Economy

Highlights Prediction 1: A major financial downturn will trigger the next major economic downturn, and not the other way round. Prediction 2: The straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time. But for those who can fine tune, the global long bond yield must rise a further 30-50 bps before reaching the tipping point for the global risk-asset edifice. Take short-term profits in the overweight position in 30-year government bonds. Take short-term profits in the underweight position in basic materials. Take short-term profits in the underweight positions in Italy (MIB) and Spain (IBEX) and overweight position in Denmark (OMX). Feature The twenty-first century has witnessed three major downturns: the first started in 2000; the second started in 2007 culminating in the Lehman crisis a year later; and the third started in 2011 (Chart of the Week). Today, we are going to stick our necks out and make two predictions about the century's fourth major downturn. Chart of the WeekThree Episodes When Equities Underperformed Bonds By 20 Percent Or More A major financial downturn will trigger the fourth major economic downturn. The straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time. Where The Consensus Is Very Wrong As investment strategists, our primary focus should be the financial markets rather than the economy. On this basis, we define a major downturn in terms of the markets: an episode in which equities underperform bonds by more than 20 percent over a period of more than six months.1 All the same, our market based definition of a major downturn perfectly captures the three occasions that the European economy went into recession or stagnation (Chart I-2). Does this mean that the economic downturns triggered the financial market downturns? No, quite the reverse. The onset of the three major financial downturns clearly preceded the onset of the three major economic downturns. Chart I-2Three Episodes When The Euro Area Economy ##br##Contracted Or Stagnated On reflection, this is hardly surprising. The twenty-first century's major economic downturns have all resulted from financial market distortions and fragilities: the bubble valuations of the technology, media and telecom sectors in 2000 (Chart I-3); the mispricing of U.S. mortgages and credit in 2007 (Chart I-4); and the mispricing of euro area sovereign credit risk in 2011 (Chart I-5). Therefore, it makes perfect sense that the downturns in financial markets should precede the downturns in the economy, even when both are measured in real time. Chart I-3The Major Downturns Stemmed From##br## Financial Market Distortions: The Dot Com ##br##Bubble In 1999/2000... Chart I-4...The Mispricing Of U.S. ##br##Mortgages And Credit##br## In 2007/2008... Chart I-5...And The Mispricing Of Euro Area ##br##Sovereign Credit Risk##br## In 2010/2011 Today, the consensus overwhelmingly believes that an economic downturn will cause the next major downturn in financial markets. But history has taught us time and time again that the causality is much more likely to run the other way. Why not learn the lesson? So here's our first prediction: a major financial downturn will trigger the fourth major economic downturn, and not the other way round. This prediction raises some obvious questions: what could be the major fragility in financial markets, and what could fracture it? A Sharp Rise In Bond Yields Triggered The Last Three Major Downturns Look carefully at the financial market downturns that started in 2000, 2007 and 2011, and you will see another striking similarity. In each episode, the global long bond yield rose by 60 bps or more in the months that preceded the onset of the financial market downturn: April 1999 through January 2000 (Chart I-6); March through July 2007 (Chart I-7); and October 2010 through April 2011 (Chart I-8). This strongly suggests that the spike in the bond yield was the trigger for the subsequent major downturn in financial markets. Chart I-6A Sharply Rising Bond Yield Triggered ##br##The Major Downturn Of 2000 Chart I-7A Sharply Rising Bond Yield Triggered##br## The Major Downturn Of 2007 And 2008 Chart I-8A Sharply Rising Bond Yield Triggered ##br##The Major Downturn Of 2011 A sharp rise in bond yields is usually the straw that breaks the back of financial market fragilities, in (at least) one of three ways: it flushes out those actors that are reliant on cheap liquidity; it pressures interest rate sensitive sectors in the economy; and it weighs on the valuations of other assets such as equities, especially if those valuations are already extremely elevated. Which segues us neatly to the current fragility in the global financial system. As we wrote last week, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies across all asset-classes. And the total value of those global risk-assets is $400 trillion, equal to about five times the size of the global economy.2 We have also consistently highlighted that not only do the rich