Developed Countries
The financial sector is regaining some momentum after this year's consolidation, and the S&P asset management and custody bank (AMCB) index has the potential to take a leadership role. AMCB remains one of the most undervalued of all the financial sector groups, even though its main profit drivers are experiencing a synchronized improvement. There is a budding shift from bond to equity products, which should gather steam based on the steady improvement in global economic sentiment, as measured by the stock-to-bond ratio (second panel). The latter is already supporting strong M&A activity and a surge in margin debt to new highs. Both of these factors suggest that AMCB earnings drivers are accelerating. The bottom line is that the undervalued AMCB index has significant catch-up potential, especially if interest rate expectations stabilize near current levels. Stay overweight. The ticker symbols for the stocks in the S&P asset manager & custody banks index are: BLBG: S5AMGT-BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ, AMG.
Highlights Lean against depressed and euphoric interest rate expectations. The ECB will remove or fade the negative deposit rate, with an outside chance that it happens this year. The U.K. economy will determine the nature of Brexit - not the other way round. The snap General Election doesn't change anything. Expect an ongoing narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. Expect the following order of currency performance: euro first, pound second, dollar third. Expect the FTSE100 to outperform the Eurostoxx50. Feature The interplay between interest rate expectations - in the U.K., U.S. and euro area - is one of the most important factors in explaining what has happened, what is happening, and what will happen, to financial markets. Chart of the WeekBrexit Depression Has Unwound; ##br##Trump Euphoria Hasn't... Yet Interest rate expectations convincingly explain the movements in the U.S. T-bond/German bund yield spread, the U.S. T-bond/U.K. gilt yield spread, euro/dollar, and pound/dollar. Thereby, they also explain FTSE100/Eurostoxx50 relative performance which is just an (inverse) currency play. Chart I-2, Chart I-3, Chart I-4, Chart I-5 and Chart I-6 should leave readers in absolutely no doubt. Chart I-2Interest Rate Expectations Explain The ##br##T-Bond/German Bund Yield Spread Chart I-3Interest Rate Expectations Explain The##br## T-Bond/U.K. Gilt Yield Spread Chart I-4Interest Rate Expectations ##br##Explain Euro/Dollar Chart I-5Interest Rate Expectations##br## Explain Pound/Dollar Chart I-6Pound/Euro (Inversely) Explains ##br##FTSE100/Eurostoxx50 Lean Against Depressed And Euphoric Interest Rate Expectations Last year's shock victories for Brexit and Trump dramatically swung the market mood towards the U.K. and U.S. economies. After Brexit, the knee-jerk response was depression; after Trump, the knee-jerk response was euphoria. But extreme mood swings to depression and euphoria are rarely justified, and ultimately tend to unwind. Responding to last year's dramatic mood swings, U.K. and U.S. interest rate policy - both actual and expected - moved very sharply in opposite directions. Following the Brexit vote, the BoE cut the base rate by a quarter percent, and the rate expected two years out plunged by three quarters of a percent. In contrast, following the Trump victory, the Federal Reserve twice hiked the Fed funds rate by a quarter percent, and the rate expected two years out surged by more than a percent. Meanwhile, throughout all this activity, the ECB repo rate and deposit rate were anchored at zero and -0.4% respectively, and the interest rate expected two years out remained in negative territory. Fast forward to today, and the U.K. interest rate expected two years out has fully unwound the Brexit vote depression - the expected BoE policy rate two years out stands exactly where it stood before the EU Referendum. In contrast, the expected Fed policy rate two years out retains its Trump euphoria (Chart of the Week). Meanwhile, the expected ECB policy rate two years out remains anchored close to the realistic limit of negativity. To reiterate, the extreme market moods of depression and euphoria are rarely justified, and tend to unwind. On this basis, we can say that policy rate expectations in relative terms now have the scope to: Get less depressed in the euro area. Remain broadly unchanged in the U.K. Get less euphoric in the U.S.1 Hence, on a 12-month horizon, expect a continued narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. For currencies, expect the following order of performance: euro first, pound second, dollar third. And therefore, expect the FTSE100 to outperform the Eurostoxx50. Brexit: A Reductionist View Many millions of words have been written about Brexit, and we suspect that many millions more will be written. But true to our reductionist philosophy, we can reduce those millions of words to a single sentence. Brexit was, is, and always will be, about the trade-off between national sovereignty and access to the European single market. Irrespective of the vote to leave the EU and the start of the divorce proceedings, the full spectrum of possibilities in this trade-off is still open to the U.K. At one extreme the U.K. could get a full divorce, and thereby regain absolute national sovereignty in all areas including law and immigration. But in this full divorce, the EU27 would regard the U.K. as a complete outsider whose status is little different to say, Russia. At the other extreme, the U.K. could near enough replicate its current economic and political relationship with the EU27 in a 'pseudo-marriage'. Technically, the U.K. would be divorced, but practically, there would be only minor differences to being married. Although the U.K. would lose its official place at the EU top table, in all likelihood the EU27 would still listen to the British voice given the U.K.'s size and global standing. But in this pseudo-marriage the EU27 would exact a cost: the U.K. could not regain any national sovereignty. All points on the spectrum between a full divorce and a pseudo-marriage are now available to the U.K. The relationship that the U.K. ends up with depends on the trade-off that the British public - and therefore its political representatives in the government and parliament - will accept. In turn, this will depend on the evolution of the economy and standards of living. A strong economy will embolden the British public to want something close to a full divorce. Conversely, a weakening economy might be blamed, rightly or wrongly, on Brexit. In which case, public opinion would shift towards something closer to a pseudo-marriage. Therefore, the causality runs from the economy to Brexit, not from Brexit to the economy. The U.K. economy will determine where the U.K. ends up on the Brexit spectrum - at least, in terms of the initial deal. The snap General Election doesn't change anything. Nor is the General Election a game changer for the pound. The preceding section demonstrated that relative interest rate expectations - rather than Brexit per se - are driving the pound. We expect the BoE to remain relatively inactive because empirically, U.K. real consumption is hyper-sensitive (inversely) to inflation. When inflation is too high, real consumption growth is undermined, making it difficult to hike rates; and when inflation is too low, real consumption tends to grow strongly, making it difficult to cut rates (Chart I-7). This ties the hands of the BoE, and explains why the post EU Referendum emergency rate cut has been the BoE's only interest rate change since early 2009! Chart I-7Why The Bank Of England's Hands Are Tied While rate expectations can get less depressed in the euro area, and less euphoric in the U.S., they are likely to change least in the U.K. Hence, we like the pound less than the euro; but we like the pound more than the dollar. Role Playing On The ECB Governing Council We are writing ahead of the ECB policy meeting, but we do not anticipate any substantive announcements - given that we are only half way through the French Presidential Election. In the absence of major developments, the euro's strong recent advance might take a tactical breather. But what then? Some people argue that ECB policy should be based not on the aggregate euro area economy, but instead on the weaker links in the euro area economy. These arguments have some merit, as the ECB - unlike other central banks - has to contend with a permanent existential threat. On this basis, let's finish this week with a role playing exercise. Imagine you're on the ECB Governing Council, and the weak link that worries you is euro area bank fragility, particularly in some of the southern member states. Your own (ECB) analysis, illustrated in Chart I-8, shows that extreme accommodative monetary policy has had a negligible net impact on bank profitability. The QE component has probably been a mild net positive - admittedly, a flatter yield has dragged down banks' net interest margins; but it has also generated profits in banks' bond portfolios; and in so far as QE has boosted economic growth, it has reduced bank charge-offs. Chart I-8What Is The Point Of The ECB's Negative Deposit Rate? But the negative deposit rate - charging banks for excess liquidity - has been a clear drag on bank profitability. And there is little evidence that it has encouraged lending. What would you do? Even if the ECB is setting policy for the euro area weak links, the central bank's own analysis suggests that it should remove, or at least fade, the negative deposit rate. Our central expectation is for this to happen early next year, with an outside chance that it is even sooner. With expectations for ECB policy rates still anchored close to the realistic limit of negativity, the euro exchange rate has cyclical upside. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Assuming that the U.S. government does not approve inappropriate fiscal stimulus. Fractal Trading Model* This week's trade is to go long the FTSE100 versus the IBEX35 with a profit target and stop loss of 4%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Markets will survive late spring and summer unscathed; Macron will win the French election; Trump's agenda is not going down in flames; U.K. snap polls support our sanguine view on Brexit; Fade the rally in Treasuries and bet against unwinding of Trump reflation; Stay tactically long EUR/USD, long the pound, and long French industrials vs. German. Feature One of the oldest adages of Wall Street is to "sell in May and go away." Data reinforce the conventional wisdom, with a strategy of staying on the sidelines during the summer months clearly outperforming the alternative of staying long every month (Chart 1). Chart 1Sell In May And Go Away Should investors adopt the same approach in 2017? Certainly the risks are skewed to the downside due to investor complacency and a busy political schedule: Complacency: Investor complacency has been spectacularly elevated ahead of Q2 this year. Our colleague Anastasios Avgeriou of BCA's Global Alpha Sector Strategy, who has been flagging warning signs since early February, lists four measures of complacency that peaked in April (Chart 2).1 The SKEW index, controlled for by the VIX, rose above 12 early in April, warning that at least a tactical pullback is at hand. The Yale U.S. one year institutional confidence index hit an all-time high of 98.68% in February. Similarly, the Minneapolis Fed's market-based probability of a 20%+ correction in the S&P 500 dropped to below 10%, a level last seen during the peak of the previous bull market in 2007 (bottom panel).2 Political Schedule: April and May have an unusually high number of high-profile deadlines, meetings, and elections packed into a tight space: April 26: U.S. President Donald Trump is expected to announce key details of his long-awaited tax reform plan; April 28: The U.S. government's stopgap funding measure, the continuing resolution, will expire - leading to a government shutdown if no replacement is passed; April 29: The EU Council will hold its "Brexit Summit" to either approve, amend, or reject Council President Donald Tusk's proposed negotiation guidelines;3 May 7: The second round of the French presidential election will be held; May 9: An extraordinary presidential election will take place in South Korea; Mid-May: U.S. President Donald Trump will present his full budget proposal, including tax plans, spending cuts, and growth projections; May 19: Iran holds its presidential election; May 25: The OPEC meeting in Vienna will determine whether to extend the current production-cut agreement. In this Weekly Report, we focus on the three most immediate risks to the markets: the second-round of French presidential election, U.S. domestic politics, and the upcoming election in the U.K. We will also address downside risk to oil prices in an upcoming joint report, to publish tomorrow, with BCA's Commodity & Energy Strategy. Our conclusion is that while risks are indeed skewed to the downside by the mere combination of investor complacency and volume of potential tail-risks, the market will likely emerge from the summer doldrums unscathed. As such, any market downturns are an opportunity to buy on dips. As we recently warned, however, the real risks will emerge in 2018.4 France: Fin? Centrist Emmanuel Macron has won the first round of the French presidential election with a narrow victory over nationalist Marine Le Pen (Table 1). As expected, the two will now contest the second round on May 7. France will subsequently hold a two-round legislative election on June 11 and 18. Chart 2Complacency At A Peak Table 1France: First-Round Election Results Investors learned three things from the first round of the French presidential election: Polls are right: Repeat after us: polls are not wrong, pundits are.5 Neither the Brexit referendum nor the U.S. presidential election came as a huge surprise to those who read polls objectively. In both cases, the outcome was inside the margin of error. Hopefully, the first round of the French presidential election will set aside the notion that all polls are useless and therefore investors are better off interpreting chicken entrails for election forecasting. In fact, polls in France have not significantly underestimated Marine Le Pen's nationalist party - Front National - since the 2002 election (Chart 3). Le Pen has no momentum: Le Pen consistently polled in the high 20s throughout late 2016 and 2017, but ended with only 21.43% of the vote on April 23 (Chart 4). In fact, she only narrowly improved on her 2012 performance of 17.9%, which is astounding considering everything that has happened in France since then (terrorist attacks in particular). Macron has meanwhile nearly doubled his polling from late 2016. French voters are angry: Protest and anti-establishment candidates came away with 49.62% of the vote (Chart 5). Chart 3FN Rarely Outperforms Its Polling Chart 4Le Pen's Momentum Is Gone Chart 5French Voters Are Angry... What to make of these three lessons? First, if lessons A and B are correct, then Le Pen is toast on May 7 (Chart 6).6 According to a poll conducted from April 17 to 21, Le Pen will struggle to get any voters from Mélenchon and Socialist candidate Benoît Hamon (Chart 7). This should not be surprising to anyone who knows France and its history: the left and the right just do not get along. We construct a "Le Pen best case scenario" out of the data by giving her all the voters who said they would abstain in the second round. Let's say that they were lying and are secret Le Pen supporters. She still loses (Chart 8)! Chart 6...But Not That Angry Chart 7Most Voters Will Swing To Macron Chart 8The No-Shows Can't Win It For Le Pen But surely a major terrorist attack could turn it around for Le Pen, right? Wrong. Macron is not pro-terrorist. Why would the French turn to a Russian-financed nationalist with no clear plan on how to prevent terrorism or stop refugee flows into Europe other than to close French borders?7 (And that description is not fake news!)8 They wouldn't. And there is empirical evidence to prove that French voters see through Le Pen's empty rhetoric. We highly recommend our clients read our February report titled "The French Revolution" where we conducted a careful study of the 2015 December regional elections.9 These elections occurred only 23 days following the November 2015 terrorist attacks in Paris and at the height of that year's migration crisis. It was as if the fates conspired with Le Pen's Front National (FN) to create a perfect storm. And yet the election was a crushing loss for the nationalists who came away with nothing in the second round. Chart 9French Public Supports The EU And Euro But hold on a minute. Are the French really about to elect a former investment banker for president even though 50% of them are "angry," as suggested by our lesson C? Well, yes. The "anger" is complicated. Mélenchon received a lot of the disgruntled Socialist Party voters who jumped the Hamon ship after it sunk during the latter's woefully uninspiring debate performances. These are not hard-core Euroskeptic voters. In fact, both Mélenchon and Le Pen moderated their Euroskepticism in the run up to this election to broaden their base of support. Le Pen promised that she would abide by the results of a referendum on the EU even if it went against her will, as polls currently suggest it would (Chart 9). And Mélenchon suggested that exiting the EU would only be his "Plan B," in case his plan to renegotiate the Treaty of the EU failed. What should investors expect of a Macron presidency? While the "French Thatcherite" François Fillon may have been more welcome to the markets than Macron, we think that a combination of President Macron and right-leaning National Assembly could accomplish some reforms. Polling for the legislative elections in June is scarce, but Le Pen's party is highly unlikely to outperform Le Pen herself. Judging by the December 2015 regional elections and Fillon's pre-scandal polling, the center-right Les Républicains are likely to win at least a plurality of seats in the legislative elections. Several prominent center right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister.10 This is highly positive for the markets as it means that French economic policy will be run by the center right, with an ultra-Europhile as president. Bottom Line: Nothing is over until it is over. Le Pen obviously still has a chance to win given that she is one of the two people running in the French election. However, given current polling, Macron is highly likely to become the next president of France. Hold tactical long EUR/USD and strategic long French industrial equities / short German industrial equities. But start thinking about closing long euro positions. The U.S.: From Math To Magic There are three reasons for global investors to worry about U.S. politics at the moment: Government shutdown: The U.S. government will face a shutdown on April 28 if the continuing resolution (CR) is not extended (via another CR) or if an omnibus funding bill is not passed. The risk for investors is that Senate Democrats could filibuster an omnibus bill that contains a conservative "poison pill" such as funding the wall on the border with Mexico or defunding Planned Parenthood. This would result in a partial government shutdown. Our view is that there is no time to find a long-term solution and the Republicans will have to extend current spending levels via short-term CRs, possibly until the end of the fiscal year on October 1. Given that the government has already been funded for half of the current fiscal year via short-term CRs, it may be the only way that Republicans can avoid a showdown with Democrats in the Senate. Obamacare repeal and replacement: The Senate and the House passed a budget resolution on January 13 that included "reconciliation instructions" allowing for the repeal of Obamacare in an eventual reconciliation bill.11 The reconciliation procedure allows measures that impact government spending and revenue - budgetary matters - to pass through Congress with a simple majority, i.e. without the need for 60 votes to defeat a filibuster in the Senate.12 These instructions are believed to "expire" at the end of May or