Disasters/Disease
Highlights The coronavirus scare is the catalyst for the recent correction, not the cause. The true cause is that the stock market had reached a point of groupthink-triggered instability and therefore needed the slightest catalyst to correct. Bond yields will stay depressed for (at least) the first half of 2020. Long-term investors should use corrections to overweight equities versus bonds, provided bond yields stay near or below current levels. The pound and UK-exposed investments will come under near-term pressure as UK/EU trade deal tensions ratchet up. But ultimately, UK-exposed investments will enjoy a major leg up later this year if both the UK and EU blink. Feature Chart of the WeekThe Next Up-Leg In The Pound And UK-Exposed Investments Will Occur Later In 2020 Corrections, Catalysts, And Coronavirus Markets have suffered a correction, begging the question: what caused it? The question is a good one, because identifying the cause can help to inform our response. Yet the danger is that the knee-jerk narrative pinpoints the catalyst rather than the true cause. In which case our response will be wrong too. For example, consider the following two narratives: Tree foliage collapses because of 40 mph winds. Tree foliage collapses because it is autumn. The first narrative is exciting, satisfying, and headline grabbing, but it only pinpoints the catalyst for the foliage collapse: the puff of wind. The second explanation is dull and less newsworthy, but it pinpoints the true cause: in autumn, tree foliage is unstable. Likewise, the coronavirus scare is the catalyst for the recent correction. The true cause is that the stock market had reached a point of groupthink-triggered instability and therefore needed the slightest catalyst to correct. The catalyst could have come from anywhere at any time. If it hadn’t been the coronavirus scare, it would have been the next worry… or the one after that. On January 9 in Markets Are Fractally Fragile we warned that usually cautious value investors had become momentum traders – undermining market liquidity and stability. When this happens, there is a two in three chance of a tactical reversal (Chart I-2). Chart I-2When Markets Are Fractally Fragile, There Is A 2 In 3 Chance Of A Tactical Reversal We also warned that the bond yield 6-month impulse – the change in the change – had recently become a severe 100 bps headwind to growth. At this severity of headwind, there is a nine in ten chance that bond yields have reached a near-term peak (Chart I-3). Chart I-3When The Bond Yield 6-Month Impulse Becomes A Severe Headwind, There Is A 9 In 10 Chance Of A Near-Term Peak In Yields In combination, we warned that equities would underperform bonds by about 4 percent on a tactical horizon. Now that this anticipated correction has happened, what next? Long-term investors should use corrections to overweight equities versus bonds. First, irrespective of coronavirus – or any other catalyst – the recent severe headwind to growth from the bond yield impulse suggests that bond yields will stay depressed for (at least) the first half of 2020. Second, the good news is that the ultra-low bond yields justify and underpin the valuation of equities. Hence, at the current level of bond yields, long-term investors should use corrections to overweight equities versus bonds. Brexit Is “Done”. Or Is It? Rumour has it that Boris Johnson will banish the word Brexit from the UK government lexicon after January 31, because Brexit is now “done”. Good luck with that. When Britain wakes up bleary-eyed on Saturday February 1, what will have changed? Not a lot. The UK will have lost its voice and votes in the EU decision making institutions. Yet in practical terms nothing will have changed, because the UK and EU will enter an 11-month ‘standstill’ transition period in which existing arrangements will continue: the free movement of people, financial contributions, and full access to the single market without tariffs or customs checks. The Conservative government made a manifesto pledge not to extend the 11-month transition, so the more important question is: what will change when the standstill period ends on December 31? The answer depends on what sort of trade deal the UK and EU can negotiate in the limited space of 11 months. Or indeed whether they can negotiate a trade deal at all. Therein lies the problem. A free trade deal with the EU will require a mutual commitment to a ‘level playing field’. If the UK wants to diverge on food standards, environmental protection, labour rights, and state aid – as the Brexit purists yearn – then there is zero chance that the EU will agree to a free trade deal. This leaves two options, neither of which is appealing. The first is for the UK to end the 11-month standstill period without a trade deal. Technically, this would not be ‘no deal’ because the withdrawal agreement would still bind both sides on citizens’ rights, financial contributions, and arrangements for Northern Ireland. A free trade deal with the EU will require a mutual commitment to a ‘level playing field’. However, for UK companies, the option of ending the standstill period without a trade deal would constitute a painful dislocation from the single market involving tariffs and customs checks. It would also hurt the EU economies most exposed to the UK, notably Ireland and the Netherlands. Moreover, a full customs and tariff border in the Irish Sea would endanger the very existence of a ‘United’ Kingdom which included Northern Ireland. The second option is for the UK to accept a trade deal on EU terms, recognising that the EU is the larger and more economically powerful party in the negotiation. The EU will offer the UK a tariff-free and quota-free trade deal conditional on strict level playing field conditions where the UK chooses to diverge from EU standards, combined with a mechanism to adjudicate on any level playing field disputes. Though economically better than no trade deal at all, the Brexit purists would claim it isn’t Brexit. Meanwhile, even without tariffs and quotas, UK companies whose just-in-time supply chains depended on the EU would still suffer disruption, as the level playing field was policed at every border crossing. So this option would satisfy nobody in the UK. The bigger practical problem is a lack of time to leave the EU regulatory orbit smoothly. Nobody believes that eleven months is enough time to implement a system in Northern Ireland that prevent a hard border in the Irish Sea; or indeed to implement a new UK immigration system if free movement were to end at the end of 2020. So what’s the resolution? The answer is the same as it has always been for Brexit – a gradual ratcheting up of tension ahead of a hard deadline to focus minds and force progress. Followed by a ‘fudged resolution’ at the eleventh hour in which both sides blink – because neither side is prepared to go over the cliff-edge. Recall that to get the withdrawal agreement over the line, the UK blinked by allowing Northern Ireland to be treated differently; but the EU also blinked by allowing the withdrawal agreement to be reopened. And once this happened, the pound and UK-exposed investments enjoyed a major leg up (Chart I-1 and Chart I-4-Chart I-7). Chart I-4The FTSE 250 Is A UK-Exposed ##br##Investment Chart I-5The FTSE 100 Is Not A UK-Exposed Investment Chart I-6UK General Retail Is A UK-Exposed Investment Chart I-7UK Clothing And Accessories Is Not A ##br##UK-Exposed Investment In the next fudged resolution, the UK could blink by retaining full regulatory alignment with the EU in most areas for a little while longer, and where it doesn’t the EU could blink by becoming flexible in its interpretation of ‘level playing field’. Obviously, nobody would call this an extension to the transition, but the UK would, in most practical terms, still be in the single market on January 1 2021. UK-exposed investments will enjoy their next major leg up later this year In this playbook, the pound and UK-exposed investments will come under near-term pressure, as UK/EU trade deal tensions ratchet up. But ultimately, UK-exposed investments will enjoy their next major leg up later this year if both the UK and the EU blink (Chart I-8). Chart I-8The Pound Still Has A Brexit Discount Fractal Trading System* There are no new trades this week. The rolling 1-year win ratio now stands at 62 percent. Chart I-9EUR/GBP 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. * 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. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Global growth is poised to accelerate this year, although the spread of the coronavirus could dampen spending in the very short term. History suggests that the likelihood of a recession rises when unemployment falls to very low levels. Three channels have been proposed to explain why that is: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation, forcing central banks to raise rates. The first channel is highly relevant for some smaller, developed economies where housing bubbles have formed and household debt has reached very high levels. However, it is not an immediate concern in the US, Japan, and most of the euro area. We would downplay the importance of the second channel, as faster wage growth is also likely to raise aggregate demand and incentivize firms to increase capital spending on labor-saving technologies. The third channel poses the greatest long-term risk, but is unlikely to be market-relevant this year. Investors should remain bullish on global equities over the next 12-to-18 months. A more prudent stance will be warranted starting in the second half of 2021. Global Equities: Sticking With Bullish Global equities are vulnerable to a short-term correction after having gained 16% since their August lows. Nevertheless, we continue to maintain a positive outlook on stocks for the next 12 months due to our expectation that global growth will gather steam over the course of the year. The latest data on global manufacturing activity has generally been supportive of our constructive thesis. The New York Fed Manufacturing PMI beat expectations, while the Philly Fed PMI jumped nearly 15 points to the highest level in eight months. The business outlook (six months ahead) component of the Philly Fed index rose to its best level since May 2018. European manufacturing should also improve this year. Growth expectations for Germany in the ZEW index surged in January, rising to the highest level since July 2015 (Chart 1). The Sentix and IFO indices have also moved higher. Encouragingly, euro area car registrations rose by 22% year-over-year in December. In the UK, business confidence in the CBI survey of manufacturers surged from -44 in Q3 of 2019 to +23 in Q4, the largest increase in the 62-year history of the survey. Fiscal stimulus and diminished risk of a disorderly Brexit should also bolster growth this year. Chart 1Some Green Shoots Emerging In The Euro Area Chart 2EM Asia Is Rebounding The manufacturing and trade data in Asia have been improving. Following last week’s better Chinese trade data, Korean exports recovered on a rate-of-change basis for a fourth month in a row. Japanese exports to China increased for the first time since last February. In Taiwan, industrial production increased by more than expected in December, as did export orders. Our EM Asia Economic Diffusion Index has risen to the highest level since October 2018 (Chart 2). Coronavirus: Nothing To Sneeze At? The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. Conceptually, outbreaks can affect the economy in two ways. One, they can reduce demand by curtailing spending on travel, entertainment, restaurants, or anything that requires close proximity to others. Two, they can reduce supply by causing people to avoid going to work. In practice, the first effect usually dominates the second. As a result, such outbreaks tend to have a deflationary impact. The Brookings Institution estimates that the 2003 SARS epidemic shaved about one percentage point from Chinese growth that year.1 The fact that this outbreak is happening during the Chinese New Year celebrations, when over 400 million people will be on the move, has the potential to exacerbate the transmission of the virus, and in the process, amplify the economic damage. That said, while it is from the same class of zoonotic viruses, early indications suggest that this particular strain is less lethal than SARS. In addition, the Chinese authorities have moved faster to address the risks than they did during the SARS outbreak. The government has effectively quarantined Wuhan, a city of 11 million people, where the virus appears to have originated. They have also sequenced the virus and shared the information with the global medical community. This has allowed the US Centers for Disease Control (CDC) to develop a test for the virus, which is likely to become available over the coming weeks. The Dark Side Of Low Unemployment Provided the coronavirus outbreak is contained, stronger global growth should continue to soak up lingering labor market slack. This raises the question of whether, at some point, declining unemployment could become counterproductive. The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. The unemployment rate in the OECD currently stands at 5.1%, below the low of 5.5% set in 2007 (Chart 3). In the US, the unemployment rate has dropped to a 50-year low. Chart 3Unemployment Rates Are Below Their Pre-Crisis Lows In Most Economies No one would deny that the decline in unemployment since the financial crisis has been a welcome development. However, it does carry one major risk: Historically, the likelihood of a recession has risen when unemployment has fallen to very low levels (Chart 4). Chart 4Recessions Become More Likely When The Labor Market Begins To Overheat Three channels have been proposed to explain this positive correlation: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation. This can force central banks to raise rates, choking off growth. Let’s examine each in turn. Unemployment And Irrational Exuberance Chart 5Growing Housing Imbalances In Some Economies A strong economy promotes risk-taking. While some risk-taking is essential for capitalism, an excessive amount can lead to the buildup of imbalances, thereby setting the stage for an eventual downturn. In Australia, New Zealand, Canada, and the Scandinavian economies, the combination of low interest rates and strong economic growth has stoked debt-fueled housing bubbles (Chart 5, panel 3). As we discussed last week, higher interest rates in those economies could sow the seeds for economic distress.2 In most other countries, financial imbalances are not severe enough to trigger recessions. Chart 6 shows that the private-sector financial balance – the difference between what the private sector earns and spends – still stands at a healthy surplus of 3.4% of GDP in advanced economies. In 2007, the private-sector financial balance fell to 0.4% in advanced economies, reaching a deficit of 2% in the US. The private-sector balance also deteriorated sharply in the lead-up to the 2001 recession (Chart 7). Chart 6The Private Sector Spends Less Than It Earns In Most Economies Chart 7The Private-Sector Surplus Is Larger Than It Was Before The End Of Previous Expansions In the US, the personal savings rate has risen to nearly 8%, much higher than one would expect based on the level of household net worth (Chart 8). Despite growing at around 2.5% in 2018/19, real personal consumption has increased at a slower pace than predicted by the level of consumer confidence. This suggests that households have maintained a fairly prudent disposition. Consistent with this, the ratio of household debt-to-disposable income has declined by 32 percentage points since 2008. Chart 8Households Are Saving More Than One Would Expect Granted, some credit categories have seen large increases (Chart 9). Student debt has risen to 9% of disposable income. Auto loans have moved back to their pre-recession highs. We would not worry too much about the former, as the vast majority of student debt is guaranteed by the government. Auto loans are more of a concern. However, it is important to keep in mind that the auto loan market is less than one-sixth as large as the mortgage market. Moreover, after loosening lending standards for vehicle loans between 2011 and 2016, banks have since tightened them. This adjustment appears to be largely complete. Lending standards did not tighten any further in the latest Senior Loan Officer Survey, while demand for auto loans rose at the fastest pace in two years. The share of auto loans falling into delinquency has been trending lower, which suggests that delinquency rates are peaking (Chart 10). Chart 9US Household Debt Levels Have Fallen, Despite Increases in Student And Auto Loans Chart 10Auto Loans: Monitoring Trends In Credit Standards And Delinquency Rates Lastly, we would point out that despite all the hoopla over the state of the auto market, auto loan asset-backed securities have performed well (Chart 11). While default rates have risen, lenders have generally set interest rates high enough to absorb incoming losses. Chart 11Securitized Auto Loans Have Performed Well Will Falling Profit Margins Derail The Expansion? Profit margins usually peak a few years before the onset of a recessions (Chart 12, top panel). This has led some to speculate that falling margins could usher in a recession by curbing companies’ willingness to hire workers and invest in new capacity. Chart 12A Peak In Profit Margins: An Ominous Sign? While it is an interesting theory, it does not stand up to closer scrutiny. Surveys of business