditions" reliant on "a fairly substantial amount of monetary accommodation" would continue. The ECB will have to make a decision whether to extend its sovereign bond purchase program into the next year or start winding it down as planned. Given news flow out of Italy that an election may be planned as early as September, the ECB may be forced to stand pat until after the end of the year. Given our view that tax reform in the U.S. would ultimately happen, and that it would eventually be marginally stimulative, any resurfacing of political risks in Europe - which we are expecting - should be negative for the EUR/USD. What should investors do about European equities? We are cautious. As we have been pointing out to our clients since September of last year, Italy is the political risk in Europe.17 However, we think that most investors are willing to bet that European equities can survive Italian political turbulence. This could be a mistake in the short term, as we think that Euroskeptic (albeit evolving) Five Star Movement could win a plurality in the next election. In the long term, Italy will become ECB's proverbial boulder, that Draghi must push up a hill like Sisyphus, only to see it roll down to the bottom with each bout of Italian political instability. As such, Italy's instability will force ECB to set its monetary policy for the weakest link in the Euro Area (Italy), rather than the aggregate. This should be positive for Euro Area risk assets, but negative for the euro, all other things being equal. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Strike While The Iron Is Hot," dated September 2, 2016, available at gss.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at fes.bcaresearch.com. 6 The dates for the two rounds of the legislative elections are June 11 and 18. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 10 We draw on several overviews of the budget reconciliation process in this report. Please see David Reich and Richard Kogan, Center on Budget and Policy Priorities, "Introduction To Budget 'Reconciliation'," dated November 9, 2016, available at cbpp.org; Megan S. Lynch, Congressional Research Service, "The Budget Reconciliation Process: Timing Of Legislative Action," dated February 23, 2016, available at fas.org; and Megan S. Lynch, Congressional Research Service, "Budget Reconciliation Measures Enacted Into Law: 1980-2010," dated January 4, 2017, available at fas.org. 11 To reach the required 60 seat filibuster-proof majority the Democrats relied on some luck and cunning. Democrat Al Franken unseated Republican Incumbent Norm Coleman in a recount in Minnesota and Arlen Specter, a Republican from Pennsylvania, switched his party affiliation to Democrat. 12 Congress, after the sweeping 1986 tax reforms, corrected certain oversights in that law by passing subsequent measures in 1987. These were made to be retroactive back to the previous calendar year, i.e. January 1, 1986, and the courts upheld the legislation. Hence, there is precedent for Republicans to pass tax reform in 2018 that takes effect January 1, 2017, though admittedly the circumstances would matter. Courts have even upheld retroactive tax legislation back to two calendar tax years. Please see Erika K. Lunder, Robert Meltz, and Kenneth R. Thomas, "Constitutionality of Retroactive Tax Legislation," Congressional Research Service, October 25, 2012, available at fas.org. 13 Please see BCA Global Investment Strategy Weekly Report, "Fiscal Policy In The Spotlight," dated May 26, 2017, available at gis.bcaresearch.com. 14 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. Geopolitical Calendar
Highlights Reflation Trade: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. New Zealand: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean government bond market. Feature "I know it makes no difference to what you're going through; but I see the tip of the iceberg, and I worry about you." - Rush Is The Liquidity Party Starting To Wind Down? Global financial markets continue to enjoy the "sweet spot" of a solidly expanding global economy, but without enough inflation pressure to force central banks to slam on the monetary brakes. That backdrop is starting to change, though. Odds are rising that the European Central Bank (ECB) will begin tapering its bond buying next year, with some hints of that possibly being announced as soon as next week's monetary policy meeting. At the same time, the Bank of Japan (BoJ) - faced with the operational constraints of buying an ever-increasing share of Japanese financial assets - is focused on targeting long-term interest rates rather than increasing liquidity. Even the Federal Reserve is now talking about reducing its massive balance sheet later this year. The liquidity tailwind to global growth and risk assets is now at risk of becoming a headwind. Already, the growth rate of the major central bank balance sheets has rolled over and is on course to decelerate further over the next year (Chart of the Week). Importantly, this downshift in global liquidity momentum is happening as signs of slowing growth have appeared in some major economies like China and the U.S. (Chart 2). Chart of the WeekLiquidity Tailwind To Risk##BR##Assets Is Fading Chart 2Growth Momentum##BR##Already Starting To Cool Off We remain concerned that the Chinese economy will see a policy-induced deceleration in the 2nd half of the year. However, we still expect the U.S. to rebound after the soft patch of growth in the first quarter, and we see nothing in the Euro Area data to suggest that the current solid expansion is at risk of fading quickly. This should allow inflation expectations to drift upward toward the central bank targets given the apparent lack of spare capacity on both sides of the Atlantic (Chart 3). Chart 3Fed & ECB Facing##BR##Economic Capacity Constraints We still expect the Fed to deliver another two rate hikes before year-end and the ECB to begin its exit strategy from the current extraordinary monetary policies by slowing the pace of asset purchases starting early next year. For now, the backdrop will remain supportive for the outperformance of growth-sensitive assets like corporate credit and equities over government bonds in the U.S. and Europe over the balance of 2017. However, the early signals sent by "leading leading" indicators such as our Global Leading Economic Indicator diffusion index (Chart 2, top panel) suggests that liquidity and growth trends will become far more challenging for the markets in 2018. Bottom Line: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. Maintain a below-benchmark duration exposure and an overweight allocation to corporate debt in global fixed income portfolios. New Zealand: Safety From A Global Bond Apocalypse? A growing number of the world's most wealthiest (and, arguably, most paranoid) people are reportedly buying real estate in New Zealand as a safe haven place to live if modern civilization collapses.1 While the immediate need for taking such precautions can be debated, there is sound logic in treating New Zealand as a location far removed from the current geopolitical and socio-economic problems of the world. We now see a case for treating New Zealand bonds as a potential "safe haven" market for global fixed income investors. The Economic Backdrop Has Become More Muddled We have been running a SHORT position in New Zealand (paying 12-month OIS rates) in our Tactical Overlay portfolio since last November. Our view then was that the New Zealand economy would surprise to the upside in 2017 and inflation was likely to start drifting upward. This would pressure the Reserve Bank of New Zealand (RBNZ) to raise the Official Cash Rate (OCR) from