thereabouts, giving Republicans one more month to replace Obamacare without causing greater traffic jams down the road.13 There are two hurdles to this process. First, the Tea Party-linked "Freedom Caucus" opposed the original Obamacare proposal and needs to be placated with provisions that may put off centrist Republicans in the Senate. Second, both the original Paul Ryan plan and the soon-to-be-revealed alternative are likely to be challenged by the Democrats under the reconciliation rules.14 Trump at first appeared willing to walk away from repealing Obamacare - which seemed to make sense given that the bill he endorsed imposes a roughly $700 billion burden on U.S. households (Chart 10). However, he has since decided that he needs the bill's roughly $320 billion in savings over ten years in order to pay for the "hyuge" tax cuts he has promised.15 Tax reform: Also coming into focus in April and May is tax reform. The White House is set to release key tax-reform details as we go to publication. Further, Trump has to deliver his full FY2018 budget in mid-May. Unlike the budget Trump released in mid-March, the May edition will include the tax proposals, measures on "mandatory" or entitlement spending, and growth projections. Concurrently, Congress has to start working on its budget resolution for FY2018, which, as mentioned, will enable using reconciliation to pass the tax bill with a mere 51 votes in the Senate. Again, the Freedom Caucus is a potential hurdle. Investors fear they will demand that any tax bill be strictly revenue neutral and thus foul up the legislative process. Chart 10Obamacare Repeal Hits Households Confused yet? You are not alone! We have noticed from client meetings and the financial media a growing obsession with details of upcoming reforms and the arcane congressional rules that will govern the legislative process. This is a mistake. Investors should step back and focus on the big picture: Trump is an economic populist who wants to see a higher rate of nominal GDP growth; Republicans are a party that favors tax cuts; Legislative rules are meant to be broken. As such, the key question is whether President Trump can bend the will of the Freedom Caucus, which plays the role of the antagonist in his efforts to clear all three hurdles listed above. We have no reason to believe that he cannot. In fact, all signs are pointing to the Freedom Caucus playing ball with the White House: Rhetoric has changed: Mark Meadows (R- North Carolina), Chairman of the Freedom Caucus, has confirmed that he is not demanding revenue-neutral tax reform plan and that he is open to a compromise on Obamacare. The Freedom Caucus is reportedly getting closer to accepting a health-care bill that passes the deadly issues to the states, allowing state legislatures to make their own decision on whether to remove the most popular regulatory requirements of Obamacare. Politically, this is a brilliant move. It allows both the Tea Party and moderate Republicans to declare victory by claiming that they upheld "state rights" - a core conservative principle - while giving conservative governors and state legislatures the option of eroding Obamacare at a state level. Moderates in the Senate, the theory goes, will not have to shoot down the new health bill for fear of a popular backlash since they presumably reside in states that will opt to keep the Obamacare measures in question (essential health benefits, community ratings, etc). The bill is by no means guaranteed to pass, but the point is that the Freedom Caucus has changed its tune after having been blamed for failing to repeal Obamacare, when repeal was one of the main reasons they were elected in the first place. Trump retains political capital: President Trump's polling with Republican voters has improved since the strike against Syria (Chart 11). He retains political capital with GOP voters and is therefore still a threat to the Freedom Caucus if he should campaign against them in the 2018 midterm primaries. The electoral threat is real: The Tea Party-favored candidate in Georgia's special election on June 20, Bob Gray, came in third place with just over 10% of the vote.16 Notably, a Trump-linked super PAC fielded campaign ads against Gray, helping propel the moderate candidate - Karen Handel - to the run-off against the Democratic challenger. While the media has obsessed about the surprise performance by Jon Ossoff, the first Democrat to make the district competitive since 1978, we are certain that House Freedom Caucus members have taken notice of Gray's fate. The message from the White House is clear: don't mess with Donald Trump. Trump will use carrots as well as sticks with the Freedom Caucus. To that end, we wish to remind our clients of "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 loss of tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, consequences that actually add to revenues. In other words, "tax cuts pay for themselves." Republican legislators have been using dynamic scoring to justify deficit-busting tax cuts for decades. And there is some truth to their claim that tax cuts generate revenue. For instance, while it is true that President Bush's White house vastly overestimated the U.S.'s long-term revenue when it oversaw major cuts in 2001-3, nevertheless revenues did ultimately go up over the ten-year period - contrary to the Congressional Budget Office's estimates at the time (Chart 12). Various studies suggest that Republicans could use a variety of growth models to write off about 10% of the cost of their tax cuts (Chart 13). And we are being conservative in those numbers. Chart 11Trump In Line With##br## GOP Predecessors Chart 12Bush Was Right,##br## CBO Was Wrong! Chart 13Dynamic Scoring Will Offset About 10% ##br##Of Revenues Lost To Tax Cuts Treasury Secretary Steven Mnuchin was anything but conservative when he explicitly told investors to expect a tax reform plan paid for largely by dynamic scoring. Speaking on the sidelines of the IMF and World Bank spring meetings in Washington, Mnuchin said, Some of the lowering in (tax) rates is going to be offset by less deductions and simpler taxes, but the majority of it will be made up by what we believe is fundamentally growth and dynamic scoring. We have been arguing since November that investors should expect tax cuts that rely on dynamic scoring to justify their deficit-busting effects.17 Mnuchin's comments, after several hints from other legislators, confirm that this is indeed the plan. For the Freedom Caucus, dynamic scoring provides a defense against the accusation that their tax cuts increase the budget deficit. That said, data clearly shows that voters care less about deficits - their concerns have subsided with the deficits themselves (Chart 14).18 It remains to be seen whether Trump's team expects for dynamic scoring to do all the heavy lifting in justifying tax cuts or whether real tax reforms are still on the agenda. Even assuming Trump rejects the House GOP's border adjustment tax (which is apparently hanging onto life by a thread), he can offset revenue losses by repatriating companies' foreign earnings, moderating tax cuts for high-income earners, and closing loopholes. These offsets would add to whatever he saves from repealing Obamacare and cutting regulations.19 Chart 14Americans Not So Worried About Deficits Now Chart 15Trump Lags Average Predecessor Ultimately, Republicans of all stripes know that if they fail to produce some legislative "wins" then they will be left with nothing to campaign on in the midterm elections except for their affiliation with President Trump's very poor nationwide approval rating (Chart 15). The current polling foreshadows a 36-seat slaughter in the upcoming midterm elections for the Republicans in the House (Chart 16). This would give Democrats a majority. Several clients have asked us if this makes tax reform less likely. We do not think so. It simply means that Republicans have 18 months to pass their most treasured policies - and much less time if they want the economic growth spurt to help them get reelected. They may not have an opportunity like this for decades. Bottom Line: Investors should step back and focus on the big picture: Trump remains popular with GOP voters, the Freedom Caucus understands this threat, and - to quote Pink Floyd - magic makes the world go round. Investors should fade the rally in Treasurys, as our colleague Peter Berezin of BCA's Global Investment Strategy recently recommended. We are sticking with our "Trump reflation" 2-year/30-year Treasury curve steepener and initiating a recommendation that clients go short the January 2018 fed funds futures contract (Chart 17).20 Chart 16Republicans Heading For Huge Defeat In 2018 Chart 17Short Jan '18 Fed Funds Futures Brexit: Early Elections Reinforce Our GBP Call British Prime Minister Theresa May's decision to hold early elections vindicates our view that the political risks of Brexit peaked - and GBP bottomed - in mid-January when May declared that her country would leave the EU's common market (Chart 18).21 At that time, May frontloaded the worst expectations of negotiations while simultaneously removing the most contentious issue: common market access. With the U.K. decisively "out," i.e. not trying to take the EU's market while rejecting its people, the EU had less of a reason to make an example of the U.K. to other countries whose Euroskeptics might think they could pick and choose what they want from the bloc. Now May and the Tories are on track for a big electoral win that will not only confirm her government's strategy but also give her more maneuverability to handle the negotiations: May's Personal Mandate: May is a "takeover" prime minister - she emerged as leader in the party reshuffle after her predecessor David Cameron's resignation following the "Leave" outcome of the referendum. Takeover prime ministers are historically weaker than "elected" prime ministers and do not last as long in office - on average they rule for 3.3 years, as opposed to six for their elected peers (Chart 19). In other words, May's position was tenuous. This was especially likely to be the case as the country entered the rocky period