sentiment clearly show that capital spending intentions are positively correlated with plans to raise wages (Chart 13, left panel). Far from cutting capital expenditures in response to rising wages, firms are more likely to boost capex if they are also planning to increase labor compensation. Chart 13AFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (I) Chart 13BFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (II) One reason for this is that rising wages make automation more attractive. By definition, automation requires more capital spending. However, that is not the entire story because firms also tend to hire more workers during periods when wage growth is rising (Chart 13, right panel). This implies that a third factor – strong economic growth – is responsible for both accelerating wages and rising hiring intentions. The fact that real business sales are strongly correlated with both employment growth and nonresidential investment is evidence for this claim (Chart 12, bottom panel). Falling Margins: A Symptom Of A Problem The discussion above suggests that faster wage growth is unlikely to dissuade firms from either hiring more workers or boosting capital spending. Indeed, the opposite is probably true: Since workers normally spend more of every dollar of income than firms do, an increase in the share of national income flowing to workers will lift aggregate demand. So why do profit margins usually peak before recessions? The answer is that declining labor market slack tends to push up unit labor costs, forcing central banks to hike interest rates in an effort to stave off rising inflation. Thus, falling margins are just a symptom of an underlying problem: economic overheating. Don’t blame lower margins for recessions. Blame central banks. Inflation Is Not A Threat... Yet For now, unit labor cost inflation remains reasonably well contained in the major economies (Chart 14). However, there is little evidence to suggest that the historic relationship between labor market slack and wage growth has broken down (Chart 15). Barring a major surge in productivity growth, inflation is likely to accelerate eventually as companies try to pass on higher labor costs to their customers. Chart 14AUnit Labor Costs Are Well Behaved For Now (I) Chart 14BUnit Labor Costs Are Well Behaved For Now (II) Chart 15Correlation Between Labor Market Slack And Wage Growth Remains Intact We do not know exactly when such a price-wage spiral will emerge. Inflation is a notoriously lagging indicator (Chart 16). Our best guess is that inflation could become a serious risk for investors in late 2021 or 2022. Thus, investors should remain overweight global equities for the next 12-to-18 months, but be prepared to turn more cautious in the second half of 2021. Chart 16Inflation Is A Lagging Indicator Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Jong-Wha Lee and Warwick J. McKibbin, “Globalization and Disease: The Case of SARS,” Brookings Institution, dated February 2004. 2 Please see Global Investment Strategy Weekly Report, “Bond Yields: How High Is Too High?” dated January 17, 2020. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Highlights Storms set a low bar for Q3 EPS. BCA's Beige Book Monitor near cycle highs despite storms. Investors should fade the Q3 housing weakness. Latest Survey Of Consumer Finances highlights student loan debt issue. Feature Chart 1Q3 GDP Growth Has Held Up##BR##Remarkably Well Despite Hurricane Impact U.S. equities hit fresh all-time highs again last week, undeterred by the downward adjustment in Q3 earnings estimates in part due to Hurricanes Harvey and Irma. Investors appear to be looking through any near-term hit to economic growth and profits. Trump's tax plan cleared a key hurdle in Congress and tax cuts would surely give the market a boost if they are eventually passed. Bond yields and the dollar edged higher on speculation that President Trump will choose John Taylor as the next Fed Chair, who many believe will be a hawk. While we agree that investors should look through the hurricane effects, we worry that equity markets appear increasingly frothy. While the storms will cast a shadow over the Q3 earnings reports, the economic data has held up remarkably well. At 2.7% and 1.5%, the Atlanta Fed GDP Now and New York Fed's Nowcast for Q3 have recouped nearly all the ground they lost in the immediate aftermath of the storms (Chart 1). The Fed's Beige Book revealed a stout underlying economy despite the most weather related disruptions since superstorm Sandy in 2012. The Beige Book and most of the other economic data released in the past few weeks, aside from the inflation data, support a December rate hike. Markets are pricing in a near 100% chance of a 25bps hike at the December 12-13 FOMC meeting. The impact of Harvey and Irma have also lowered expectations for housing and residential investment in Q3, but housing is poised to rebound in the coming quarters even if the Fed raises rates once this year and three more times as we expect next year. The Fed's latest Survey of Consumer Finances will raise more concern over student loan debt, but also show that households' low cash balances and elevated allocation to equities match consumers' elevated confidence readings. Q3 Earnings Outlook Clouded By Storms Hurricanes Harvey and Irma may temporarily undermine corporate profits in a few industries in the third quarter. The annual growth rate of the 4-quarter moving total was poised to peak anyway, given more demanding year-ago comparisons (Chart 2). Still, EPS growth is peaking at a high level and should decelerate only slowly through 2018 toward a level more commensurate with 3.5-4% nominal GDP growth. We thus expect the earnings backdrop to remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any positive impact on growth from tax cuts. The announcement of tax cuts would be positive for EPS and the S&P 500 price index in the short term, although this would also bring forward Fed rate hikes. Rising oil prices are turbocharging earnings in the energy patch and we expect this to continue. Indeed, BCA's Commodity & Energy Strategy service raised its 2018 target price for both Brent and WTI last week to $65.15/bbl and $62.95/bbl, respectively. These estimates are up by $5.51 and $5.98/bbl from our forecast last month.1 The soft industrial production readings in September would be a concern for BCA's profit forecast, absent the storms' impact (industrial production is included in our top-down EPS model). However, the Fed noted that "the continued effects of Hurricane Harvey and, to a lesser degree, the effects of Hurricane Irma combined to hold down the growth in total production in September by 1/4 percentage point. For the third quarter as a whole, industrial production fell 1.5 percent at an annual rate; excluding the effects of the hurricanes, the index would have risen at least 1/2 percent." Moreover, strong readings in September and October on both the New York and Philadelphia Fed's manufacturing indices imply that the aftermath of the storms did not extend beyond Texas and Florida, and suggest a rebound in IP in Q4. The elevated readings on the Cass Freight index in recent months support that view (Chart 3). Chart 2Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Chart 3Storms Impacted IP In Q3 Bottom Line: The earnings season is underway and forecasts have collapsed to a mere 4.2% year-over-year growth rate for Q3. They were as high as 5.5% at the start of Q3. Financials are heavily weighing on the outlook and the sector's profits are expected to contract by 9%. While the insurance sub-sector may be behind the bulk of the negative EPS revisions owing to the hurricanes, such extreme pessimism is unwarranted and the bar is set extremely low for both financials and the overall market. Based on the September and October Beige Books, corporate managements will not be too concerned with the dollar during this earnings reporting season. The Beige Book: Beyond The Storms The Beige Book released on October 18 supports the Fed's stance that the hurricanes will not alter the U.S. economy's medium-term trajectory and will keep the Fed on track to boost rates by another 25 basis points in December. BCA's quantitative approach2 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market, but there is still a disconnect between the Beige Book's view of inflation and the market's stance. Moreover, the stronger dollar has disappeared from the Beige Book and despite the lack of progress in Washington on Trump's pro-business agenda, business uncertainty is down. In addition, the prospects for commercial and residential real estate remain bright. Chart 4Beige Book Monitors Support Fed's Outlook##BR##On Economy And Inflation At 63%, BCA's Beige Book Monitor stayed near its cycle highs in October, providing more confirmation that