the highly accommodative level of 1.75%. So far, that expectation has not panned out as the RBNZ has held rates steady amid a more uncertain outlook for the New Zealand economy. Growth indicators have been a bit mixed over the past few months, but the current uptick in the manufacturing purchasing managers' index (PMI) is pointing to real GDP expanding around 3% on a year-over-year basis (Chart 4). If maintained for the full year, this would be slightly above the RBNZ's estimate of potential growth at 2.8%. There are some downside risks, however, given that consumer and business confidence are both below previous cyclical peaks and fiscal policy is expected to be mildly restrictive in 2017 (bottom three panels). The housing market remains a key cyclical wild card. Residential construction has been a significant source of growth over the past few years, driven by a surge in net immigration into New Zealand and declining interest rates (Chart 5). However, the RBNZ is projecting immigration inflows to slow from the current high level, largely due to improving labor market conditions in the developed economies (most notably, Australia, which is the largest source of New Zealand immigrants). Chart 4Stable NZ Growth...For Now Chart 5NZ Housing Activity Starting To Peak Out Slower immigration would reduce the demand for New Zealand housing at a time when mortgage rates have already been rising off the record lows seen in 2016 (bottom panel). This has occurred without any rate hikes from the RBNZ, as rising global bond yields have put upward pressure on New Zealand bank funding costs, which have been passed through to higher mortgage rates. The RBNZ is currently projecting growth in house prices to slow sharply from last year's robust 15% pace to just 5% in 2017. The main drivers are higher borrowing costs and the ongoing impact of macro-prudential regulations against high loan-to-value ratio mortgage lending. Importantly, slower housing activity will not only have a direct impact on GDP growth through softer construction, but will also indirectly dampen consumer spending growth via wealth effects. Yet even with this expected drag on growth from housing, the New Zealand economy is still expected to face capacity constraints over the rest of the year. Higher Uncertainty Over Price Pressures Both the RBNZ and the International Monetary Fund estimate that the output gap has fully closed and is projected to move into positive territory this year (Chart 6). At the same time, the current unemployment rate of 4.9% is below the OECD's estimate of the full employment level and the RBNZ projects a further decline in joblessness in 2017 (third panel). Despite this evidence of the economy reaching capacity constraints, both wage growth and price inflation remain subdued and inflation expectations remain well-anchored around 2% - the midpoint of the RBNZ's 1-3% target range. Wage costs are particularly depressed, growing only 1% on a year-over-year basis in Q1. This may be related to the rise in the labor force participation rate - up to an all-time high of 70.6% in Q1 from a cyclical low of 68.2% at the end of 2015 - that has increased the available supply of labor. The most recent headline inflation print for Q1 was quite strong, taking the year-over-year growth rate up to 2.2%. Yet in the RBNZ's April Monetary Policy Statement (MPS), the central bank took a surprisingly dovish tone, citing uncertainty over the true degree of slack in the economy and downside risks to growth that would prevent a further acceleration of inflation.2 The RBNZ now forecasts inflation to not rise above 2.2% this year and to fall back to 1.1% in both 2018, led by a sharp decline in growth for tradeables, mostly energy and food inflation (Chart 7). Importantly, this forecast includes the recent decline in the trade-weighted New Zealand Dollar (NZD). Non-tradeables inflation is also expected to stabilize on the back of slower housing-related items in the consumer price index. Chart 6RBNZ Not Expecting A Big Rise In Inflation... Chart 7...As Growth In Tradeables Prices Cools A Weaker Case For Tighter Monetary Policy The official RBNZ projection is that the OCR will stay unchanged at 1.75% until September 2019. The market expectation priced into the NZD OIS curve calls for 27bps of hikes over the next twelve months (Chart 8). Our New Zealand Central Bank Monitor has been suggesting the need for tighter monetary policy since mid-2016, but appears to be rolling over (2nd panel). The diminished rate hike expectations have coincided with a decline in the NZD and a sharp underperformance of New Zealand equities. The markets are giving a consistent signal on softening growth prospects in New Zealand, confirming the central bank's more recent dovish turn. Chart 8Market Expectations Of##BR##RBNZ Hikes Are Fading Given the newfound uncertainties over the New Zealand growth and inflation outlook, the case for owning New Zealand interest rate exposure has grown a little bit stronger. Admittedly, we do not envision a major pullback in growth, and inflation may not fall by as much as the RBNZ is expecting given how little spare capacity there appears to be in the economy. Yet there is now just enough uncertainty to keep the central bank on hold for longer than expected, as was noted in the "scenario analysis" section of the April MPS.3 The RBNZ noted that if the level of spare capacity is smaller than currently assumed, then the latest growth forecast will result in inflation eventually moving to 2.0% in 2018 and 2.3% in 2019, resulting in the OCR needing to rise to 2.25% in two years. Alternatively, if housing demand slows even faster than current projections, inflation would be below the 2% target during the next two years and the OCR would need to fall to 1.25% by the end of 2018. Our takeaway from this is that, even in the more positive scenario, interest rates are not expected to rise by much more than the markets are currently discounting. Position For Tighter New Zealand Spreads Versus Treasuries & Bunds The economic risks in New Zealand now appear evenly balanced. This argues for stable monetary policy and diminished bond volatility. Current market forwards for both government bonds and NZD swaps shows that very little movement in interest rates is expected over the next year (Chart 9). We generally agree with this pricing, although the uncertainty over the degree of spare capacity, and underlying inflation pressures, make a directional view on interest rates or the shape of the yield curve an unattractive risk proposition. A more interesting opportunity presents itself in looking at spread trades between New Zealand government bonds versus other developed market sovereign debt. The yield betas for New Zealand versus the U.S. and Germany have fallen steadily over the past year (Chart 10), indicating that New Zealand bonds can be more insulated from the rise in yields that we expect for U.S. Treasuries and German Bunds over the latter half of 2017. Given the competitively high yields on offer in New Zealand, even on a currency-hedged basis (bottom panel), we see a case for going long New Zealand interest rate exposure versus U.S. and Germany. Chart 9Higher NZ Bond Yields##BR##Priced Into Forwards Chart 10NZ Bonds: Now Lower Beta##BR##With Higher Hedged Yields At current yield levels, going long New Zealand versus Germany looks more compelling relative to spread compression trades versus U.S. Treasuries. We see strong potential for New Zealand-Germany spreads to tighten faster than the forwards over the next six months (Chart 11), largely through rising German yields as the ECB signals that a tapering of bond purchases is set to begin next year. The