of formal exit in 2019 and general elections in 2020. Her struggles in turn could have threatened the Brexit deal or her party's control. At the same time, May has received a bigger "bounce" in popular opinion after assuming office than other takeover prime ministers have done (Chart 20), partly as a result of the rally-around-the-flag effect after the referendum shock. Thus, it was eminently sensible to seek public approval of her leadership at this time. Chart 18GBP Bottomed When U.K. ##br##Forswore Common Market Chart 19Theresa May Faced##br## A Short Tenure Chart 20May Received ##br##A Brexit Boost A Thin Majority: The Conservative Party has also rallied post-referendum, especially in contrast with the divided Labour Party, under Jeremy Corbyn, that will hit its lowest point since 1918 if it performs according to current polling (Chart 21). Yet the government has a thin majority in parliament of only 17 seats, among the thinnest majorities in recent decades (Chart 22). This is a liability heading into the parliamentary vote on the final exit deal with the EU in 2019, raising the menace of a "Brexit cliff" in which the U.K.'s two-year negotiating period could expire without any EU deal at all. That would be an unmitigated disaster. With a greater majority, May will be able to cow the other parties further and whip her own party's backbenchers into shape. There was also a festering scandal about the Conservative Party's 2015 fundraising that could trigger a number of by-elections jeopardizing the thin majority.22 2022 is better than 2020: The Tories also faced the prospect of running for re-election in 2020, one year after Brexit actually occurs. By that time negative economic effects (not to mention any cyclical downturn) are more likely to be felt by the public than today. The Tories would also have to face the public immediately after any embarrassing compromises in the EU negotiations. Although Labour is currently in free fall - as illustrated by the astounding loss to the Tories in the by-election in Copeland in February23 - the next two years provide opportunities for revival. The negotiations may be messy, the economy will suffer as reality sets in,24 and the union itself may come under threat from a second Scottish referendum.25 Hence the new election timeline will suit the Tories better than the old, giving them till 2022 to cement Brexit itself and address some of the effects of the aftermath before facing voters. Chart 21Labour In The Doldrums Chart 22Tories Want A Bigger Majority To Manage Brexit Few doubt that May's timing is impeccable. There can be backlash from election opportunism and voter fatigue, but May's popular approval and the national atmosphere do not suggest it will be significant. Pollsters project from current opinion polls that she will secure a 100-seat majority or greater, and since 1997 party-preference polling has become more, not less, predictive of parliamentary seats after elections. Moreover our extremely conservative estimate based exclusively on opportunities that the Tories have to snatch seats from rivals at odds with the Brexit referendum suggests that they cannot do worse than to add 11 seats to their majority (Table 2). Table 2Minimal Scenario Gives Tories 11 New Seats For Their Majority In turn, a bigger majority more securely linked to Theresa May's leadership will bring greater maneuverability in the EU talks and assurance that she can get her final deal through parliament - even if it is an ugly one. How do the elections affect the EU? Contrary to the posturing on both sides, the early election will send a further electoral confirmation to the EU that the U.K. is dead-set on leaving and that the EU cannot deliberately negotiate a bad deal in hopes that the U.K. will change its mind. It could hardly hope to overturn domestic politics and elicit a reversal on Brexit after a third national electoral outcome in favor of leaving the union. Yet the EU saw the writing on the wall already. EU Council President Tusk's negotiating guidelines are not vindictive.26 The EU is opening the possibility of a multi-year transition period after the formal 2019 exit date and acknowledging the need under Article 50 of the Lisbon Treaty to take account of the future relationship, i.e. to provide a framework for a trade deal. The City of London stands to lose the most, but the guidelines are so far fairly tame outside of the financial sector. Moreover, we do not expect a harder line to emerge from the EU Council meeting on April 29. Already the Dutch, Irish, and Danish have called for negotiations on a trade agreement to begin promptly, essentially agreeing with Britain's urgent timeline.27 True, the probability that Macron will be the next French president - along with a likely shift toward a more outspoken Europhile stance in Germany after elections in September - presents the prospect of a "clash" with May's triumphant Tories. Macron has called for a "strict approach" to negotiations, has threatened to model his pro-market reforms in France in such a way as to steal "banks, talents, researchers, academics" from the U.K., and has suggested that the U.K. can at best hope for a deal comparable to Canada's Free Trade Agreement with the EU. That would set a low bar for the U.K.'s all-important services exports (Chart 23). However, Macron is an establishment player who will not significantly change France's position in the negotiations from what it would have been otherwise. (A Le Pen presidency obviously would mark a change by throwing the EU into chaos, but it is highly unlikely.) France is going to demand with the rest of the EU that the U.K. pay its dues (namely a 60 billion-euro budget contribution), but it is not in the interest of France or the EU to impose, effectively, a British recession - not while they seek to cultivate their own economic recoveries. Moreover, wreaking vengeance would not necessarily discourage Euroskeptics on the continent. With Le Pen mortally wounded, the significant Euroskeptic threat lies in Italy, where an imperious approach to Brexit from Germany and France may not be well received (Chart 24). Chart 23Services Are Key For The U.K. Chart 24Punishing The U.K. May Not Dissuade Italy Bottom Line: May's early election helps remove additional political risk by giving her party more maneuverability in negotiations and a greater ability to "make do" with what the Europeans give. Though this is highly unlikely to lead to a "soft Brexit" (common market access, customs union membership, subordination to the European Court of Justice), it is much more likely to prevent Britain from sailing off into a "no deal" abyss. To be clear, we can still see scenarios in which a reversal of Brexit is possible, as discussed previously,28 but they are very low probability. The snap election enables May's government to be flexible in the negotiations and accept some difficult truths in the final deal, which will reinforce the existing tendency of the EU to avoid causing a destabilizing "punitive" break. Both sides of the Channel are positioning for a relatively market-friendly outcome. We maintain our view that the pound has bottomed. Our short USD/GBP recommendation is up 2.85% since March 29 and short EUR/GBP is up 0.14% since January 25. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Alpha Sector Strategy Weekly Report, "Eerie Calm," dated February 10, 2017, available at gss.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Caveat Emptor," dated March 24, 2017, 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 Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 6 French toast in fact... we'll be here all night folks! 7 The reason this plan does not make sense is because most perpetrators of terrorist attacks in France have been French or European citizens. Le Pen's plan amounts to closing the barn door after the horse has bolted. 8 Please see Bloomberg, "Le Pen Struggling to Fund French Race as Russian Bank Fails," dated December 22, 2016, available at bloomberg.com. 9 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 10 Former conservative prime ministers Jean-Pierre Raffarin and Alain Juppé, as well as other prominent members of Les Républicains have already announced that they would support Macron in the second round. 11 Please see "S. Con. Res. 3 - A concurrent resolution setting forth the congressional budget for the United States Government for fiscal year 2017," United States Congress, available at www.congress.gov. 12 For a great summary of the arcane procedure, please see "Introduction to Budget 'Reconciliation,'" dated November 9, 2016, available at cbpp.org. 13 If Republicans choose to delay beyond May, they will have to delay producing the fiscal year 2018 budget resolution. This is possible but introduces problems for next year's budget appropriations and the tax reform measures which will depend on the yet-to-be-written FY2018 budget resolution's reconciliation instructions. "The reconciliation legislation that the GOP is using to partially repeal and replace the ACA has a half-life. It will expire when Congress begins drafting the fiscal 2018 budget blueprint, which will likely be sometime in May. So if Republicans want to resurrect the AHCA and avoid the need for bipartisan votes in the Senate, they will have to vote on the bill within the next several weeks." Please see Baker and Hostetler LLP, "GOP Struggles To Revive Health Bill," Lexology, April 7, 2017, available at www.lexology.com. 14 In short, reconciliation can only be used to pass bills that impact spending and revenue. As such, any changes to Obamacare that do not impact fiscal matters could be found inadmissible by the Senate parliamentarian and thus could defeat the entire bill. There is of course always the "nuclear option" of simply ignoring the ruling of the Senate parliamentarian, but it is not clear whether the Senate GOP would want to go "Kim Jong-Un" twice in the same year! 15 Please see Congressional Budget Office, "American Health Care Act," March 13, 2017, available at www.cbo.gov. 16 Georgia's sixth congressional district is holding this special election to fill the seat left vacant by Tom Price, the new Secretary of Health and Human Services, as appointed by Trump. 17 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 18 Wouldn't dynamic scoring fail to pass the "smell test" with the CBO? Yes, it would. The CBO will likely ignore Republican "magic" and apply actual "math" to the tax proposal. However, this is not an impediment to passing tax reform as the reconciliation rules can still be used as long as the legislation expires after ten years. This is how President George W. Bush passed tax cuts in 2001. 19 A study by the conservative American Action Forum suggests that Trump's regulatory cuts may save $260 billion over ten years. This is a likely source of savings to justify tax cuts, and Trump is only getting warmed up when it comes to deregulation! For the study, please see Sam Batkins, "Fiscal Benefits Of The CRA, Regulatory Reform," April 20, 2017, available at www.americanactionforum.org. 20 Please see BCA Global Investment Strategy Weekly Report, "Fade The Rally In Treasurys," dated April 21, 2017, available at gis.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 22 Please see "Conservatives fined £70,000 over expenses by election watchdog," Channel 4 News, March 16, 2017, available at www.channel4.com. 23 The Conservatives won the Copeland seat for the first time since 1982 after the Labour MP Jamie Reed's resignation there. 24 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 27 Please see "Brexit Shouldn't Delay Trade Talks Too Long, Say Leaders," Bloomberg, April 21, 2017, available at www.bloomberg.com. 28 See note 26 above. Geopolitical Calendar
Highlights China/EM growth will decouple (to the downside) from the business cycle in developed markets (DM). Continued demand strength in DM will not prevent a relapse in EM/China growth. EM is much more leveraged to China than to DM. Higher bond yields in DM, a stronger U.S. dollar and weak China/EM domestic demand are bearish for commodities and EM risk assets. A new equity trade: short KOSPI / long Nikkei. Feature In our recent reports1 we have argued that China's growth is likely to relapse again in the second half of this year based on its aggregate credit and fiscal impulse. Chart I-1 illustrates that this impulse leads Korean, Taiwanese, Japanese, German and U.S. aggregate exports to China by six months, and this indicator is reinforcing the message that shipments from these economies to the mainland have peaked and will stumble. Consistently, the bottom panel of Chart I-1 reveals that Chinese imports of capital goods are set to decelerate significantly and probably contract anew by the end of this year or early 2018. If markets are forward looking, they should begin discounting a potential growth slump very soon. Chart I-2 demonstrates that there is a tight correlation between each of these countries' shipments to China and the mainland's credit and fiscal impulse. Chart I-1Chinese Imports To Relapse Chart I-2Exports To China To Weaken In this context, a relevant question is whether the expansion of U.S. and European imports will be sufficient to safeguard the recovery in EM and global trade as China's imports tumble. Our analysis substantiates that domestic demand strength in the U.S. and Europe will boost these economies but will likely not preclude another downturn in EM/Chinese growth and global trade. In brief, China/EM growth will decouple (to the downside) from the business cycle in developed markets (DM). Our basis is that EM and China trade much more with one another, and as such the DM business cycle has become a less important driver. If DM demand holds up as China's imports tumble anew, EM share prices and currencies will underperform their DM counterparts. In this context, our negative view on EM is contingent on a deceleration in China's business cycle rather than a major relapse in DM domestic demand. In the near term, higher bond yields in DM due to strong domestic demand combined with weakness in EM/Chinese growth will reverse the EM rally. EM Is Much More Leveraged To China Than To DM Chart I-3EM Is Leveraged To China Much More Than DM Chart I-3 shows that the relative performance of EM versus DM stocks typically fluctuates with the relative import volume trend between China and DM. This supports our thesis that the EM world is much more leveraged to China than DM. The following considerations certify China's greater importance for EM economies compared to the U.S. and Europe: Table I-1 shows the share of exports going to China and to the U.S. for individual EM countries. The mean for exports to China is 14.6% of total, and 11.3% for shipments to the U.S. These numbers corroborate the fact that developing countries sell more to China than to the U.S. Chart I-4 is constructed using the numbers from Table I-1. It demonstrates that Korea, Taiwan, Chile and Peru are more exposed to China while India, Turkey, and the Philippines are more leveraged to the U.S. We did not include Mexico and central Europe in this chart because the former trades with the U.S. and the latter predominantly with European countries due to their geographical proximity. Table I-1Export To China And U.S. Chart I-4Exposure To China And Exposure To The U.S. Chinese demand is critical for commodities, particularly for industrial metals prices. China consumes 6-7-fold more industrial metals than the U.S. Unsurprisingly, the mainland's credit and fiscal impulse leads industrial metals prices (Chart I-5). At this moment, we are negative on both metals and oil prices, as we view the 2016 rally as a mean-reverting rally in a structural bear market. As commodities prices drop again, commodities-producing nations will suffer from a negative terms-of-trade shock. This is regardless of which countries they export commodities to. There is one global price for each commodity, and when it deflates commodity producing nations are the ones that get hurt - irrespective of whether they sell that commodity to China, the U.S., Europe or the rest of the world. Countries like Korea and Taiwan do not sell commodities, but their largest export destination is still China (Chart I-6). The latter accounts for 25% of Korean and 27% of Taiwanese exports Chart I-5China's Credit And Fiscal##br## Impulse And Industrial Metals Chart I-6Korea And Taiwan: The ##br##Composition Of Exports. Even if we assume that 30% of goods exported to China by Korea and Taiwan are assembled and then re-exported to other countries, the mainland's domestic absorption of Korean and Taiwanese goods is still considerable. Notably, the recovery in Korean, Taiwanese and Japanese exports has been driven more by China than the rest of the world (Chart I-7). Therefore, China's business cycle is also important for some non-commodity producing countries like Korea, Taiwan and others in Asia. China itself has become much more reliant on its credit origination and fiscal spending than on exports in general and exports to DM in particular (Chart I-8). Chart I-7Asia's Exports Recovery Has Largely ##br##Been Driven By China's Demand Chart I-8China Has Become Reliant ##br##On Stimulus Not Exports Finally, Table I-2 exhibits the product structure of Chinese imports. By and large, China imports three categories of goods: various commodities, capital goods and some luxury goods. All three are at risk of a slowdown because they are leveraged to the nation's credit cycle. Table I-2Composition Of Chinese Imports Bottom Line: China's imports are critical not only for commodity producers (Latin America, Russia, Africa, the Middle East and Indonesia) but also for non-commodity economies in Asia. Altogether this comprises most of the EM universe. EM/China's Importance In Global Trade EM/China account for much larger global trade flows than advanced economies. In short, global trade will relapse again if global shipments to China and the rest of the EM universe slump. EM including Chinese imports (but excluding the mainland's imports for re-exports) in U.S. dollars are equal to imports by the U.S., EU and Japan combined (Chart I-9). Chinese imports for processing - imports that are used to manufacture goods for exports - are excluded from the calculation of this chart. Only Chinese imports for domestic consumption are accounted for. Also, this EM aggregate excludes Mexico and central European countries because their manufacturing is intertwined with the ones in the U.S. and EU. Exports to EM countries account for 25%, 28% and 17% of German, Japanese and U.S. exports, respectively. As a share of GDP, exports to vulnerable EM economies stand at 2%, 5% and 5% of U.S., German and Japanese GDP, respectively (Chart I-10). Chart I-9EM Imports Are Equal To Combined##br## Imports Of U.S., EU And Japan Chart I-10Japan And Germany Are More ##br##Exposed To EM Than The U.S. Japan and Germany are much more vulnerable to an EM/China slowdown than the U.S. and the rest of Europe (Europe ex-Germany). China's exports are exposed more to EM than DM. Chart I-11 shows that 45% of Chinese exports are shipped to Asia ex-Japan, 18% to Latin America, Russia, the Middle East, Africa, Australia and Canada and only 18% to the U.S. and 16% to the EU. Capital spending in China and EM ex-China makes up 5% and 5% (together 10%) of global GDP in real terms (Chart I-12). By comparison, EU and U.S. capital expenditures are 5% and 4.5% of world GDP in real terms. Hence, EM and especially China's investment outlays are big enough to matter for the global economy. Chart I-11China Sells More To EM Than DM Chart I-12EM/China Capex Is Large As Chart I-1 indicates, China's imports of industrial goods will soon tumble. Capital goods imports for EM ex-China have revived, but as their bank loan growth slumps the recovery in capital goods imports is likely to be short lived. Bottom Line: Two-pronged trade flows between EM and China are considerable for their own economies as well as global trade flows. Continued demand strength in DM countries will not prevent a relapse in EM/China growth. Market Observations And Conclusions Our conviction is that China's imports are set to dwindle in the second half of this year. This is bearish for commodities producers and Asian economies selling to China. If markets are forward