valuations of $400 trillion of risk-assets depend (inversely) on bond yields, but that this relationship is an exponential function.3 So here's our second prediction: the straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time - just as it did in 2000, 2007 and 2011. But Bond Yields Haven't Gone Up Far Enough... Yet Now comes some bullish news, at least for those who can play shorter-term moves in the market. The global long bond yield has been trapped within a tight channel and is only 20 bps up from its recent low in April (Chart I-9). Therefore, it has the scope to rise a further 30-50 bps before reaching the tipping point for the global risk-asset edifice and unleashing a 'risk-off' phase. Chart I-9In 2018, The Bond Yield Has Not Risen Sharply...Yet For those who want to fine tune their investment strategy, the journey up to that turning point would define a phase when many of this year's cyclical sector underperformances would end or even switch to a phase of modest outperformances. Bear in mind that the cyclical sector underperformances this year have been substantial: European banks have underperformed healthcare by 35 percent; global basic materials have underperformed the market by 10 percent; emerging market equities have underperformed developed market equities by 15 percent. So it is prudent to take some short-term profits, especially as these trends are likely to end, at least in the near term. Hence, three weeks ago we closed our underweight banks versus healthcare position, booking a tidy profit of 23 percent. Today, we are closing our underweight position in basic materials versus the market, booking a profit of 6 percent. In a similar vein, we are taking the modest profits in our overweight position in 30-year government bonds. Sector allocation has unavoidable implications for stock market allocation - because the mainstream stock market indexes all have dominant sector skews which determine their relative performances (Chart I-10). Chart I-10Italy Vs. Denmark = Banks Vs. Healthcare On this basis, closing our underweight banks versus healthcare removes the justification for being underweight bank-dominant Italy (MIB) and Spain (IBEX) and the justification for being overweight healthcare-dominant Denmark (OMX). These three positions now move to neutral. While we consider our next shift, our European stock market allocation is temporarily reduced to just five positions. Overweight: France, Ireland, Switzerland. Underweight: Sweden, Norway. Finally, just to say that there will be no report next week as I will be attending our annual Investment Conference which is in Toronto this year. I look forward to seeing some of you there. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Based on the relative performance of the MSCI All Country World Index versus the JP Morgan Global Government Bond Index, both in local currency terms. 2 Please see the European Investment Strategy Weekly Report 'Trapped: Have Equities Trapped Bonds?' September 13 2018 available at eis.bcaresearch.com. 3 Please see the European Investment Strategy Weekly Report 'The Rule Of 4 For Equities And Bonds' August 2 2018 available at eis.bcaresearch.com. Fractal Trading Model* This week, we note that the very strong recent outperformance of U.S. telecoms versus U.S. autos is technically extended, reaching a fractal dimension that has previously signalled the start of a countertrend move. Hence, the recommended trade is short U.S. telecoms, long U.S. autos. Set a profit target of 9% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - 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 Duration: The Fed is unlikely to slow its 25 bps per quarter rate hike pace until there is sufficient evidence pointing to a slow-down in economic growth. Maintain below-benchmark duration in U.S. bond portfolios. Yield Curve: The yield curve will remain near its current level and await confirmation from rising wage growth. The 2-year maturity point is becoming more attractive, and it will soon be time to switch our yield curve positioning from favoring the 5-year/7-year part of the curve to the 2-year. Economy: The global growth data improved somewhat during the past month, but weak foreign growth remains the greatest risk to the U.S. recovery and the Fed's 25 bps per quarter rate hike cycle. Feature Treasury yields increased last week. The 10-year is once again flirting with 3% and the market now discounts four 25 basis point rate hikes by the end of 2019. This time last week it was only priced for three (Chart 1). Chart 110-Year Testing 3% Last week's bearish price action occurred despite core inflation and retail sales both printing well below expectations. But the market saw through the economic data and instead took its cue from a speech given by Fed Governor Lael Brainard.1 A speech that was rightly interpreted as hawkish. We view last week's speech as important because Governor Brainard effectively refuted two arguments that the Fed