downside potential for New Zealand-U.S. spread compression looks less likely from current tight levels, although if Treasury yields rise by as much as we expect in the coming months, some spread tightening should occur here, as well. Chart 11Go Long 5Yr NZ Bonds Vs##BR##USTs and German OBLs Based on our analysis, we are closing our current NZD rates trade in our Tactical Overlay portfolio with a tiny profit of +3bps , and entering two new trades: long 5-year NZD government bonds versus 5-year U.S. Treasuries, on a currency-hedged basis; and long 5yr NZD government bonds versus 5-year German government debt, on a currency-unhedged basis.4 We are choosing to hedge the currency exposure back into USD for the former given the view of BCA's currency strategists that the EUR/USD exchange rate is now stretched too far to the upside and is at risk of declining as the Fed delivers on additional rate hikes in the coming months.5 In other words, we see a greater potential for a decline in NZD/USD than NZD/EUR in the next 3-6 months. Bottom Line: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation, in contrast to the strong likelihood of additional Fed rate hikes and an ECB taper announcement in the next few months. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: A Bad Moon Rising For Bond Yields Chart 12Markets Not Worried##BR##About The New President The new South Korean president, Moon Jae-In was elected on May 9th, ending a year of political turmoil after the previous president's scandal and impeachment. Our colleagues at BCA Geopolitical Strategy view Moon and his Democratic Party as a major shift to the political left.6 The new president's policy agenda is aimed at economic stimulus for the working class alongside reforms of the country's chaebol industrial giants. Korean financial markets have greeted the election result positively, with the benchmark KOSPI equity index up 2.7%, and the Korean won up 1% versus the U.S. dollar, from the pre-election levels on May 8th. (Chart 12). This is consistent with past market behavior, as the won tends to be less reactive toward domestic events (i.e. after the previous president's impeachment, the won actually strengthened) and more sensitive to international uncertainties (i.e. North Korea-U.S. military tensions, as occurred in mid-March). Korean interest rates, however, have shown little response to the change in leadership in Seoul, with bond yields unchanged since the election. We see this as presenting an opportunity for fixed income investors. Clearly, the new regime in Seoul represents a real change for the Korean people, but it also represents a potential shift in the economic backdrop - namely, through an expected large fiscal stimulus from the new government - that will impart a steepening bias to the Korean interest rate curve. A Sluggish Economy Greets The New President While the steady, if unspectacular, pace of global growth in the past few years has been enough to absorb spare capacity in many countries, South Korea's sub-par economic performance has left the country with a widening output gap (Chart 13). Policymakers are well aware that consumer spending, which contributes about 60% of GDP, has been steadily weakening alongside slowing credit growth. Chart 13Sluggish Growth In South Korea The new government will attempt to boost domestic consumption, and thus overall growth, by increasing social welfare spending. Moon's economic agenda calls for raising the minimum wage by 55% by 2020, increasing subsidies for education costs and parental leave, and doubling the basic pension payment for the elderly regardless of their income level. It might prove to be very effective in the short term at boosting consumer spending, but this may not prove to be a sustainable driver of growth in South Korea, where the marginal swings in the economy have historically been driven more by exports. Youth joblessness is another problem that Moon will attempt to tackle with his ambitious economic program. While the labor market may appear healthy, with an overall unemployment rate of only 3.7%, the situation is far more challenging for young adults in South Korea - the jobless rate for those aged 20-29 is 11.3%. One of the reasons for such a high unemployment rate among young South Koreans is that university graduates, of which there are many in this highly-educated nation, expect (and look for) high-paying jobs, but cannot find enough of them.7 The labor market has become more competitive in recent years as weak economic growth has limited the ability of private sector, especially large corporations, to hire as much. To solve this problem, the new government has promised to create 810,000 jobs in the public sector. Creating public sector jobs may temporarily solve the high unemployment rate, but in the long run, this will also cause larger fiscal burdens for taxpayers. Position For A Steeper South Korean Yield Curve Headline CPI inflation in South Korea is currently hovering around the 2% target of the Bank of Korea (BoK), while core CPI growth is lower at 1.3%. The BoK has maintain the policy rate at 1.25% since June 2016, with a bias towards additional easing given the lack of sustained inflationary pressure amid weak domestic demand. The BoK did sound a slightly more upbeat tone on the economy at last week's monetary policy meeting, led by the spillover effects from improving global growth rather than a more bullish expectation on the Korean consumer. Importantly, the central bank still expects inflation pressures to remain subdued - no surprise given the large output gap. The BoK did note that it is monitoring several factors in judging future policy decisions: the pace of rate hikes by the Fed, trends in global trade, geopolitical tensions, the pace of household debt accumulation and "the directions of the new government's fiscal policies." The latter may end up being the most important factor, as President Moon is proposing an increase in government spending equal to 0.7% of GDP - an amount equal to ½ of the estimated output gap coming after a 2016 budget surplus of 1% of GDP. This increase in fiscal spending could directly drive up the longer-end of Korean yield curve, as this would result in a narrower budget surpluses and greater KGB issuance. At the same time, the lack of domestic inflation pressures, even with the fiscal stimulus, will keep the BoK on an easing bias that will keep short dated yields well anchored. Therefore, we see the potential for the Korean yield curve to eventually steepen and break the downward-sloping trendline in place since 2014 (Chart 14). We recommend positioning for this move by entering a 2-year/10-year steepening trade in the Korean yield curve. Admittedly, this trade is more structural than tactical in nature, as the Moon stimulus policies will take time to unfold. Importantly, a flattening of the 2-year/10-year KGB curve is currently priced into the forwards, meaning that positioning now for a steepener does not incur negative carry (Chart 15). Chart 14More Fiscal Stimulus =##BR##Steeper Korea Curve Chart 15Enter A 2Yr/10Yr##BR##Korean Bond Curve Steepener Also, Korean 10-year bond yields are currently exhibiting a strong correlation to similar maturity U.S. Treasuries with a yield beta around 1.0 (bottom panel). Given our view that longer-dated U.S. yields have upside risk from both additional Fed rate increases and higher U.S. inflation expectations, that high yield beta suggests that the Korean yield curve could suffer some of the same cyclical bear-steepening pressures that we expect for U.S. Treasuries in the next 3-6 months. Bottom Line: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end curve of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean bond curve. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 https://www.theguardian.com/technology/2017/jan/29/silicon-valley-new-zealand-apocalypse-escape 2 The central bank noted that its "suite" of output gap estimates, using varying methodologies, have an unusually wide range at the moment between -1.5% and +2%. 3 http://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement 4 These trades can be done using interest rate swaps as well (receiving NZD rates vs paying USD & EUR rates), as swap spreads are expected to remain broadly stable in all three regions. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Bloody Potomac", dated May 19 2017, available at fes.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets" dated May 24 2017, available at gps.bcaresearch.com. 7 According to the OECD, Korea's college enrollment rate was a whopping 87% as recently as 2014. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Monetary Policy: The Fed will deliver two rate hikes between now and the end of the year and will also begin the process of winding down its balance sheet. The market is only priced for 36 bps of rate hikes this year. Maintain below-benchmark duration. Economy: Weakness in Q1 GDP was concentrated in consumer spending and inventories. Both of these components are likely to strengthen in the months ahead. Inflation: The Fed is content to rely on Phillips Curve inflation forecasts, and does not need to see actual inflation rise in order to lift rates. However, if inflation does not rebound as expected, the Fed will become increasingly concerned about falling inflation expectations and could adopt a more dovish reaction function later this summer. We think inflation will be strong enough to avoid this outcome. Financial Conditions: The Fed strongly believes that financial conditions lead economic growth. Absent any major changes in the economic data, the pace of rate hikes will be determined by the Fed's targeting of financial conditions. Feature The market-implied probability of a June rate hike jumped sharply during the past two weeks (Chart 1), and stood at 81% as of last Friday's close. In all likelihood the fourth rate hike of the cycle, and the third in the past six months, will occur at the next FOMC meeting on June 14. In our view, the Fed will deliver two 25 basis point rate hikes between now and the end of the year and will also begin the process of winding down its balance sheet (see Box). With the market only priced for 36 bps of rate hikes during that timeframe, we continue to advocate a below-benchmark duration stance. Chart 1Still On For June The minutes from the May FOMC meeting, released last week, suggest that most Fed policymakers still maintain a forecast for two more hikes this year. The minutes also provide some useful insight about how FOMC participants think about the economy and what developments could cause their forecasts to change. This week we take a look at what the Fed believes, and consider whether those beliefs are well founded. Box Balance Sheet Strategy Revealed We wrote about the potential impact of the Fed’s balance sheet policy in last week’s report (please see U.S. Bond Strategy Weekly Report, “Two Challenges For U.S. Policymakers”, dated May 23, 2017, available at usbs.bcaresearch.com), but provide a brief update this week because of new information gained from the May FOMC minutes. Previously, it was unknown whether the Fed would cease the reinvestment of its securities holdings all at once, or whether it would “taper” the reinvestment by gradually increasing the amount of securities it allowed to run off. We now know that “nearly all policymakers expressed a favorable view” of a tapering strategy where the Fed will set a series of gradually increasing caps on the total amount of securities it allows to run off its balance sheet. The plan calls for the caps to be raised every three months, according to a schedule that will be set in advance. The only reason for this plan to not function smoothly would be if market participants start to view the reinvestment caps as an additional policy tool that the Fed will vary according to economic conditions. This would risk taking the focus off the fed funds rate as the main policy tool, and would make it difficult for the market to interpret the overall stance of monetary policy. The minutes show that the Fed plans to avoid this messy outcome by setting a fixed schedule for changing the reinvestment caps. If the market believes that the Fed will stick to this schedule, then the plan should work fine. The May minutes also showed that “nearly all policymakers” thought that it would be appropriate to begin the reinvestment process this year, as long as economic conditions do not deteriorate. While we still lack some important details, such as the Fed’s target for the ultimate level of reserves in the banking system, we now think it is very likely that these details will emerge at either the June or September FOMC meeting and that balance sheet run off will begin following either the September or December meeting. What The Fed Believes: Weak Q1 Growth Is Transitory Although the incoming data showed that aggregate spending in the first quarter had been weaker than participants had expected, they viewed the slowing as likely to be transitory.1 Even after last week's slight upward revision, at 1.2%, first quarter GDP growth came in well below its post-crisis average (Chart 2). However, a quick look at the major components of GDP reveals that the weakness was concentrated in consumer spending and the change in private inventories (Chart 2, bottom two panels). Growth contributions from residential and non-residential investment were actually considerably above their post-crisis averages, and the contributions from net exports and government spending were in-line with theirs (Chart 3). Chart 2The Consumer Was A Drag In Q1 Chart 3Investment Is A Bright Spot We know from history that large changes in inventories tend to mean-revert fairly quickly. In fact, we can model the inventory component of GDP growth based on the lagged change in inventories and the Backlog of Orders component of the ISM Manufacturing survey (Chart 4). Both of these factors suggest that inventories will bounce back strongly next quarter. In fact, the ISM survey shows the largest backlog of manufacturing orders since 2014. Likewise, weakness in consumer spending is unlikely to persist. The fundamental drivers of consumer spending all continue to paint a positive picture (Chart 5). Chart 4Big Backlog Of Orders Chart 5Consumer Spending Drivers: Part I Consumer confidence has hardly given back any of its post-election gains (Chart 5, panel 1). Personal income growth is already on the upswing, and income expectations point to further acceleration (Chart 5, panel 2). Employment is still growing at a reasonably robust pace, and the mild slowdown since early 2015 has been offset by stronger wage growth (Chart 5, bottom panel). Longer-run drivers of consumer spending are also solid. Households continue to accumulate wealth, and household leverage has returned to late 1990s levels. In other words, household balance sheets are the healthiest they have been since prior to the housing bubble (Chart 6). More broadly, indicators of overall GDP growth are also pointing toward an acceleration (Chart 7). The ISM Non-Manufacturing index increased to 57.5 in April from 55.2 in March, and the BCA Beige Book Monitor - an indicator based on the occurrence of certain keywords in the Fed's Beige Book2 - has gone vertical. It would be unusual for GDP growth to diverge from these two indicators for a prolonged period