looking, they should begin discounting this now. Moreover, bank deleveraging in EM/China has further to run. Altogether, this leads us to maintain the strategy of underweighting EM risk assets relative to their DM counterparts, and maintaining a negative stance on EM in absolute terms. Furthermore, it appears the U.S. dollar and U.S. bond yields have recently bounced from their technical support levels, and odds are they will rise further (Chart I-13). DM bond yields will move higher for now before the EM/China slowdown becomes visible later this year. For the time being, rising U.S. bond yields and a stronger greenback (versus EM, Asian and commodities currencies) will weigh on EM risk assets. Remarkably, Chinese interest rates are rising and corporate bond prices are plunging as the People's Bank of China continues along a gradual tightening path (Chart I-14). Chart I-13The U.S. Dollar And U.S. Bond Yields To Rise Chart I-14China: Borrowing Costs Are Rising As long as economic data from China and DM remain positive, financial regulators in Beijing are determined to curb leverage and speculative activities in China's credit system. Higher interest rates and regulatory tightening amid the lingering credit bubble are bound to cause meaningful stress in China's financial system and lead to a deceleration in credit growth. EM risk assets are very complacent about this risk. Interestingly, the commodities currencies index - an equal-weighted average of the Australian, New Zealand and Canadian dollars - has already halted its rally and begun depreciating even versus safe-haven currencies like the Swiss franc (Chart I-15). Such poor showing by commodities currencies should be taken seriously because it has occurred at a time when the U.S. dollar has been soft and global share prices have been well bid. As such, we read this message from the commodities currencies as a harbinger of a major top in commodities prices and EM risk assets. There is no reason why EM ex-China currencies should diverge from the commodities currency index this time around (Chart I-16). Chart I-15Commodities Currencies Versus ##br##Safe-Haven Currency Chart I-16EM Currencies ##br##To Tumble In short, we are reiterating our bearish strategy on EM currencies and recommend shorting a basket of the following currencies: ZAR, TRY, BRL, CLP, COP, MYR and IDR versus the U.S. dollar or a basket of the U.S. dollar and the euro. The main risk to our downbeat view on EM risk assets is not EM/China fundamentals but the rally in DM share prices. That said, DM stocks and credit markets were well bid in 2012-2014 yet EM stocks and currencies did very poorly during that period. This could be repeated again in the next couple of months before fundamental problems/weaker growth in China/EM become evident and stem the rally in DM equities too, as occurred in 2015. A New Equity Trade: Short KOSPI / Long Nikkei We have identified a tactical opportunity for a relative equity trade: short Korean / long Japanese stocks, currency unhedged. The Korean won is overvalued versus the Japanese yen, according to the relative real effective exchange rate based on unit labor costs (Chart I-17). This will provide a competitive advantage to Japanese manufacturers and will dent performance of the KOSPI versus the Nikkei. Even though the won could still appreciate versus the yen, equity prices in Japan will still fare better than their Korean counterparts in common currency terms. Japan's more competitive positioning is also reflected in its manufacturing PMI, which is much stronger than Korea's (Chart I-18). This should lead to outperformance of Japanese manufacturers versus their Korean peers. Chart I-17The Korean Won Is Expensive ##br##Versus The Yen Chart I-18Manufacturing PMI: ##br##Korea And Japan Korea is much more exposed to China than Japan. Exports destined to China make up 25% and 18% of Korean and Japanese exports, respectively. In the meantime, combined exports to the U.S. and EU account for 22% of Korea's total exports and 31% of Japan's total exports (Chart I-19). Provided our view that China's growth will disappoint relative to U.S. and EU growth pans out, Japan is in better position than Korea. Japanese policymakers continue to be much more aggressive in reflating their economy than Korean policymakers. Bank loan growth is accelerating in Japan but is slowing in Korea, albeit from a higher level (Chart I-20). Finally, the technical profile of relative performance between Korean and Japanese share prices favors the latter (Chart I-21). Chart I-19Japan And Korea: Structure Of Exports Chart I-20Bank Loan Growth Is Stronger In Japan Than Korea Chart I-21Short KOSPI / Long Nikkei Bottom Line: Short KOSPI / long Nikkei, currency unhedged. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Reports titled, "A Time To Be Contrarian", dated April 5, 2017, "Signs Of An EM/China Growth Reversal", dated April 12, 2017 and "EM: The Beginning Of The End", dated April 19, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Overall Duration: The factors that have driven global bond yields lower over the past month are not sustainable. Maintain a below-benchmark duration exposure, with current yield levels looking attractive to add to underweight/short positions as we did last week. French Election: We got the market-friendly outcome in the French election that we were expecting. We are closing our recommended long 10-year France vs 10-year Germany Tactical Overlay trade after the post-election spread tightening, at a profit of 1.3%. Feature Investors breathed a sigh of relief yesterday, after the French presidential election produced the most market-friendly result - a Macron-Le Pen matchup in the May 7 run-off. Pre-election polling showed that the pro-Europe reformer Macron and his En Marche ("On The Move") party would easily trounce the anti-Europe populist Le Pen in a head-to-head showdown. That outcome would eliminate the possibility of a confidence-shattering "Frexit" along the lines of last year's U.K. vote that could stall the current global economic expansion. Elevated political risks in Europe, and geopolitical risks in Syria and North Korea, have been a factor driving volatility higher, and bond yields lower, in recent weeks. There have also been some data disappointments in the U.S. that have occurred at the same time (Chart of the Week). It is difficult to tell which factor has been more important for government bond markets. The fact that yields jumped worldwide yesterday after the French election result and, more importantly, the lack of any serious repricing in global equity and credit markets alongside the recent pop in volatility, suggests that bond markets are likely not sniffing out a sustained growth slowdown. Government bond yields remain too low relative to underlying economic and inflation trends, and we continue to recommend below-benchmark duration exposure and above-benchmark allocations to corporate credit versus government bonds (especially in the U.S.). Falling Bond Yields: Some Shifting Expectations, But Not A Change In Trend The recent decline in global bond yields began in mid-March. The move in most of the major markets was largely driven by falling inflation expectations, with real yields staying relatively stable, although in the U.S. the split was more 50/50. Importantly, both the nominal 10-year U.S. Treasury and German Bund yield are bouncing off the bottom of their upward sloping trend channels that started in early 2016 (Chart 2). Chart of the WeekA Series Of Unfortunate Events Chart 2Upward Trend In Yields Still Intact We see those upward trending channels as being the primary medium-term trend for bond yields. The recent pullback in yields has been the result of several individual factors that have occurred at the same time that are likely to reverse in the months ahead: Slower U.S. growth & inflation: The latest soft readings on U.S. retail sales and core CPI inflation are not consistent with the robust readings on business confidence and manufacturing activity, as well as the accelerating trend in U.S. corporate profit growth that our models expect will continue in the coming quarters (Chart 3). The latter is being driven by significant improvements in corporate pricing power that are helping boost profit margins, according to our equity strategists (bottom panel).1 We find it hard to believe that there can be a prolonged slowdown in the U.S. economy if earnings growth is accelerating and firms are not forced to cut back on hiring and investment to preserve profitability. The U.S. Overnight Index Swap (OIS) curve is now only discounting 38bps of rate increases over the next year, Treasuries look expensive as the Fed is likely to deliver at least 50bps worth of hikes by year-end and the large short positions in the Treasury market have been unwound (Chart 4). Chart 3The U.S. Economy Is Not Rolling Over Chart 4Treasuries Are Expensive & Positioning Is Now Long Softer U.S. wage inflation: Some of that boost to U.S. profit margins is also due to the recent slower pace of wage growth, which we do not expect to continue given the tightness in the U.S. labor market and the continued robust readings on labor demand indicators (Chart 5). We expect wage growth to begin ticking higher in the months ahead, as will overall U.S. inflation expectations which still appear too low. The Cleveland Fed Median CPI has been steady around 2.5%, which is where we expect headline CPI inflation to be if the Fed's inflation target of 2% on the PCE deflator is met.2 We see TIPS breakevens gravitating towards those levels in the coming months, driving longer-term U.S. Treasury yields higher. Setbacks on the Trump economic agenda: President Trump's failure to get health care reform passed in Congress was interpreted as a sign that the more pro-growth parts of his agenda, like tax reform and infrastructure spending, would also have difficulties getting implemented. We are not strong believers in the idea of a significant "Trump trade" impact on growth and bond yields, as the U.S. economy was already showing improvement before Trump won the presidency. Nonetheless, any delay in the fiscal easing that Trump