the underlying economy remained upbeat in Q3 despite Hurricanes Harvey and Irma (Chart 4). The latest Beige Book covered the period from mid-September to October 6. Hurricane Harvey hit Texas and Louisiana in late August while Irma made landfall in Florida in early September and moved on to neighboring southeastern states through mid-month. While there were only four mentions of "weather", "hurricane" was used 58 times and "storm" nine times. The total 71 puts the weather impact on the Beige Book at its highest since superstorm Sandy struck the northeastern U.S. in Q4 2012 (Chart 4, panel 2). Based on the Beige Book, the dollar should not be an issue in the Q3 or Q4 earnings seasons. The greenback is no longer a concern for small businesses and bankers, which is in sharp contrast to 2015 and early 2016 when there was a surge in Beige Book mentions of a strong dollar (Chart 4, panel 4). In October, there were no remarks at all. The past three Beige Books (July, September and October) have seen only a single reference to a stronger dollar. The last time that three consecutive Beige Books had so few mentions was in late 2014. Remarkably, business uncertainty over government policy (fiscal, regulatory and health) has moved lower in 2017. The implication is that the business community is ignoring the lack of progress by Washington policymakers on Trump's agenda (Chart 4, panel 5). Echoing the market's disagreement with the Fed on inflation, a significant discrepancy in the Beige Book was evident in the number of inflation words (Chart 4, panel 3). Expressions of inflation dipped to a 7-month low in October. However, a disconnect persists between the still-elevated mentions of inflation and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The recent Beige Book backs BCA's view that the hurricanes will not derail the economy. Indeed, the September reading on our Beige Book monitor in early October suggests that the economy rebounded smartly as the effects of the storms waned in late Q3 and early Q4. However, the Beige Book has done little to resolve the debate around why an economy growing above potential and a tightening labor market have not boosted inflation. Moreover, the October Beige Book all but warned investors to fade the Q3 weakness in the housing data. Housing Woes Continue In Q3 The weakness in residential investment in Q3 is temporary and housing has not peaked for the cycle. The monthly data on housing in August and September were affected by Hurricanes Harvey and Irma. Housing starts for September were weaker than anticipated and below August's readings. Specifically, the 9% m/m drop in September's starts in the South followed the 5% drop in August. Existing home sales posted a modest month-over-month gain in September after a three month decline. Nonetheless, October's 68 reading on homebuilder sentiment was four points above September's reading and the highest since May (Chart 5). Rising rates are not a threat to housing affordability, even if the Fed is able to lift rates in line with its dot plot. Chart 6 shows the influence of higher rates on housing affordability and effective mortgage rates under two scenarios. A 200-basis point increase in mortgage rates (Chart 6, panel 1) would push the housing affordability index below its long-term average for the first time in nine years. BCA assigns a low probability to a rate jump given the Fed's commitment to gradually increase rates. A more plausible path for mortgage rates in the next year is a 100bps rise (Chart 6, panel 3). Under this scenario, the affordability index would deteriorate, but remain a tailwind for housing. Chart 5Solid Housing##BR##Fundamentals In Place Chart 6Housing Affordability Under##BR##Various Rate Assumptions The historically low reading on Bloomberg's Housing and Real Estate Surprise Index also suggests that housing is poised to rebound in the coming quarters (Chart 7). The last time that the index was as low as the -1.2 reading in mid-October was in late 2013 amid the taper tantrum, and prior to that in late 2008/early 2009. Moreover, the gap between Bloomberg's overall Economic Surprise Index and the Housing Surprise index has never been wider. Therefore, the weakness in the housing data is a weather-related anomaly. Chart 7Big Disconnect Between Housing Surprise And Economic Surprise It is important to assess whether residential investment has peaked for the cycle. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced.3 While housing's contribution to overall economic growth plunged in Q2 and Q3, we expect housing to provide fuel for the next few years as pent up demand is worked off from the depressed household formation rate since the 2008 financial crisis. Moreover, BCA does not anticipate that rising rates will be a serious threat to housing in the next 12 months. The implication from our upbeat view on housing is that the next recession is still several years away. Reliable leading indicators of a recession such as the LEI, the yield curve and the 26-week change in claims, are not signaling a downturn (Chart 8). BCA's recession model puts the probability in the next 12 months at a meager 2%. Only one of the eight components signal a downturn. Furthermore, neither the St. Louis Fed's nor the Atlanta Fed's recession indicators is in the danger zone. BCA does not expect a buildup in the types of imbalances that previously led to economic declines. Instead, a recession may be triggered by a Fed policy mistake,4 a terrorist attack that disrupts economic activity over a large area for an extended time, or a widespread natural disaster. Chart 8Odds Of A Recession In Next Year Remain Low Bottom Line: In the next 12 months, investors should remain positioned for stocks to outperform bonds and rising rates. While markets have entered a more dangerous late-cycle "blow off" phase,5 housing's contribution to GDP has not peaked for the cycle, which means that recession is still more than a year away. Housing will rebound in Q4 after an appalling performance in Q2 and Q3. A healthy housing market will continue to support the consumer. Surveying The Consumer Table 1Household Balance Sheets Prior##BR##To Recessions And Today The Fed's latest triennial Survey of Consumer Finances (SCF) shows that the consumer is less sensitive to housing, holds less cash and more equities than in the past. However, the report also shows that households that own interests in small businesses may disproportionately benefit from the GOP's corporate tax cut proposal. The SCF data supply a detailed examination of consumer health, not provided by the macro data. Nonetheless, key household- and consumer-related spending, which are saving- and balance sheet-related concepts in the SCF, closely track similar statistics in the macro datasets such as the Flow of Funds and the NIPA accounts.6 Table 1 shows household balance sheets in 1989, 1998, 2007, a year or two before the recessions and bear markets of 1990, 2001 and 2008-2009. The latest (2016) is also shown. Households are more sensitive to business conditions than ever before. Households in 2016 hold less cash (as a percentage of financial assets) than in any other pre-recession year, while consumers' equity holdings are the highest on record. Consumers' mix of nonfinancial assets showed that while housing was still the largest single asset (42.4% in 2016), the share of household assets devoted to primary residences was the lowest on record. Vehicles were only 4.8% of a household's nonfinancial assets in 2016, a new low. In contrast, individuals' equity in business (34%) was the highest ever. The implication is that a plunge in housing prices would be as detrimental to consumers today as it was in the mid-2000s. Hence, households' higher exposure to business ventures suggests that a tax cut that favors small businesses over individuals may shore up household finances. Despite improvement in many areas of consumer finances, the household exposure to student loans in 2016 was alarmingly high (Table 2). On the surface, the SCF data do little to ease fears that student loans will compromise household balance sheets and lead to the next recession. The mean student loan debt per household in 2016 was $34,200, 37% higher than in 2007, and more than triple the 1989 level. While 22% of families had student debt in 2016, a slight improvement from 2013, only 9% of families had student debt in 1989. Moreover, educational debt accounts for 8% of household debt. While that figure is dwarfed by the 67% of family debt in housing, a scant 4% of family debt was related to student loans prior to the last recession in 2007.7 Furthermore, 42.6% of families with education debt report that they have student loan debt of more than $25,000, a sharp upsurge from 2007 and more than double the percentage reporting $25,000 or more in 1989.8 Table 2Nearly Half Of All Families With Education Debt Have Student Loan Debt Of At Least $25,000 That said, BCA's view remains that student debt is a modest drag on economic growth, and is not a threat to U.S. government finances nor does it represent the next subprime crisis.9 John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," October 19, 2017. Available at ces.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report "The Great Debate Continues", dated April 17, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Disconnected," September 11, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks and the Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 6 https://www.federalreserve.gov/econresdata/feds/2015/files/2015086pap.pdf 7 Sourced from 1989-2016 Survey of Consumer Finances Database at https://www.federalreserve.gov/econres/scfindex.htm. Historic Tables - Table 16 - Amount of debt of all families, distributed by purpose of debt. 8 Jeffrey P. Thompson and Jesse Bricker, "Does Education Loan Debt Influence Household Financial Distress? An Assessment Using The 2007-09 SCF Panel," October 16, 2014, Federal Reserve. 9 Please see The Bank Credit Analyst Special Report, "Student Loan Blues: Can't Replay What I Borrowed," November 2016. Available at bca.bcaresearch.com.