of time. Chart 6Consumer Spending Drivers: Part II Chart 7Overall Growth Indicators Bottom Line: Weakness in Q1 GDP was concentrated in consumer spending and inventories. Both of these components are likely to strengthen in the months ahead. The Fed is probably correct that weak Q1 growth will prove transitory. Recent Weak Inflation Readings Are Also Transitory Overall, most participants viewed the recent softer inflation data as primarily reflecting transitory factors, but a few expressed concern that progress toward the Committee's objective may have slowed.3 We dealt with the inflation outlook in last week's report,4 through the lens of our Phillips Curve inflation model. To recap, using our model we found it very difficult to craft a realistic set of economic assumptions that resulted in year-over-year core PCE inflation below 1.88% by the end of the year. In our base case economic scenario the model projects that core inflation will reach 2.11%. Because our model is based on one that Janet Yellen referred to in a 2015 speech,5 we assumed that the Fed would reach a similar conclusion with regards to the inflation outlook. Although it must be said that the May FOMC meeting occurred prior to the disappointing April CPI release, it is notable that the minutes from the May meeting say that only "one member view[ed] further progress of inflation toward the 2 percent objective as necessary before taking another step to remove policy accommodation." In other words, almost all Fed members are content to rely on Phillips Curve style inflation models, which suggest that inflation will rise in the near future, and are putting less weight on the current low level of actual inflation. Of course, that dynamic could change relatively quickly. Chart 8 shows the track record of our Phillips Curve model, and we can see that it is not unusual for large residuals - on the order of 0.5% - to persist for significant periods of time. This means that even if all of our forecasts of the independent variables in the model turn out to be correct, there is still a chance that actual inflation will not keep pace with the model. In light of current circumstances, one period in particular stands out. The period from late-1993 to mid-1994, denoted by the shaded region in Chart 8. Chart 8The Fed Still Believes In The Phillips Curve In that episode the fair value from our model suggested that inflation should trend higher. Instead, inflation fell quite sharply. Eventually the model's fair value also moved lower, driven by a declining contribution from the model's lagged inflation term,6 and also by falling inflation expectations. In our view, this latter point is particularly important. In 1993-94, the failure of inflation to keep pace with Phillips Curve forecasts eventually caused market participants to lose faith and revise their inflation expectations lower. In a worst case scenario, a large decline in inflation expectations can feed on itself, leading to a deflationary spiral from which the Fed would have difficulty escaping. Chart 9Inflation Expectations Are ##br##Tough To Measure The Fed is very worried about falling (or more specifically "un-anchored") inflation expectations. In her aforementioned 2015 speech,7 Chair Yellen cautioned that temporary fluctuations in import prices or resource utilization could lead to permanent changes in inflation if they also caused inflation expectations to shift. Also, the longer the Fed misses its inflation target, the more likely it is that inflation expectations will become un-tethered. This is a very real risk. For now, the FOMC continues to view inflation expectations as well anchored, although the May minutes showed that "some participants" expressed concern that "the public's longer-term inflation expectations may have fallen somewhat." One problem is that there is no perfect way to measure inflation expectations (Chart 9). Market-based measures of inflation compensation are well below levels that have been consistent with the Fed's 2% inflation target in the past (Chart 9, panel 1), but these measures are volatile and are often driven by market-specific factors unrelated to inflation expectations. Meantime, the inflation expectations of professional forecasters have been quite stable (Chart 9, panel 2), while the message from consumer inflation expectations is mixed (Chart 9, bottom panel). The University of Michigan consumer survey shows inflation expectations near an all-time low, but the New York Fed's survey shows them in an uptrend. In any event, the strong correlation between consumer inflation expectations and gasoline prices makes them questionable at best. Bottom Line: The Fed is content to rely on Phillips Curve inflation forecasts, and does not need to see actual inflation rise in order to lift rates. However, if inflation does not rebound as expected, the Fed will become increasingly concerned about falling inflation expectations and could adopt a more dovish reaction function later this summer. We think inflation will be strong enough to avoid this outcome and that the Fed is still on track for two more rate hikes this year. Financial Conditions Are Crucial [Some participants] noted variously that the decline in longer-term interest rates and the modest depreciation of the dollar over the intermeeting period would provide some stimulus to aggregate demand, that the Committee's recent policy actions had not resulted in a tightening of financial conditions, or that some of the decline in longer-term yields reflected investors' perceptions of diminished odds of significant fiscal stimulus and an increase in some geopolitical and foreign political risks.8 The above passage shows that the Fed believes that financial conditions lead growth, a result we have also shown in prior reports (Chart 10).9 In this context, the Fed would expect financial conditions to tighten as it lifts rates, eventually causing economic growth to moderate. If financial conditions fail to tighten it would suggest that monetary policy needs to become more restrictive, and vice-versa. Financial conditions tightened dramatically following the December 2015 rate hike (Chart 11) and the ensuing growth slowdown caused the Fed to postpone the next rate hike for 12 months. Then, financial conditions were relatively unchanged following the December 2016 rate hike, and this allowed the Fed to deliver another hike in March. The large easing in financial conditions since the March hike is telling the Fed that it needs to step up its pace. Chart 10The Fed Believes That Financial Conditions Lead Growth Chart 11A Big Easing Since March Ultimately, the Fed still needs inflation to increase. This means that it does not want financial conditions to tighten too much, and would likely prefer to keep the Chicago Fed's Adjusted Financial Conditions index below the zero line (Chart 11, top panel). A negative reading from the adjusted index signals that financial conditions are easy relative to the strength of the economy. That is, they should be sufficiently accommodative to allow the economic recovery to continue and cause inflation to rise. At the same time, levels that are deep in accommodative territory signal that the Fed can move more rapidly. Bottom Line: The Fed strongly believes that financial conditions lead economic growth. Absent any major changes in the economic data, the pace of rate hikes will be determined by the Fed's targeting of financial conditions. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 2 For further details on the BCA Beige Book Monitor please see U.S. Investment Strategy Weekly Report, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com 3 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 4 Please see U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers", dated May 23, 2017, available at usbs.bcaresearch.com 5 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 6 One of the independent variables in our model is a 12-month lag of the year-over-year change in core PCE inflation. The lagged inflation variable pressures the model's fair value toward the level of actual inflation. If no other variables change, then over time the lagged inflation variable will ensure that the model fair value converges toward actual inflation. 7 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 8 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 9 Please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy Downgrade communications equipment stocks to underweight. All three end-markets are weak and signal that profits will continue to surprise to the downside. Continue to avoid the electrical components & equipment index. Deficient demand warns that the profit down cycle is far from over. Recent Changes S&P Communications Equipment - Downgrade to underweight. Table 1Sector Performance Returns (%) Feature Equities broke out to new highs last week. The minutes from the latest FOMC meeting implied that it would take considerable economic strength for the Fed to tighten more than markets currently forecast. A reactive rather than proactive Fed raises the odds that the equity overshoot will persist, because it means monetary conditions will still support profits. A good part of this year's market advance has been concentrated in a small number of stocks, but that belies the breadth of the profit recovery. Net analyst earnings revisions have hit their highest level since the initial post-GFC surge. The number of S&P industry groups with rising earnings estimates has climbed above 80%, reflecting broad-based earnings upgrades. Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates (Chart 1). Evidence of a healthy earnings recovery is supported by our own Indicators. Of our ten sector pricing power gauges, seven are in positive territory. On a more granular basis, the majority of our 64 industry group pricing power proxies is also rising. This reflects increased global business activity and U.S. dollar depreciation. In terms of costs, six out of ten wage inflation proxies are decelerating, and more than 50% of our industry labor expense gauges are falling. As a result, seven out of ten of our broad sector profit margin proxies are in positive territory, i.e. pricing power is rising at a faster pace than wage inflation. Of the three in negative territory, two are easing in intensity, i.e. margin pressures are diminishing. These profit trends will support stocks, at least until they generate economic overheating and by extension, a more restrictive Fed. Thus, the good news for bulls is that financial conditions will remain sufficiently easy to sustain a durable profit recovery (see Chart 1 from last week's Report), so much so that investors are lengthening their time horizons. Evidence of the first synchronized global expansion in years and the ability of regional economies to bounce back from a headline risk, such as Brexit, have boosted conviction in the sustainability and strength of long-term earnings growth: analyst 5-year earnings growth forecasts are being steadily upgraded. History shows that as long as economic tail risk remains on the back burner, then valuations can camp out in overshoot territory, as occurred in the second half of the 1990s (Chart 2). To be sure, nosebleed valuation levels underscore that the rally is in a high risk phase and virtually guarantee paltry long-term returns. Still, timing pullbacks is notoriously difficult. We follow a checklist of five reliable indicators that should provide a helpful timing tool. Emerging market currencies have weakened prior to or coincident with U.S. stock market corrections (Chart 3). Exchange rate depreciation in these high beta economies is emblematic of growth disappointment, fears of capital flight and/or risk aversion. At the moment, our proxy of EM currencies is accelerating. Chart 1Buoyant Breadth Bodes Well Chart 2Long-Term Profit Conviction Is Driving Multiples Chart 34/5 Lights Flash Green Corporate bond spreads, both in the U.S. and emerging markets, have also widened coincident with, or in advance of, meaningful equity setbacks (Chart 3). So far, spreads remain tight in both regions, suggesting minimal concerns about debt servicing capabilities. In addition, bullish individual investor sentiment has also eclipsed the 60% zone in advance of the two largest post-GFC drawdowns. Individual investors are currently upbeat, but are not yet frothing bulls, according to the latest survey data (Chart 3). Of the five checklist items, the behavior of the yield curve is the most disconcerting. The curve has narrowed considerably in recent weeks, and is closing in on the pre-U.S. election lows as inflation expectations recede (Chart 3). If real long-term yields do not soon advance and confirm the profit/economic recovery narrative, then the odds of an imminent corrective phase will ratchet higher. In sum, the overshoot should remain intact for a while longer. But we continue to recommend a barbell portfolio rather than one with excessive beta, favoring select defensives and early cyclical sectors such as consumer discretionary and financials given the lack of economic confirmation from the bond market. This week we highlight two exceptions to the generally bullish profit backdrop, which reinforces that selectivity remains critical to portfolio construction. A Weak Signal From Communications Equipment: Downgrade To Underweight Communications equipment stocks have diverged negatively from the broad tech sector and have also trailed the broad market. Instead, this small corner of the tech industry moves with the ebb and flow of telecom carrier stocks - a key end-market, with a slight lag (top panel, Chart 4). The latest signal from telecom services stocks is bearish, and we recommend a downgrade to a below-benchmark allocation in the S&P communications equipment group. While the share price ratio has lost ground and valuations look compelling (Chart 4), the risks of further near-term losses and a longer-term value trap remain high. Technical conditions are still far from previously extreme washed out levels. In fact, the overbought conditions' unwind is recent and there is ample downside left before a full capitulation materializes (middle panel, Chart 4). Worryingly, all three key communications equipment end-markets point to additional weakness in the coming months. Telecom carrier outlays have hit a wall. Telecom providers are at each other's throats and a full blown price war has engulfed the industry. This is outright deflationary, and telecom services pricing power has contracted at a double-digit rate during the past three months (bottom panel, Chart 5). In the absence of revenue growth, telecom capex is unlikely to reaccelerate. U.S. telecom facilities construction and communications equipment new order growth move in lockstep (second panel, Chart 5). Both have collapsed on a short-term rate of change basis, warning that communications equipment demand is soggy. Tack on the quickest industry inventory accumulation since 2011 (third panel, Chart 5), a soft order backlog (not shown), and the industry sales growth outlook has darkened even further. Overall corporate outlays are also soft. While a capex upcycle looms and some capital will inevitably flow to the communication equipment industry (middle panel, Chart 6), anemic C&I loan growth (an excellent proxy for broad corporate health, not shown) is a yellow flag. Chart 4Value Trap Chart 5Weak Telecom Segment Capex... Chart 6...Aggravates The Sales Risk Moreover, enterprise spending has not been concentrated on communications equipment gear for years, as the industry has been unable to gain any share of total corporate investment. The implication is that any business sector uptick is unlikely to match the pressure stemming from the telecom services sector. The government segment represents another source of drag. True, a global move away from austerity is a plus, but delays/uncertainty with regard to U.S. fiscal policy is a sizeable offset. In fact, U.S. government spending as a percentage of output is in decline (not shown) and the Trump administration's strict budget control warns that the government's purse strings will remain tight for some time. Finally, export markets are unlikely to offset domestic cooling. While the cheapened U.S. dollar should boost U.S. communication equipment manufacturers' competitiveness, China's global networking ascendancy and Europe's recent V-shaped export recovery suggest that U.S. gear providers are losing market share (Chart 7). All of this paints a grim picture for communications equipment sales. As such, cyclically stretched operating margins are at risk (Chart 8). Industry productivity growth has crested, and is likely to recede because slowing new orders and rising inventories imply reduced output. The implication will be profit margin pressure and a return on equity squeeze (middle panel, Chart 8). While the industry constantly realigns headcount to the challenging operating environment, a sustainable profit turnaround requires a demand driven rebound. Chart 7U.S. Manufacturers Are Losing Market Share Chart 8Beware A Margin Squeeze Meanwhile, industry specific forces will also contribute to margin pressure. Five years ago, Cisco's CEO dismissed the nascent virtual networking threat. However, today, virtual networking is a deflationary reality. Such intense deflationary pressure is a clear profit negative and warns that relative EPS are headed south (Chart 8). Bottom Line: The S&P communications equipment index is breaking down. Trim exposure to below benchmark. The ticker symbols for this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV. Electrical Components & Equipment Are Out Of Power The niche S&P electrical components & equipment (ECE) industrials sub-index has marked time since our late-November downgrade to underweight. Our bearish thesis remains intact. Cyclical momentum has sputtered after the relative share price ratio failed to sustain its post-U.S. election euphoria. Valuations remain dear, with the forward P/E ratio trading at a 15% premium to the broad market (bottom panel, Chart 9). If profits continue to disappoint, as we expect, then a de-rating phase is inevitable. ECE companies garner roughly half of their sales from abroad. Thus, the U.S. dollar's fluctuations are inversely correlated with relative share prices. Delayed translation effects from the U.S. dollar's large run-up last year should continue to weigh on profits, and offset the European and emerging market economic recoveries. Worrisomely, there is a wide gap between relative performance and the greenback. If history rhymes, then a convergence phase is likely with the relative share price ratio deflating closer to the level predicted by the U.S. dollar (currency shown inverted, top panel, Chart 9). Domestically, news is equally grim. Investment spending on electrical equipment remains moribund: outlays are contracting in absolute terms and continue to trail overall investment. Historically, the industry's new orders-to-inventories ratio has been closely correlated with relative outlays and the current message is bleak (bottom panel, Chart 10). Chart 9No Reasons To Pay For Premium Valuations Chart 10No Reasons To Pay For Premium Valuations Importantly, the surge in ECE inventory growth and deceleration in backlog growth point to pricing power pressure in the coming months. Chart 11 shows that a rising wage bill and anemic pricing power have squeezed our industry margin proxy. In terms of industry productivity, gains have given way to losses, according to our gauge. This suggests that profits will continue to languish (middle panel, Chart 10). Tack on the slump in weekly hours worked, and there is cause to doubt recent sell side analyst optimism (bottom panel, Chart 11). A demand-driven increase in revenues/backlogs is needed to reverse the industry's profit fortunes. However, our relative EPS model is forecasting the opposite: profits will continue to underwhelm and trail the broad market into the back half of the year (Chart 12). Chart 11Lean Against Analysts' Exuberance Chart 12EPS Model Says Sell Against this backdrop, we remain reluctant to pay a premium valuation to own an industry with an uncertain, at best, earnings profile. Bottom Line: While we are neutral on the broad industrials sector, we continue to recommend underweight exposure in the S&P electrical components & equipment index. The ticker symbols for the stocks in this index are: BLBG: S5ELCO - EMR, ETN, ROK, AME, AYI. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights Business capital spending is still trending up, adding another layer of support for the U.S. economy in the next 6-12 months. Profit growth has accelerated at a faster pace than our top-down model had projected and we expect growth to accelerate further into year end. We estimate that the delayed pass-through of previous dollar strength will remain a slight drag on U.S. EPS growth over rest of 2017. Our tactical view on gold remains bearish, but the BCA Commodity & Energy Strategy service sees strategic value in gold as a hedge. Feature The S&P 500 is attempting to break through the 2400 barrier as we go to press. This is impressive given that the flagging relative performance of infrastructure stocks and highly-taxed companies suggests that investors have given up hope of ever seeing significant tax cuts, infrastructure spending and incentives for capital spending. As we discuss below, disappointment on the policy front has thankfully been offset by solid corporate earnings figures. We believe that investors have gone too far in pricing out tax reform. True, the growing number of White House scandals will serve to delay the GOP's market-friendly policy agenda. Nonetheless, the President desperately needs a win ahead of mid-term elections, and tax reform and deregulation are two key areas where the President and congressional Republicans are on the same page. Capital spending is the part of the economy that could benefit the most from tax reform. Surprising Support From Capex Business capital spending is still trending up, adding another layer of support for the U.S. economy in the next 6-12 months. The post-election rollover in C&I loan growth worried investors that rising rates and election-related uncertainty had cut the flow of credit to the business sector, thus putting capex at risk (Chart 1, top panel). That concern was overdone, as we pointed out in a recent report.1 Business expenditures on plant, equipment and software were a surprising source of strength in first-quarter GDP, and bank lending has stabilized in the past six weeks. The FOMC minutes of the May 2-3 meeting noted that "financing conditions for large nonfinancial firms stayed accommodative." The minutes also stated that, while there was weaker demand for C&I loans in April, the weakness "pertained to customers' reduced needs for financing." The reduced need likely reflected a preference to issue corporate bonds. Chart 1Outlook For Capex Looks Solid Our BCA Capex indicator for business investment points to solid business spending in