promised during the campaign would act to dampen expectations for U.S. growth and Fed rate hikes on the margin, to the benefit of U.S. Treasuries. Trump announced that he will unveil his tax reform proposals this week, with Congressional hearings on the subject also set to begin. Our colleagues at BCA Geopolitical Strategy expect Trump to try and move quickly to get a deal done, especially after the initial failure on health care reform. The political risks for the Republicans are very real in next year's mid-term elections, with current polling pointing to large losses of seats that could return the House of Representatives to Democrat control. If the Republicans want to push through their reform agenda and try and boost growth heading into the 2018 midterms to try and avert a loss of the House, they cannot delay on tax reform this year. While the U.S. political situation is always a wild card, we do not think that "Trump trade" disappointment will be a factor weighing on Treasury yields over the rest of 2017. Lower oil prices: Some of the decline in the inflation expectations component of global bond yields can be attributed to the pullback in oil prices since late February. Our colleagues at BCA Commodity & Energy Strategy continue to have a bullish outlook on global oil prices, however, and view the recent dip as a buying opportunity.3 They expect Russia and Saudi Arabia to honor their agreement to remove 1.8mm barrels/day of production from the global oil market our by mid-2017, as visible inventory levels remain too high. Combined with stronger expected demand, our strategists expect oil prices to move toward the $60/bbl level by year-end (Chart 6). That move would boost help to raise inflation expectations, and bond yields, in the months ahead. Chart 5U.S. Inflation Expectations Still Too Low Chart 6Oil Prices Set To Move Higher Slower Euro Area inflation: Just like in the U.S., there was a pullback in Euro Area inflation expectations after the dip in realized inflation readings in March. While some cooling was expected simply from base effects related to swings in oil prices and the Euro, our headline CPI diffusion index indicates that an increasing majority of sectors are seeing accelerating price growth (Chart 7). If our commodity strategists are correct on the call for higher oil prices, we would expect to see some re-acceleration of Euro Area inflation, and more bear-steepening of Euro Area government bond yield curves, in the coming months. Especially if the European Central Bank (ECB) begins to send a signal about a tapering of its asset purchases - an outcome that is more likely if the polling data proves correct and Macron wins the French Presidency in two weeks, thus reducing the near-term political uncertainty in Europe. The ECB meets this week, and while we still think any shift in the ECB's tone is more likely at the June meeting (when a new set of economic projections will be produced), this will be the first opportunity for comments after the French election result. French Election Uncertainty: The pre-election rise in French risk premia fully unwound yesterday in a matter of hours (Chart 8). Implied volatilities on Euro Area equities and the EUR/USD exchange rate plunged, as did France sovereign CDS spreads. France-Germany government bond spreads tightened sharply as well, with the benchmark 10-year OAT-Bund spread declining -19bps from last Friday's closing levels. With Macron having a 20 point lead on Le Pen in a two-way race according to the latest opinion polls - which proved to be very accurate in the first round of voting - we think that current spread levels are consistent with a Macron victory on May 7. Chart 7Only A Brief Setback##br## In Euro Area Inflation Chart 8Taking Profit On Our Long France/Short ##br##Germany Spread Trade We do not expect much additional spread tightening if Macron does indeed win, especially if the ECB does begin to signal a tapering of bond purchases in 2018. That would result in wider risk premia across all European bond markets as valuations start to return to levels more in line with fundamentals. Given France's high sovereign debt levels and low productivity growth vis-à-vis Germany, we do not see the OAT-Bund spread returning to the pre-election lows if the ECB slows its bond buying. Thus, we are taking profits on the long France/Short Germany 10-year bond trade in our Tactical Overlay Portfolio, which we established back in early February when the spread was 76bps; 26bps higher than yesterday's close.4 Bottom Line: The factors that have driven global bond yields lower over the past month are not sustainable. Maintain a below-benchmark duration exposure, with current yield levels looking attractive to add to underweight/short positions as we did last week. We got the market-friendly outcome in the French election that we were expecting. We are closing our recommended long 10-year France vs 10-year Germany Tactical Overlay trade after the post-election spread tightening, at a profit of 1.3%. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Pricing Power Comeback," dated April 24 2017, available at uses.bcaresearch.com 2 That assumes a difference between headline CPI and PCE deflator inflation in line with its historical average of around 50bps. 3 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017/H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20 2017, available at ces.bcaresearch.com 4 Please see BCA Global Fixed Income Strategy Special Report, "Our Views On French Government Bonds," dated February 7 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: The market is now priced for only 30 bps of rate hikes between now and the end of the year, despite little evidence that growth is actually slowing. Stay at below-benchmark duration and remain short the January 2018 Fed Funds Futures contract. TIPS: Although we still expect TIPS breakevens to widen as inflation rises, this week we review possible arguments for why breakevens might have shifted to a permanently lower post-crisis equilibrium. Remain overweight TIPS versus nominal Treasuries. Corporate Valuation: Our Default-Adjusted Spread remains at reasonably attractive levels, suggesting that corporate spreads will tighten in the coming months if the economic recovery remains on track. Remain overweight corporate bonds within U.S. fixed income portfolios. Feature Chart 1Yields Lower Since March FOMC In last week's report we argued that recent bond market strength was caused by a politically-induced flight-to-quality. In particular, we noted that the term structure of implied equity volatility had inverted - investors were paying more to hedge equity positions over a 1-month horizon than over a 3-month horizon. But political tensions have eased somewhat during the past week. President Trump promised to unveil his administration's tax reform plan this Wednesday, and the first round of the French election resulted in centrist candidate Emmanuel Macron securing a significant advantage over far-right candidate Marine Le Pen. As a consequence, 1-month implied equity vol fell back below 3-month vol, and the bond rally ebbed with the 10-year Treasury yield edging up to 2.29% from 2.17% at this time last week. Nonetheless, bond yields are still far below the levels seen following the last FOMC meeting in mid-March. Since that meeting, the 10-year Treasury yield has fallen 27 bps, split between a 12 bps decline in the real yield and a 15 bps drop in the cost of inflation compensation (Chart 1). Real Yields Are Too Low As shown in the top panel of Chart 1, the 10-year real yield is tightly linked to the number of rate hikes discounted in the overnight index swap curve during the next 12 months. Further, the drop in both of these series since mid-March occurred alongside a string of economic data disappointments, as evidenced by the sharp fall in the Economic Surprise Index (Chart 2). Our assessment, however, is that the mean reversion in the surprise index represents excessively optimistic expectations rather than a trend change in the pace of U.S. growth. Chart 2Disappointments Are Discounted To test this theory, we looked at the New York Fed's Nowcast for Q1 GDP growth and noted that it has been revised lower from 2.96% (as of March 24) to 2.65% (as of April 20). We observed that the data releases responsible for the bulk of the downward revision were: Real consumer spending Retail sales and food services Import & Export growth Housing starts As can be seen in Chart 3, with the exception of real consumer spending, all of the other data disappointments represent small corrections from elevated levels. As for real consumer spending, we noted last week that the recent weakness is probably explained by problems with Q1 seasonal adjustments.1 Taking a step back, U.S. growth still appears to be on solid footing. The BCA Beige Book Monitor, introduced last week by our U.S. Investment Strategy service,2 scans the Federal Reserve's Beige Book3 for the words "strong" and "weak" (and their derivatives like stronger, weakened, etc...). The Monitor is the number of "strong" words less the number of "weak" words, and it has been an excellent coincident indicator of GDP growth since the mid-1990s (Chart 4). At present, the Beige Book Monitor is sending a robust signal for U.S. growth. Similarly, despite supposed weakness in housing starts and trade data, our preferred leading indicators point to continued strength in both the residential investment and net export components of GDP (Chart 4, bottom 2 panels). Chart 3What Weak Data? Chart 4Growth Still Looks Strong Bottom Line: The market is now priced for only 30 bps of rate hikes between now and the end of the year, despite little evidence that growth is actually slowing. We still expect the Fed will lift rates by at least 50 bps between now and the end of the year. Stay at below-benchmark duration and remain short the January 2018 Fed Funds Futures contract. TIPS Breakevens: How Far From Fair Value? As was mentioned above, the cost of 10-year inflation compensation has also declined since mid-March alongside some weakness in the headline non-seasonally adjusted Consumer Price Index (see Chart 