Highlights Finally, an upside surprise on inflation. Recent significant developments reinforce BCA's bullish view on crude oil. Investors should consider the Monthly Report on personal income and spending, and not the quarterly GDP data, to gauge hurricanes' impact on economy. While the Fed will consider impact of Harvey and Irma, policy will ultimately be made on health of underlying economy. Feature Chart 1Rally For Risk Assets##BR##A Week Before The FOMC Risk assets and oil prices rose last week along with Treasury yields ahead of this week's FOMC meeting. Both the S&P 500 and the Dow hit new highs last week as the dollar moved lower. The stock-to-bond ratio also climbed, approaching the highs it reached earlier this year (Chart 1). All of this occurred amid an absence of any meaningful news on corporate earnings, aside from Apple's launch of the latest iPhone. Q3 earnings season is still a month away. Our base case projects stocks outperforming cash and bonds over the next 6-12 months, but in early September we recommended that clients be prudent, pare back any overweight positions and hold some safe-haven assets within diversified portfolios. The most significant movement in assets prices last week came in the U.S. Treasury market. Aided by hints of some progress on tax cuts in Washington less damage than initially feared from Hurricane Irma's impact on Florida, and despite another rocket launch by North Korea, the 10-year Treasury yield moved from near 2.0% in the first week of September to 2.20% on September 15. BCA's U.S. Bond Strategy service notes1 that bond markets are priced as though the link between growth and inflation is broken. We expect they will be proven wrong as inflation regains its uptrend during the next few months. Finally A Surprise On Inflation Chart 2Does One Month Make A Trend? After five months of downside surprises, U.S. core CPI met expectations in August. It is still too soon say that this is enough for the Fed to raise rates again this year. To get a better sense of the underlying trends, we like to break core CPI into three sub-groups: shelter, core goods and core services ex-shelter and medical care. Shelter, which accounts for over 40% of core CPI, rose 0.4% m/m in August. This was the biggest contributor to core CPI during the month. Our shelter model suggests that this strength is unlikely to persist. On the flip-side, core goods prices (25% of core CPI) fell 0.1% m/m. Given the weakness in the dollar, core goods prices should soon begin to rise. To some degree, a slowdown in shelter and a pick-up in core goods could offset each other over the coming months (Chart 2). Therefore, a sustained pick-up in overall core inflation requires an upturn in core services ex-shelter and medical. This sub-component of core CPI is the most tightly correlated with wage inflation. There was a slight tick higher in annual core services ex-shelter and medical inflation in August. However, it is still near a 25-year low of just 1.1%. Bottom Line: Following five months of persistent downside surprises, the 0.2% m/m increase in core CPI during August was a welcomed change for the Fed. However, one month does not make a trend and Fed will need to see more evidence of inflation turning the corner before raising interest rates again. Any rise in oil prices would also give inflation a lift, although it would affect the headline more than the core inflation rate. Bullish Oil Supply And Demand Recent significant developments reinforce BCA's bullish view on crude oil. The International Energy Agency (IEA) revised its forecasts for global oil demand. Oil consumption will be 100,000 bpd higher this year than the IEA's previous projection. Furthermore, renewed turmoil in Libya curbed production by 300,000 bpd from a 4-year high of more than 1 million bpd. BCA's Commodity & Energy Strategy service states that while predicting OPEC compliance is tricky, little to no cheating will occur. At worst, Saudi Arabia will step in and curtail production if Libya and/or Iraq begins to pump oil above quota. Finally, the Energy Information Administration (EIA) in the U.S. lowered its estimated shale oil output by 200,000 bpd for this year's third quarter. The decreased estimation confirms BCA's assertion that the EIA has overestimated the pace of the shale production response during 2017. Chart 3Drawdown In Global Oil##BR##Inventories Is Underway Taken together, these factors will help to improve the global net demand/supply balance by 600,000 bpd, if the current situation remains unchanged. As a result, global oil inventories will continue to be drawn down (Chart 3). Severe weather in the U.S. has temporarily distorted the energy markets. Crack spreads have widened in the U.S. as product inventories have declined along with Brent - WTI spreads. Nonetheless, BCA's commodity strategists remain bullish on crude oil, forecasting a rise in WTI to over $55/bbl and Brent to $60/bbl by year-end. Looking to next year, crude prices could go higher with an extension of the OPEC/Russian production cuts beyond March 2018 and continued strong growth in global oil demand. A sudden jump in the U.S. dollar could risk BCA's bullish view. Bottom Line: There is a disagreement between the market's view of the fundamentals of the global oil balance, which is guided by the EIA data, and BCA's view that is driven by the OPEC 2.0 framework.2 Oil prices could spike higher if the market adheres to the OPEC framework. BCA's Equity Trading Strategy service recommends an overweight to the S&P 500 Energy Sector and initiated an overweight in the Oil and Gas Refining and Marketing sub-group on September 11, 2017.3 Hurricane Redux Turning to the U.S. hurricane destruction, history shows that natural disasters have only a passing effect on the U.S. economy, the financial markets and the Fed.4 Ultimately, the macro environment in place before the storm will reassert itself. Nonetheless, it may be a few months before investors determine the long-term impact of the storms on Houston, Florida and nearby southern states. The U.S. data gathering agencies (BEA, BLS and Census) have processes to ensure that the storm's sway is reflected in the economic data. In the past, all three have produced post-disaster evaluations and will likely release the same type of information in the months ahead. Most of the storms' effects will be felt in the September data, but have already affected the initial claims data for the last week in August and the first week of September. The storms will also buffet the Q3 GDP (due out in late October). However, GDP data may not provide a comprehensive picture; GDP is not directly affected by natural disaster losses involving property, plants, equipment and structures. However, GDP can take a direct hit from the loss of productive capacity linked to a storm. The BEA notes that "while GDP may be affected by the actions that consumers, businesses, and governments take in response to a disaster, these responses are generally not separately identifiable, and they may be spread out over a long period of time." Investors should consider the monthly report on personal income and spending, and even more, the regional accounts by state, and not the quarterly GDP data, for details on the storms' economic fallout. Only hurricanes Katrina and Rita warranted a mention in the Q3 2005 GDP release, and none of the other major storms since that time have been noted by the agency. On the other hand, the personal income and spending reports released after all the major hurricanes since 2005 have provided key specifics on