the next few quarters. (Chart 1, bottom panel) Our past research shows that sustainable capital spending cycles only get underway when businesses see evidence that consumer final demand is on the upswing. While consumer expenditures were quite soft (+0.3% annualized gain) in Q1, our view is that the weakness was transitory.2 This view was confirmed by the FOMC minutes. A rebound in consumer spending in the second quarter will boost CEO confidence that increased capital spending will be justified in terms of future sales. Our base case is that at least some tax cuts will be enacted by year end, but the risk is that political turmoil further delays a fiscal package or even totally derails the GOP legislative agenda. This scenario would be negative for stocks temporarily, but could end up being positive over the medium term by extending the expansion in the economy and corporate profits. U.S. Profits, Beats And Misses Profit growth has accelerated at a faster pace than our top-down model had projected earlier this year (Chart 2). On a 4-quarter moving total basis, S&P 500 earnings-per-share were up by more than 13% in the first quarter (84% reporting). We expect growth to accelerate further into year end, peaking at just under 20%, before moderating in 2018. The favorable profit picture reflects two key factors. First, profits are rebounding from a poor showing in 2016, when EPS was dragged down by the collapse in oil prices and a global manufacturing recession. Oil prices have since rebounded and global industrial production is recovering as expected (Chart 3). Earnings are of course leveraged to corporate sales, helping to explain why profits are highly correlated with industrial production in the major countries. BCA's U.S. Equity Strategy service estimates that operating leverage for the S&P 500 is 1.4x.3 Chart 2Impact Of Stronger Dollar Is Fading Chart 3IP On The Rebound Globally Second, the corporate sectors in the major economies are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. This is the case even in the U.S., where labor market slack has largely been absorbed. Indeed, margins rose in Q1 2017 for the third quarter in a row. Our indicators suggest that the corporate sector has gained some pricing power at a time when wage gains are taking a breather.4 The hiatus of wage pressure may not last long, but for now our short-term EPS growth model remains upbeat for the next 3-6 months (not shown). What About The Dollar? We estimate that the delayed pass-through of previous dollar strength will remain a slight drag on U.S. EPS growth of about one percentage point for the remainder of this year, assuming no change in the dollar from today's level (Chart 2, second and third panels). However, our base case remains that the dollar will appreciate by another 10% in trade-weighted terms. A 10% appreciation would trim EPS growth by roughly 2½ percentage points, although most of this would occur in 2018 due to lagged effects. The key point is that another upleg in the dollar, on its own, should not provide a major headwind for the stock market. Indeed, the dollar would only be rising in the context of robust U.S. economic growth and an expanding corporate top line. Even though the message from our EPS model is upbeat, it still falls short of bottom-up estimates for 2017. Is this a risk for the equity market, especially since valuations are stretched? Investors are well aware that bottom-up estimates are perennially optimistic. Table 1 compares the beginning-of-year EPS growth estimate with the actual end-of-year outcome for 2007-2016. Not surprisingly, bottom-up analysts massively missed the mark in 2008, which was a recession year. But even outside of the recession, analysts significantly over-estimated earnings in seven out of nine years. Despite this, the S&P 500 rose sharply in most cases. One exception was 2015, when the S&P 500 fell by 0.7%. Plunging oil and material prices contributed to an EPS growth "miss" of seven percentage points. Chart 4 highlights that the level of the 12-month forward EPS estimate fell that year, unlike in the other years considered. Valuations are more demanding today than in the past, but the message is that attaining bottom-up EPS year-end estimates is less important for the broad market than the direction of 12-month forward estimates (which remains up at the moment). Table 1Bottom Up Estimates Are##BR##Always Too Optimistic Chart 4Oil Related##BR##Dip In 2015 The bottom line is that the backdrop is constructive for equities even if the Republicans are unable to push through any fiscal stimulus. In fact, it may be better for the stock market in the medium term if the GOP fails to pass any meaningful legislation. The U.S. economy does not need any demand stimulus at the moment (although measures to boost the supply side of the economy would help lift profits over the long term). The current long-in-the-tooth expansion is likely to stretch further in the absence of stimulus, extending the moderate growth/low inflation/low interest rate backdrop that has been positive for risk assets in recent years. Gold Update Our tactical view on gold remains bearish, but the BCA Commodity & Energy Strategy service sees strategic value in gold as a hedge against rising inflation and inflation expectations, geopolitical risk and increased equity volatility.5 Chart 5A shows that the price of gold in real terms is still very expensive. On a nominal basis, gold is at the top end of a trading channel that it has been in since early 2012 (Chart 5B). There has been a big gap between the model value and the actual price of gold for the past three years. The real price of gold remains elevated despite the fact that inflation has been well contained.6 Chart 5AModel Suggests Gold Is Overvalued Chart 5BIn A Downward Channel Since 2012 Our 6-12 month view on gold is that it will take its cues from Fed policy and policy expectations. The Fed is not behind the curve on inflation, and inflation expectations and measured inflation remain low. Our CPI and PCE models (Chart 6) show only a modest acceleration in inflation by year end, just enough to keep the Fed on track this year as it begins to shrink its balance sheet and raise rates two more times. Thus, we do not see a great need to hold gold as a hedge against inflation over the next year. Nonetheless, for those investors concerned about a pullback that turns into a correction or a bear market, we mention that gold has a 33% weight in our Protector Portfolio.7 Chart 6Core Inflation To Stay Near##BR##Fed's Target This Year Bottom Line: Gold is expensive in real terms relative to a set of fundamentals that have explained its real price since 1970. However, the yellow metal may have value on a strategic basis or as part of a portfolio designed to protect against falling equity prices. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "Earnings Rebound Will Earn Some Respect", April 10, 2017. Available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Growth, Inflation And The Fed", May 8, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?," published April 17, 2017. Available at uses.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?," published April 24, 2017. Available at usis.bcaresearch.com. 5 Please see Commodity & Energy Strategy Weekly Report, "Go Long Gold As A Strategic Portfolio Hedge," published May 4, 2017. Available at ces.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report, "Gold: The Asset Allocation Dilemma," published August 1, 2011. Available at usis.bcaresearch.com. 7 Please see U.S. Investment Strategy Weekly Report, "Still Awaiting The Next Pullback," published May 15, 2017. Available at usis.bcaresearch.com.