1). Our Financial Model of TIPS Breakevens - which models the 10-year TIPS breakeven rate using the stock-to-bond total return ratio, the price of oil and the trade-weighted dollar - attributes the recent decline to weakness in the stock-to-bond ratio and the fact that the 10-year breakeven rate was already quite elevated compared to our model's fair value (Chart 5). The 10-year breakeven rate is still somewhat wide compared to our model's fair value, but much less so. We remain overweight TIPS versus nominal Treasuries on the view that growth will be strong enough to keep measures of core inflation on a steady upward trajectory, eventually converging with the Fed's 2% inflation target. The fair value reading from our TIPS Financial Model should also trend gradually higher in this environment. Historically, core PCE inflation anchored around the Fed's 2% inflation target has corresponded with a 5y5y TIPS breakeven inflation rate in the range of 2.4% to 2.5% (current value 1.89%) and a 5y5y CPI swap rate between 2.8% and 2.9% (current value = 2.31%) (Chart 6). These remain our target levels for TIPS breakevens and CPI swaps, respectively. Chart 5TIPS Financial Model Chart 6Still Below Target However, we must also consider the possibility that these target ranges, based on the mid-2000s, may no longer be applicable. Put differently, it is possible that the market for inflation protection underwent a structural shift following the financial crisis and the appropriate level for long-maturity TIPS breakeven rates when core PCE is anchored around 2% might now be lower. A Structurally Lower Inflation Risk Premium? It is common to think of the 10-year TIPS breakeven inflation rate as: TIPS Breakeven Inflation = Inflation Expectations + Inflation Risk Premium The inflation risk premium is the extra return required by nominal bond investors to bear the risk that future inflation will differ from expected inflation. In theory, this premium can be influenced by uncertainty about the inflation outlook, but also by structural factors that make it more or less attractive to include TIPS in a portfolio. For example, any asset that is negatively correlated with equities is more valuable as a hedge in the context of an overall portfolio and investors should demand less of a risk premium to hold that asset. As one recent Fed paper4 noted, the correlation between long-maturity TIPS breakeven rates and equities has shifted from being negative in the 1980s to being sharply positive in recent years. This means that TIPS have become less valuable as a hedge against equity positions. All else equal, this should increase the yield that investors demand to hold TIPS and thus lower the TIPS breakeven inflation rate. We acknowledge the strong positive correlation between equities and TIPS breakevens, but are inclined to view it as more of a cyclical phenomenon. Chart 7 shows that the correlation between inflation expectations5 and equities was negative when inflation was above the Fed's 2% target in the 1980s and also that the correlation becomes more positive when the Fed eases and more negative when the Fed tightens (Chart 7, bottom panel). Chart 7Correlation Between Breakevens & Equities Is Cyclical In other words, when inflation is low the Fed has an incentive to maintain an accommodative monetary policy. It does not react strongly when inflation rises, and this supports increases in both inflation expectations and equity prices. However, when inflation becomes too high, the correlation between inflation expectations and equity prices shifts because higher inflation now signals a more rapid pace of Fed tightening which tends to depress equities. It therefore seems likely that the correlation between TIPS breakevens and equity prices will weaken as inflation rises and the Fed tightens policy. So we do not view this as a compelling reason for why TIPS breakevens might be permanently lower. Structural Limits To Arbitrage? A potentially more interesting line of argument comes from a 2010 paper by Fleckenstein, Longstaff and Lustig.6 In this paper, the authors document a persistent arbitrage opportunity between TIPS and nominal Treasury bonds. Investors can earn risk-free returns using inflation swaps and TIPS to replicate the cash flows from a nominal Treasury bond. The authors also find that this arbitrage opportunity biases TIPS breakeven rates lower, and that this bias worsens in times of increased financial market volatility. Chart 8Repo Market Less Efficient Specifically, the authors demonstrate that the size of the downward bias in TIPS breakevens increases as repo market fails trend higher. The rationale being that repo fails occur when market participants are unable to acquire specific Treasury collateral. This is taken as a signal that the supply of government bonds is constrained, which makes it more difficult to take advantage of the arbitrage between TIPS and nominal Treasuries. Interestingly, repo fails have been trending higher since the financial crisis as repo market activity has been reduced by strict post-crisis regulations (Chart 8). The case has been made that new regulations - specifically the Supplementary Leverage Ratio which forces dealer banks to set aside a fixed amount of capital for any assets they hold, regardless of riskiness - have caused dealers to shy away from low margin businesses such as making markets in repo.7 It is conceivable that reduced activity in the repo market has resulted in less available collateral and increased fails. If this is the new state of affairs, then it is possible that TIPS breakevens will be permanently lower in the post-crisis world because lack of liquidity in the repo market has reduced the attractiveness of arbitraging the difference between nominal and real yields. So far, we are reluctant to draw any sweeping conclusions from this analysis. In fact, if the Fed believes that the fair value for long-maturity TIPS breakevens is between 2.4% and 2.5%, then does the "limits to arbitrage" argument even matter? Also, Manmohan Singh of the IMF has argued that the act of the Fed unwinding its balance sheet would free up balance sheet space for dealer banks, mitigating some of the regulatory burden and leading to a more efficient repo market.8 If this is correct, then repo fails could decline as the Fed starts to let its balance sheet run down, a process that is likely to start later this year. For now, we consider the theory of a permanently lower equilibrium for TIPS breakevens a risk to our view that merits further research in the coming weeks. Corporate Bond Valuation Update With the release of the Moody's Default Report for March we were able to update our High-Yield Default-Adjusted Spread (Chart 9). Our Default-Adjusted Spread is equal to the average option-adjusted spread from the Bloomberg Barclays High-Yield index less a 12-month forecast of default losses. That 12-month forecast is based on Moody's baseline forecast for the speculative grade default rate and our own forecast of the recovery rate. Chart 9Default-Adjusted Spread Moody's data show that the speculative grade default rate was 4.7% for the 12 months ending in March, and the baseline forecast calls for it to fall to 3% during the next 12 months. Using this forecast we calculate that the current Default-Adjusted Spread is 228 bps. Our analysis shows that excess returns for both Investment Grade and High-Yield corporate bonds are usually positive unless the Default-Adjusted Spread is below 100 bps. The relationship between excess returns and the Default-Adjusted Spread for both Investment Grade and High-Yield corporates is shown graphically in Charts 10 & 11 and also in Tables 1 & 2. Chart 1012-Month Excess Investment Grade Returns ##br##Vs. Ex-Ante Default-Adjusted Spread (2003 - Present) Chart 1112-Month Excess High-Yield Returns Versus Ex-Ante ##br##Default-Adjusted Spread (2003-Present) Table 112-Month Investment Grade Excess Returns & Ex-Ante Default-Adjusted Spread Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Given our relatively optimistic outlook for U.S. growth, we tend to view current valuation levels as attractive and see scope for spread tightening during the next few months. However, the weakening state of corporate balance sheets means spreads are at risk once inflation starts to bite and monetary policy turns less accommodative, possibly as early as next year.9 Bottom Line: Our Default-Adjusted Spread remains at reasonably attractive levels, suggesting that corporate spreads will tighten in the coming months if the economic recovery remains on track. Remain overweight corporate bonds within U.S. fixed income portfolios. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Fade The Flight To Safety", dated April 18, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Investment Strategy Weekly Report, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com 3 According to the Fed, the Beige Book provides "an up-to-date depiction of regional economic conditions based on anecdotal information gathered from a diverse range of business and community contacts." 4 Chen, Andrew Y., Eric C. Engstrom, and Olesya V. Grishchenko (2016). "Has the inflation risk premium fallen? Is it now negative?," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, April 4, 2016, http://dx.doi.org/10.17016/2380-7172.1720 5 In order to benefit from more back-data, in Chart 7 we use the Cleveland Fed's measure of inflation expectations rather than TIPS breakeven rates. Details about the Cleveland Fed's methodology can be found here: https://www.clevelandfed.org/en/our-research/indicators-and-data/inflation-expectations.aspx 6 Fleckenstein, Matthias, Francis A. Longstaff, and Hanno Lustig (2010). "Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle", NBER Working Paper No. 16358. September 2010. JEL No. E6,G12,G14. http://www.nber.org/papers/w16358 7 https://www.forbes.com/sites/lbsbusinessstrategyreview/2016/03/11/why-are-big-banks-offering-less-liquidity-to-bond-markets/#64286f5729de 8 https://ftalphaville.ft.com/2017/04/24/2187716/guest-post-why-shrinking-the-fed-balance-sheet-may-have-an-easing-effect/ 9 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