could use to justify a slower pace for rate hikes in the coming months. Brainard's message to markets is that if any investor still expects the Fed to rely on one of those excuses, they should think again. Getting Close To Neutral One potential reason for the Fed to slow its 25 bps per quarter rate hike pace is that current FOMC estimates place the longer-run neutral fed funds rate between 2.8% and 3.5%.2 This means that four more rate hikes would be sufficient for monetary policy to move from accommodative to neutral. If those neutral rate estimates turn out to be correct, then the Fed might be justified in halting its rate hike cycle this time next year. The problem, as we have pointed out in several prior reports, is that the error bars around such neutral rate estimates are very wide. So wide that we think the FOMC will pay them little attention and focus instead on trends in the actual economy and financial markets.3 Governor Brainard attacks the issue from a different angle, but arrives at the same conclusion. Brainard's framework draws a distinction between the short-run neutral rate - which is allowed to fluctuate in response to changes in the economy - and the long-run neutral rate - which is the neutral rate that prevails "after transitory forces reflecting headwinds or tailwinds have played out." In practice, this distinction means that if the economy proves resilient to a rising fed funds rate, we should conclude that the short-run neutral rate is moving higher. This would mean that higher interest rates are required before monetary policy turns restrictive. If economic tailwinds are strong enough, the short-run neutral rate could even move above the long-run rate. This framework leads to the same investment strategy we have suggested in many prior reports. Investors should ignore neutral rate estimates altogether, and focus instead on monitoring the economy and financial markets for signals that monetary policy is turning restrictive. Some potential signals we have suggested in the past include:4 When year-over-year nominal GDP growth is below the fed funds rate When cyclical spending slows as a percentage of overall GDP When the Treasury curve inverts When the gold price breaks dramatically lower Governor Brainard's speech pointed to one more indicator that we should add to our list: evidence of tightening from indicators of overall financial conditions. The strong relationship between financial conditions and future economic growth is well documented, meaning that Fed rate hikes will only exert a drag on growth if they translate into tighter overall financial conditions. Charts 2, 3 and 4 show how this played out during the past three Fed tightening cycles. Chart 2 shows that financial conditions tightened immediately after the Fed first raised rates in March 1997. They continued to tighten until the Fed stopped hiking in mid-2000. In contrast, Chart 3 shows that financial conditions did not tighten immediately when the Fed first lifted rates in June 2004, but that they eventually tightened as the Fed persisted with hikes. Chart 4 shows how financial conditions have evolved in the current cycle. Broadly speaking, overall financial conditions appear easier now than when the rate hike cycle began in December 2015. In other words, Fed rate hikes have so far not translated into tighter financial conditions. In Brainard's framework this can only mean that the short-run neutral rate has been rising alongside the fed funds rate. This suggests that more rate hikes are required to tighten overall financial conditions and slow growth. Chart 2Financial Conditions: 1990s Chart 3Financial Conditions: 2000s Chart 4Financial Conditions: Present Day Inflation Is Well Contained A second reason why many have suggested that the Fed could slow its pace of rate hikes is that inflation remains well contained near the Fed's target, and the risk of a meaningful overshoot appears low. At 2.19%, year-over-year core CPI inflation is consistent with the Fed's target. However, our Base Effects Indicator suggests it will decelerate during the next six months (Chart 5). Our core PCE Base Effects Indicator sends a similar message, as we showed in a recent report.5 But Brainard suggested that the Fed should broaden its scope beyond a simple inflation target. Specifically, she observed that: The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. The Federal Reserve's assessment suggests that financial vulnerabilities are building[.] As evidence that financial vulnerabilities are rising, Brainard pointed to low corporate bond spreads, rising corporate debt levels and easing underwriting standards (Chart 6). This would appear to make the case for further rate hikes even if inflation remains well contained near the Fed's target. Chart 5Inflation Will Stay Close To Target Chart 6Brainard Looks Beyond Inflation Bottom Line: The Fed is unlikely to slow its 25 bps per quarter rate hike pace until there is sufficient evidence pointing to