incomes. For example, the BEA stated that "work interruptions" linked to Hurricane Sandy reduced wages by $18 billion in October 2012 when the storm hit the northeastern U.S. The Bureau of Economic Analysis (BEA) also tends to note a storm's influence on other primary income categories including personal rental incomes, proprietors' incomes, and other current transfer receipts (i.e. insurance payments received). Table 1Total Federal Spending And Total Economic Damage For Selected Hurricanes, 2000 To 2015 A 2016 Congressional Budget Office (CBO) report found that federal spending after major hurricanes can add as much as 0.6% to GDP growth (Table 1). CBO notes that most of the economic impact is in the first year after a storm, with most of those expenditures helping victims to obtain food and shelter, fund search and rescue operations, and protect critical infrastructure. Federal outlays for public infrastructure occur after the first year and provide a much smaller lift to GDP (Chart 4). Chart 4Federal Government Outlays For Hurricane Relief The severe weather in the U.S. has raised the odds that the Trump administration and Congress will make progress on fiscal policy this fall. We think that the outlines of a tax bill will emerge in the next month or so, and while the probability of passing legislation this year is still low, BCA's Geopolitical Strategy service expects the market to react when it sees the bill. The implication for investors is that the President Trump trades (Chart 5) that have unwound since the start of the year may soon become profitable again. The recent agreement between Trump and the Democrats to extend the debt ceiling and avoid a government shutdown support our stance. Chart 5Trump Trades Making A Comeback? Bottom Line: The hurricanes may have a bearing on the economic data for the next few months. Investors should closely monitor the input data to GDP, but not GDP itself. However, we do not anticipate that any economic disruptions from the storms will have a meaningful influence on near-term Fed monetary policy. Disasters And The Fed The hurricanes will probably play a supporting role in the Fed's outlook on the economy, inflation and labor market at this week's meeting. The FOMC statement will mention the storms and Fed Chair Yellen may include them in her opening remarks. Moreover, the news conference will provide another opportunity to discuss the issue. For example, the FOMC statement released in mid-December 2012, six weeks after Sandy, stated that "economic activity and employment have continued to expand at a moderate pace in recent months, apart from weather-related disruptions". Fed staff noted that manufacturing production was held down by Sandy and that household spending, notably vehicle sales, declined in October due to the storm (Table 2). Similarly, the wrath of Hurricanes Katrina and Rita was noted in FOMC statements and minutes in the fall and early winter of 2005. For example, in the statement released at the meeting after Katrina hit in August 2005, the FOMC observed: "The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term." Fed policymakers made similar observations in the aftermath of other natural and man-made disasters in the past 25 years (Table 2). Table 2FOMC Reaction To Disasters, Natural And Man Made Bottom Line: Fed officials will consider the disruptions to the economy and economic data caused by Hurricanes Harvey and Irma, but ultimately make policy decisions based on the underlying strength of the economy, labor market and inflation. FOMC Preview The FOMC will initiate shrinking its balance sheet at this week's meeting, but neither BCA nor the market anticipate that the Fed will bump up rates. Moreover, the Fed will need more evidence that inflation, inflation expectations and/or inflation surprise has turned higher before resuming its rate hike regime. Furthermore, there is still a significant disconnect between the market and the Fed concerning rates for the next 12 months, and how that gap closes could be crucial for the financial markets, especially the bond market. At 43 basis points, the gap between the June dot plots and the market on the Fed funds rate in the next 12 months remains near its widest level of the year. The market is currently predicting only 30 bps in increases in the next 12 months. However, an uptick in inflation could quickly change that view (Chart 6). Despite the disagreement on rates, the Fed and the market are mostly aligned on the economy, the labor market and inflation, at least in 2017. For the first time, the FOMC will provide projections for 2020 at this week's meeting. At 4.4% in August, the unemployment rate is a mere tenth above the Fed's end-2017 forecast, but it is 0.2% below the central bank's latest estimate of full employment (4.6%). The Fed's measure of full employment has declined in recent years and we would not be shocked to see a drop again this week. The consensus outlook for the unemployment rate matches the Fed's path through the end of 2018 (Chart 7 and Chart 8). Chart 6Big Disagreement Between The Fed ##br##And The Market On Rates Chart 7The Fed Vs. The Market Chart 8The FOMC's "Long Run"##BR##Forecasts Since 2012 The economy is on pace this year to grow at the Fed's 2.2% projection but is running above the FOMCs long-run calculation of 1.8%, which is the low point since the Fed started publishing these long-run projections in 2009. The consensus forecast for GDP in 2018 and 2019 is slightly above the upper end of the Fed's range set in June (Chart 7 and Chart 8). The Fed and the market are relatively close on inflation this year, but there is still a wide gap in 2018 and beyond. In June, the Fed lowered its inflation forecast for 2017 to 1.6% from 1.9% in March. PCE inflation is at only 1.4% (year-to-date in 2017), so there is not much disagreement in this regard. The market does not agree with the Fed's view that inflation will return to 2.0%, and this is a key reason why the 10-year Treasury yield recently touched a new post-election low at 2.0%, although geopolitical tensions also played a role. The central bank's view of inflation in the long run has not deviated from 2.0% since 2012. Bloomberg consensus estimates for core inflation for this year and next are below the low end of the Fed's forecast range (Chart 7 and Chart 8). Market participants and some Fed officials are still concerned that the traditional Phillips curve model may be broken and that inflation may never accelerate even with an unemployment rate that is below the Fed's estimate of full employment. (Please see a BCA Special Report, "Did Amazon Kill The Phillips Curve?").5 Who Will Be The Next Fed Chair? As some investors consider the Fed's next policy move, others are taking a longer view and thinking about Fed Chair Yellen's replacement. Yellen's term as Chair will end in February 2018, and the markets have not yet shown any concerns about her potential replacement. Until last month, the frontrunner to replace Yellen was Gary Cohn, the Chairman of President Trump's National Economic Committee; his appointment would conform to some historical precedents but violate others.6 Several new names have emerged as possible Fed nominees as Cohn fell out of favor in the White House in early September. Kevin Warsh, Glen Hubbard and John Taylor, are all high-profile economists with links to the GOP, but Warsh stands out because he served on Trump's Strategic and Policy forum before it disbanded in August, and was a Fed Governor in the early 2000s (Table 3). Hubbard, who is currently an academic, was President George W. Bush's chief economist. However, he has not worked with Trump and has no Fed experience. John Taylor is well known in monetary policy circles, but has no Fed or government background, nor has he served with Trump. Taylor advocates for rules-based monetary policy.7 Another possible name, Larry Lindsey, an advisor to George W. Bush's campaign in 2000, a Fed Governor in the 1990s, and worked in the Reagan White House but he has no connection to Trump. He has recently spoken in favor of the House tax plan. Table 3Characteristics Of Fed Chairs Since 1970 The other two names under consideration - Richard Davis and John Allison - may have difficulty winning confirmations by the Senate. Both men were CEOs at major banks although neither have directly served Trump, nor been at the Fed or in government. Allison, a former president of the Libertarian Cato Institute, has argued that the Fed should be abolished and blamed the Fed for the financial crisis. The timing of Trump's announcement on Yellen's replacement may be critical. As a reminder, names floated by the Obama White House in the summer of 2013 were mainly rejected by the markets. Yellen's official announcement came in early October 2013. In August 2009, President Obama reappointed Bernanke for a second four-year term. Bernanke was initially nominated to be Fed Chair by George W. Bush in October 2005. If the appointment comes in October and the nominee is perceived to be hawkish, the risk is that markets may begin to price in the regime change sometime in the next few months. As we noted in the sections above, there is already a wide discrepancy between the Fed and the market over the pace and timing of rate hikes in the coming year. BCA's fair value model for the 10-year Treasury yield (based on Global PMI and dollar sentiment) currently places fair value at 2.67%.8 Moreover, our 3-factor version of the model (which includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.68%. Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Bottom Line: Markets will be increasingly concerned in the next six weeks about the next Fed Chair and his or her policies. While the reappointment of Fed Chair Yellen for another term would please the markets, several other possible successors would not. We anticipate that the President will make a choice within the next month. Taking a longer view, the next Fed chair will oversee the policy response to the next recession and its aftermath. Investors should understand how the next Chair views the Fed's role in the business cycle. Economy Focus: Some Good News From The Quarterly Services Survey Even with the increasingly dominant role of the service sector's contribution to the economy (~69% of GDP), most of the high-frequency data are related to the manufacturing sector (~12% of GDP) (Chart 9, top panel). However, the Quarterly Services Survey (QSS), initiated in 2003-2004 by the Bureau of Economic Analysis (BEA), measures the services sector of the economy, including companies of all sizes (small- and medium-sized). It produces the most timely revenue data, on a quarterly basis, within the flourishing service sector. The dataset is used primarily by the BEA to estimate a more accurate picture of the national accounts, notably personal consumption and the intellectual property segment of private fixed investment. The survey is also essential for FOMC policymakers as it is very useful to track current economic performance. Even more, during the financial crisis, the BEA "aggressively responded to policymakers' needs for data on financial services". The QSS is a significant source of revisions to real GDP, as about 42% of the quarterly estimates of PCE for services is now based on QSS data. The "key services statistics" include information services; health care services; professional, scientific, and technical services; administrative and support and waste management and remediation services (Chart 9). For the first half of 2017, upward revisions to second and third estimates to real GDP stemmed from revisions to PCE services and nonresidential fixed investment, namely: health care services, financial & insurance services and intellectual property products (specifically software) and other services accounted for by cellular telephone services. The most recent QSS for 2017Q2 showed U.S. selected services total revenue rising by 3.2% over the last quarter and 6.2% over the last four quarters (in nominal terms and non-seasonally adjusted data only available). The strongest growth came from revenues of Other Services (9.4% QoQ% and 18.4% YoY) followed by Arts, Entertainment & Recreation and Administration, Support & Waste Management. Sales in Finance & Insurance and Health Care & Social Assistance, which make up about 50% of total service revenues, are advancing at a sturdy pace, as is revenue in Information services (Chart 9). Chart 9Growth For Service Sector##BR##Industries Is Broad-Based Chart 10QSS Survey Heralds Some##BR##Upward Revision To Real GDP Bottom Line: Given that the majority of service industries from the QSS sample survey continue to show upward momentum, perhaps we will see some upward revision to real consumer spending for services for the third estimate of real GDP next week (Chart 10). We continue to expect U.S. GDP growth to match or exceed the Fed's modest target for 2017. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report "Open Mouth Operations", published September 12, 2017. Available at usbs.bcaresearch.com. 2 Please see BCA Commodity & Energy Strategy Weekly Report "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance", published September 14, 2017. Available at ces.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report "Still Goldilocks", published September 11, 2017. Available at uses.bcaresearch.com. 4 Please see BCA U.S. Investment Strategy Weekly Report "Shelter From The Storm", published September 5, 2017. Available at usis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report "Did Amazon Kill The Phillips Curve?", published August 31, 2017. Available at bca.bcaresearch.com. 6 Please see BCA U.S. Investment Strategy Weekly Report "Global Monetary Policy Recalibration", published July 17, 2017. Available at usis.bcaresearch.com. 7 Please see BCA U.S. Investment Strategy Weekly Report "Trump And The Fed", published March 6, 2017. Available at usis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report "The Cyclical Sweet Spot Rolls On", published September 5, 2017. Available at usbs.bcaresearch.com.
Highlights U.S. product inventories - particularly gasoline and distillates - will show sharp declines over the balance of September, as refining capacity continues to trail demand in the wake of Hurricane Harvey. U.S. crude inventories will accumulate as refineries slowly come back on line. This will keep the Brent vs. WTI spreads and crack spreads elevated, as refiners outside the U.S. Gulf scramble for crude (Chart of the Week).1 Global product storage facilities will be drained to more normal levels responding to this imbalance. It is understandable that the significance of the increased frequency of messaging from OPEC 2.0's leadership re its willingness to extend production cuts beyond March 2018 would be secondary to hurricane recovery. Nonetheless, we advise investors to stay focused on OPEC 2.0's evolution, particularly next year, as it develops a modus operandi for providing forward guidance to markets and investors. Energy: Overweight. Brent futures are backwardated to January 2018, reflecting a tight market as refiners, particularly in Europe, scramble for barrels to meet U.S. and Latin American product demand. We remain long Brent and WTI $50/bbl vs. $55/bbl call spreads in Dec/17, which are up 183.8% and 30.2%, respectively, since inception. Base Metals: Neutral. Our tactical COMEX copper short initiated last week is up 3.4%. Precious Metals: Neutral. The Dec/17 COMEX Gold contract gapped lower earlier in the week, as a strengthening USD, and a 15 - 0 vote Monday by the UN Security Council to adopt sanctions proposed by the U.S. against N. Korea took some of the luster off the metal. Our long strategic portfolio hedge is up 8.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. Grains appear to be finding support around current levels. We are bearish, but do not advise shorting the complex, especially with erratic weather as a backdrop. Feature Chart of the WeekBrent - WTI Spread,##BR##Cracks Reflect Refining Scramble The Kingdom of Saudi Arabia (KSA) and Russia, the putative leaders of what we've dubbed OPEC 2.0, are taking every opportunity to signal their willingness to consider an extension of their production-cutting agreement beyond March 2018, when it is scheduled to expire.2 We believe this to be part and parcel of an evolving forward guidance strategy, which KSA and Russia will deploy to signal their production intentions over the near term. This is consistent with our view such a strategy is necessary to keep the producer coalition durable, and to work out an even larger plan to begin messaging firms and institutions allocating capital to oil and natural gas markets globally. This is critical for KSA, which will be looking to IPO Saudi ARAMCO next year, and Russia, which is preparing for elections in March and still relies heavily on hydrocarbon exports to fund its government.3 The last thing either needs is out-of-control oil production tanking the market, as it almost did at the beginning of 2016. Other members of the OPEC 2.0 coalition seeking foreign direct investment (FDI) - e.g., Gulf Arab producers and non-OPEC states like Mexico and Kazakhstan - benefit from an oil-production-management framework as well. The significance of OPEC 2.0's emerging forward guidance strategy could be lost amid the devastation of hurricanes Harvey and Irma, which is understandable. But it will be critical to understanding the coalition's strategy regarding how it intends to manage its own production, now that U.S. shale is the marginal barrel in the world, even after Hurricane Harvey disrupted production and refining in Texas, and U.S. crude and product exports from the Gulf. Thus far, OPEC 2.0 continues to deliver on its production cuts, and global demand - which we expect will dip by less than 1mm b/d over the next few weeks due to the hurricanes - remains strong. In a month or two, we expect hurricane recovery efforts will restore lost refining capacity and product demand. As rebuilding goes into high gear, we expect product demand to get a significant boost. OPEC 2.0 Maintains Discipline We will be updating our oil supply/demand balances next week, but so far it appears KSA and Russia are honoring their commitments to restrain production. This allows them to maintain credibility with their respective OPEC and non-OPEC allies within OPEC 2.0, and with the market in general (Chart 2). KSA, in particular, has led the way among OPEC members of the coalition, according to a tally done by S&P Global's Platts, which put KSA's average crude oil production over the January - August 2017 period at 9.97mm b/d vs. its quota of 10.06mm b/d. This is up slightly over the 9.93mm b/d average production for January - June 2017 reported by JODI. KSA's August production reported in the September OPEC Monthly Oil Market Report was 9.95mm b/d. For the January - August 2017 period, Russia's total crude and liquids production averaged 11.22mm b/d, according to U.S. EIA estimates. For the May - August period, it averaged 11.16mm b/d, putting total output 300k b/d below its October 2016 level, against which OPEC 2.0 benchmarks. Russia committed to reducing output by 300k b/d under the OPEC 2.0 Agreement as part of an overall effort to remove 1.8mm b/d of production from the market to end-March 2018. Russia's crude oil production averaged 10.38mm b/d over the January - June 2017 period, according to JODI data, vs. an October level of 10.51mm b/d. For 2Q17, Russia's average production reported to JODI was 10.31mm b/d, or 200k b/d below its Oct/16 output. Overall OPEC compliance of members with quotas was 112% of agreed volumes last month, meaning OPEC members with quotas under the OPEC 2.0 Agreement are producing 630k b/d below agreed volumes, according to Platts.4 Seven of the OPEC states still covered by the Agreement are producing below quota. Iraq leads in over-production at 4.46mm b/d on average in the January - August period, or 82k b/d over quota. Overall, however, production discipline is holding (Chart 3, panel 2). Chart 2KSA, Russia Leading##BR##OPEC 2.0 By Example Chart 3Production Discipline, Strong Demand##BR##Will Continue To Support Prices Bottom Line: OPEC 2.0's forward guidance to markets, firms and institutions allocating capital in the energy sector has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018, when their Agreement is due to expire. We believe this reflects the desire of OPEC 2.0's leadership to maintain the coalition as a long-term production-coordinating body. This will allow the major oil producing nations to communicate production plans and allay investor fears of out-of-control production in the future. Global Demand Will Remain Strong We have noted repeatedly global economic growth has been firing on all cylinders, which will keep global oil demand robust for at least the balance of 2017, and likely into 2018 (Chart 3, panel 3). This is particularly evident in global trade data, which we also will be updating next week.5 Global economic data continue to support this thesis: All 46 countries monitored by the OECD are on track to grow this year, the first time this has happened since 2007, according to BCA's Global Investment Strategy (GIS).6 In addition, BCA's Global Investment Strategy notes U.S. growth projections have been broadly stable, but these likely will be revised higher. The easing in U.S. financial conditions since the start of the year should boost real GDP growth over the next few quarters, which, along with the expected boost to product demand coming on the back of hurricane-recovery efforts, will continue to be bullish for refined product demand. Global Product Inventory Draws Will Accelerate OPEC 2.0's efforts to draw global inventories - particularly in the OECD - received an unexpected assist from hurricanes Harvey and Irma. We expect the trend of drawdowns seen over the past few months to accelerate (Chart 4). This will return global product inventories to more normal levels, and, with crude oil inventories accumulating, favor refiners as they scramble to meet demand. Our colleagues at BCA's Energy Sector Strategy upgraded U.S. refiners last week to overweight in line with their view Harvey has the "potential to finally normalize bloated refined product inventories. Over two weeks since the hurricane made landfall, the industry still has 1.0 MMb/d of refining capacity shut down (5 refineries), 2.15 MMb/d of capacity not operating but working on restarting operations (6 refineries), and 1.4 MMb/d of capacity operating below full capacity (5 refineries). Over the past 16 days, at least 55 million barrels of refined product have not been generated, which will result in increased crude inventories and shrinking refined product inventories, benefitting refiners" (Chart 5).7 Chart 4OECD Oil Inventory Declines Will Accelerate Chart 5Refinery Outages From Harvey Persist Over the short term, Brent crude - and related streams pricing off Brent - and products will remain bid, keeping refiner crack spreads elevated, as operations return to normal, and Florida emerges from the economic damage and dislocations caused by Irma. Typically, product demand falls immediately after severe storms, and recovers as rebuilding begins and progresses. We will be updating our balances model next week to reflect the effects of hurricanes and the continued indications of strong global growth. Bottom Line: Demand for refined products will dip slightly - likely less than 1% of global demand - as hurricane-ravaged markets recover. As rebuilding progresses, product demand likely will be boosted. This will drain OECD product inventories in the short term, providing an unexpected assist to OPEC 2.0's efforts to bring global stocks down to five-year average levels. This evolution will favor refiners, as well. OPEC 2.0's forward guidance to markets continues to evolve. In recent weeks, it has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018. We believe this messaging is designed to allay fears of another production-free-for-all of the sort that threatened to take global benchmark crude oil prices below $20/bbl last year. It is too early to expect OPEC 2.0 will replace the original OPEC Cartel. But, we believe KSA and Russia are signaling their common desire to make OPEC 2.0 a durable feature of budgeting and investment considerations over the medium term. Actions speak louder than words, in this regard. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 A "crack spread" refers to the difference in refined-product prices and crude oil prices. It takes its name from the "cracking" long-chain hydrocarbon bonds in crude oil required to produce refined products like gasoline and diesel fuel. The Brent - WTI spread is the price difference in USD/barrel ($/bbl) between the global benchmark crudes. 2 Please see, for example, "Saudi Arabia Says It's Open to Another OPEC Cuts Extension," updated on bloomberg.com September 11, 2017; "Saudi, UAE agree extension of oil cuts may be considered - statement," published on the same day on reuters.com's U.K. service; and "Russia's Novak says to consider extension of oil cut deal if glut persists" published on reuters.com September 6, 20107. We have repeated noted markets are looking for OPEC 2.0 to provide forward guidance, if the principals to the deal intend to maintain a durable coalition. Please see, e.g., "KSA's Tactics Advance OPEC 2.0's Agenda," published by BCA Research's Commodity & Energy Strategy Weekly Report August 10, 2017, and available at ces.bcaresearch.com. 3 The U.S. CIA estimates Russia exported 5.1mm b/d of crude oil in 2016, roughly half of crude production. This squares with exports reported by the Joint Organizations Data Initiative (JODI), a transnational agency headquartered in Riyadh, Saudi Arabia. Last year, Russia also exported 223 billion cubic meters of natural gas. KSA exported 7.65mm b/d of crude oil last year, according to JODI, or close to 75% of KSA's production. 4 Please see S&P Global Platts OPEC Guide published September 7, 2017, online. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published on July 27, 2017. It is available at ces.bcaresearch.com. 6 Please see BCA Research's Global Investment Strategy Weekly Report "Central Bank Showdown," published on September 8, 2017. It is available at gis.bcaresearch.com. 7 Please see BCA Research's Energy Sector Strategy Weekly Report "Rebalancing Recommendations," published on September 13, 2017. It is available at nrg.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