a slow-down in economic growth. Maintain below-benchmark duration in U.S. bond portfolios. Treasury Curve: Considering The 2-Year As we pointed out last week, the Treasury curve has already discounted a significant acceleration in wage growth (Chart 7).6 This is fairly common cyclical behavior. In each of the past two cycles the Treasury curve has flattened sharply and then leveled-off at a low level as wages accelerated. We expect we have now reached this latter stage. The 2/10 slope will stay near its current level for a time, awaiting confirmation from wage growth. Chart 7Waiting For Wages In our view, the more interesting yield curve trend is that the spread between the 2-year yield and the fed funds rate has widened to above the 2/10 slope (Chart 7, panel 2). Periods where the fed funds/2-year slope exceeds the 2-year/10-year slope are rare, and tend to be quickly followed by fed funds/2-year flattening. The attractiveness of the 2-year note is confirmed by our butterfly spread models. We model different butterfly spread (bullet over duration-matched barbell) combinations relative to the slope between the two legs of the barbell.7 Our models show that the 2-year bullet is consistently cheap relative to different barbell combinations, and in fact cheaper than all other bullet maturities (Table 1). Table 1Butterfly Strategy Valuation At present, we recommend a yield curve position that is long the 7-year bullet and short the 1/20 barbell. We will continue to hold this position for the time being because, while the 2-year note appears cheaper than the 7-year, we think the 2-year has room to cheapen even further. As mentioned at the beginning of this report, the Treasury market is priced for just barely four rate hikes between now and the end of 2019. The 2-year yield has further upside as more rate hikes get priced in. The upside in the 7-year yield is more limited. Bottom Line: The yield curve will remain near its current level and await confirmation from rising wage growth. The 2-year maturity point is becoming more attractive, and it will soon be time to switch our yield curve positioning from favoring the 5-year/7-year part of the curve to the 2-year. Global Growth Update Governor Brainard's speech shot down two arguments for why the Fed might turn more dovish, but this certainly does not rule out the Fed slowing its pace of rate hikes if economic growth starts to weaken. In past reports we noted that the Global Leading Economic Indicator (LEI) excluding the U.S. is below zero (Chart 8). Since 1993, every time the Global ex. U.S. LEI has fallen below zero, the U.S. LEI has eventually followed. It is conceivable, and perhaps even likely, that the same dynamic will play out again. However, the most recent data on global growth have been somewhat more optimistic. While the Global Manufacturing PMI (excluding the U.S.) has been trending lower, it remains at healthy levels compared to recent history (Chart 8, panel 2). Further, our Global PMI Diffusion index perked up in August, and now shows that 86% of the 36 countries in our sample have PMIs above the 50 boom/bust line (Chart 8, panel 3). The Global LEI also ticked higher in July, and its diffusion index increased, though it remains below 50% (Chart 8, bottom panel). While the monthly LEI and PMI data have improved, indicators of investor sentiment derived from both surveys and financial market prices remain downtrodden. The Global ZEW survey of investor sentiment, the performance of cyclical equity sectors versus defensives and our Boom/Bust Indicator all suggest that U.S. bond yields are too high for the global growth environment (Chart 9). Chart 8Slight Improvement In Global Growth Chart 9High Frequency Global Growth Indicators It's difficult to say how this will all play out, but our sense is that there remains a strong chance that weak foreign growth will eventually drag the U.S. lower. This will cause the Fed to pause its rate hike cycle for a time. However, given the uncertainty surrounding this outcome and the fact that the market is already priced for only two rate hikes in the remainder of 2018 and two more in all of 2019, we view the balance of risks as still consistent with below-benchmark portfolio duration. Bottom Line: The global growth data improved somewhat during the past month, but weak foreign growth remains the greatest risk to the U.S. recovery and the Fed's 25 bps per quarter rate hike cycle. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/brainard20180912a.htm 2 Governor Brainard defines the neutral fed funds rate as: "the level of the federal funds rate that keeps output growing around its potential rate in an environment of full employment and stable inflation." 3 Please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Tracking The Two-Stage Treasury Bear", dated August 14, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Playing Catch-Up", dated September 11, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification