Economy
Highlights The global trade slowdown will intensify, even if U.S. domestic demand remains robust. The large emerging Asian bourses will recouple to the downside with their EM peers. Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. In Chile, receive 3-year swap rates. Continue to overweight stocks relative to the EM benchmark. Short the Colombian peso versus the Russia ruble. Stay neutral on Colombian equities and local bonds but overweight sovereign credit within their respective EM universes. Feature Performance of large equity markets in north Asia - Korean, Taiwanese and Chinese investable stocks -- has been relatively resilient compared with other EM bourses. Specifically, the EM ex-China, Korea and Taiwan equity index has already dropped 16% in U.S. dollar terms, while the market cap-weighted index of investable Chinese, Korean and Taiwanese stocks is down only 8% from its peak in late January.1 These three markets account for 60% of the MSCI EM stock index. A pertinent question is whether these North Asian markets will de-couple from or re-couple with the rest of EM. Our bias is that they will re-couple to the downside. Global equity portfolios should continue to underweight Asian stocks versus the DM bourses in general, and the S&P 500 in particular. That said, dedicated EM equity portfolios should overweight Korea and Taiwan and maintain a neutral stance on China and Hong Kong relative to the EM and Asian equity benchmarks. The Global Trade Slowdown Will Intensify Emerging Asian stock markets are very sensitive to global trade cycles. Slowing global trade is typically negative for them. There is growing evidence that the global trade deceleration will intensify: The German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart I-1). Chart I-1Global Trade Slowdown Will Persist Export volume growth has already slowed across manufacturing Asia (Chart I-2). The most recent data points for these series are as of April. Asia's booming tech/semiconductor industry is also slowing. Both Taiwan's export orders growth and Singapore's technology PMI new orders-to-inventory ratio have relapsed (Chart I-3). Chart I-2Asian Exports Growth: Heading Southward Chart I-3Asian Tech: Feeling The Pinch One of the causes of weakness in the global semiconductor cycle could be stagnating global auto sales (Chart I-4). The latter are being weighed down by weakness in auto sales in China and the U.S. Cars require a significant amount of semiconductors, and lack of improvement in global auto sales will suppress semiconductor demand. So far, China has not been at the epicenter of investors' concerns, but this will soon change as its growth slowdown intensifies. Credit conditions continue to tighten in China, which entails downside risks to mainland capital spending and consequently imports. China's imports are set to slump considerably, reinforcing the global trade downturn.2 First, China's bank loan approvals have dropped considerably in the past 18 months, suggesting a meaningful slowdown in bank financing and in turn the country's investment expenditures (Chart I-5). Chart I-4Global Auto And Semiconductor Sales Chart I-5China: Bank Loan Approval And Capex Second, not only are bank loan standards tightening but costs of financing are also rising. The share of loans extended above the prime lending rate has risen to a 15-year high (Chart I-6, top panel). This represents marginal tightening. Finally, onshore corporate bond yields as well as offshore U.S. dollar-denominated corporate bond yields have broken to new highs in this cycle (Chart I-6, bottom panels). Mounting borrowing costs and tighter credit standards in China point to further deceleration in credit-sensitive spending such as investment expenditures and property purchases. On the whole, rising interest rates and material currency depreciation in EM ex-China and credit tightening in China will prompt a considerable slump in imports, depressing world trade. EM including Chinese imports account for 30% of global imports, while the U.S. and EU together make up 24% of global imports values. Hence, global trade will disappoint if and as EM and Chinese imports stumble. A final word on the history of de-coupling among EM regions is in order. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - when they plummeted (Chart I-7, top panel). Chart I-6China: Rising Borrowing Costs Chart I-7De-coupling Between Asia And Latin America In 2007-'08, emerging Asian equities tumbled along with the S&P 500, but Latin American bourses fared well until the middle of 2008 due to surging commodities/oil prices (Chart I-7, middle panel). Finally, the bottom panel of Chart I-7 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Bottom Line: Global trade is set to head southward, even if U.S. demand remains robust. China's growth slump will be instrumental to this global trade slowdown. Consequently, Chinese, Korean and Taiwanese equities will be vulnerable. Heeding To Market Signals Financial markets often move ahead of economic data, and simply tracking data is not always helpful in gauging turning points in business cycles. By the time economic data change course, financial markets would typically have already partially adjusted. Besides, past economic and financial market performance is not a guarantee of future performance. This is why we rely on thematic fundamental analysis and monitor intermediate- and long-term trends in financial markets to navigate through markets. There are presently several important market signals that investors should be heeding to: EM corporate bond yields are surging, which typically foreshadows falling EM share prices (Chart I-8). Meanwhile, there is no robust correlation between EM equities and U.S. bond yields. Chart I-8EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening, offsetting the drop in U.S. bond yields. Hence, a drop in U.S. bond yields is not in and of itself sufficient to halt a decline in EM share prices. So long as EM corporate and sovereign credit spreads are widening by more than the decline in U.S. Treasury yields, EM corporate and sovereign bond yields will rise, heralding lower EM share prices. The ratio of total return (including carry) of six commodities currencies relative to safe-haven currencies3 is breaking below its 200-day moving average after having bounced from this technical support line several times in the past 12 months (Chart I-9). This could be confirming that the bull market in EM risk assets is over, and a bear market is underway. Chinese property stocks listed onshore have broken down, and those trading in Hong Kong seem to be forming a head-and-shoulder pattern (Chart I-10). In the latter case, such a technical formation will likely be followed by a considerable down-leg. Chart I-9An Important Breakdown Chart I-10Chinese Property Stocks Look Very Vulnerable Further, China's onshore A-share index has already dropped by 15% from its cyclical peak in late January. Finally, both emerging Asia's relative equity performance against developed markets, as well as the emerging Asian currency index versus the U.S. dollar (ADXY) seem to be rolling over at their long-term moving averages (Chart I-11). The same technical pattern is presenting itself for global energy and mining stocks in absolute terms, and also in the overall Brazilian equity index (Chart I-12). Chart I-11Asian Equities And Currencies Are ##br##At Critical Juncture Chart I-12Commodity Equities And Brazil ##br##Are Facing Technical Resistance The failure of these markets to break above their long-term technical resistance levels may be signalling that their advance since early 2016 has been a cyclical - not structural - bull market, and is likely over. These technical chart profiles so far confirm our fundamental analysis that the EM and commodities rallies since early 2016 did not represent a multi-year secular bull market. If correct, the downside risks to EM including Asian markets are substantial, and selling/shorting them now is not too late. Bottom Line: EM including Asian stocks, currencies and credit markets are at risk of gapping down. Absolute-return investors should trade these markets on the short side. Asset allocators should underweight EM markets relative to DM in general and the U.S. in particular. A complete list of our currency, fixed-income and equity recommendations is available on pages 20-21. An EM Equity Sector Trade: Long Consumer Staples / Short Banks EM consumer staples have massively underperformed banks as well as the overall EM index since January 2016 (Chart I-13). The odds are that their relative performance is about to reverse. Equity investors should consider implementing the following equity pair trade: long consumer staples / short banks: Consumer staples are a low-beta sector because their revenues are less cyclical. As EM growth downshifts, share prices of companies with more stable revenue streams will likely outperform. Bank stocks are vulnerable as local interest rates in many EMs rise in response to the selloff in their respective currencies (Chart I-14). Consumer staples usually outperform banks when local borrowing costs are rising. Chart I-13Go Long EM Consumer Staples / ##br##Short EM Banks Chart I-14EM Banks Stocks Are Inversely Correlated With##br## EM Local Bond Yields We expect more currency depreciation in EM, which will exert further upward pressure on local rates, including interbank rates. Further, growth weakness in EM economies typically leads to rising non-performing loan (NPL) provisions. Chart I-15A and Chart I-15B demonstrates that weakening nominal GDP growth (shown inverted on the charts) leads to higher provisioning. Hence, a renewed EM growth slowdown will hurt bank profits. Chart I-15AWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Chart I-15BWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Our assessment is that banks in many EM countries have provisioned less than what is probably necessary following years of a credit boom. Indeed, in the last 12-18 months or so, many banks have even been reducing their NPL provisions to boost profits. Hence, a reversal of these dynamics will undermine banks' earnings. Bottom Line: Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. This is in addition to our long-term strategy of shorting EM banks versus U.S. banks as well as shorting banks in absolute terms in individual markets such as Brazil, Turkey, Malaysia and small-cap banks in China. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These calculations are done using MSCI investible stock indexes in U.S. dollars terms. 2 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports", dated May 24, 2018, available at ems.bcaresearch.com. 3 Average of cad, aud, nzd, brl, clp & zar total returns (including carry) relative to average of jpy & chf total returns (including carry). Chile: Stay Overweight Equities, Receive Rates 31 May 2018 Chart II-1Chilean Equities Relative Performance And Copper Prices It is often assumed that Chilean financial markets are a play on copper. While this largely holds true for the Chilean peso, it is not always correct regarding its stock market's relative performance to its EM peers. Chile has outperformed in the past amid declining copper prices (Chart II-1). Despite our negative view on copper prices, we are reiterating our overweight allocation to this bourse within an EM equity portfolio. There are convincing signs that growth in the Chilean economy is moving along fine for now (Chart II-2). While weakness in global trade will weigh on the economy, the critical variable that makes Chile stand out from other commodities producers in the EM universe is its ability to cut interest rates amid currency depreciation. Chart II-3 illustrates that interest rates in Chile can and do fall when the peso depreciates. This stands in stark contrast with many others economies in the EM universe. There are a number of factors that suggest inflationary pressures will remain dormant for some time. This will allow the Central Bank of Chile (CBC) to cut rates as and when required. Chart II-2Chile: Economic Conditions Chart II-3Interest Rates In Chile Can Fall When Peso Depreciates First, the output gap is negative and has been widening, which has historically led to falling core inflation (Chart II-4). Second, a wide range of consumer inflation measures - services and trimmed-mean inflation rates - are very low and remain in a downtrend (Chart II-5). Chart II-4Chile: Output Gap And Inflation Chart II-5Chile: Inflation Is Very Low And Falling Finally, there are no signs of wage inflation, which is the key driver of genuine inflation. In fact, wage growth is decelerating sharply (Chart II-6). Odds are that this disinflationary rout will go on for longer, given Chile's demographic and labor market dynamics. The country's labor force growth has accelerated and the economy does not seem able to absorb this excess labor supply (Chart II-7). Consistently, our labor surplus proxy - calculated as the number of unemployed looking for a job divided by the number of job vacancies - has surged to all-time highs (Chart II-8). Chart II-6Chile: Wage Growth Is Very Weak Chart II-7Chile: Rising Labor Force Chart II-8Chile: Excessive Labor Supply... Interestingly, this is not happening because of weak employment. Chart II-9 shows that the employment-to-working population ratio is at a record high, while employment growth is robust. This upholds that decent job growth is not sufficient to absorb the expanding supply of labor. All in all, a structural excess supply of labor as well as a cyclical slowdown in global trade and lower copper prices altogether will likely warrant a decline in interest rates in Chile. Consequently, we recommend a new fixed income trade: Receive 3-year swap rates. The recent rise provides a good entry point (Chart II-10). Chart II-9...Despite Robust Employment Growth Chart II-10Chile: Receive 3-Year Swap Rates The ability to cut interest rates will mitigate the effect of weaker exports on the economy. We recommend dedicated EM investors maintain an overweight allocation in Chile in their equity, local currency bond and corporate credit portfolios. For absolute return investors, the risk-reward profiles for Chilean stocks and the currency are not attractive. The peso will depreciate considerably, and shorting it versus the U.S. dollar will prove profitable. Consistent with our negative view on copper prices, we have been recommending a short position in copper with a long leg in the Chilean peso. This allows traders to earn some carry while waiting for copper prices to break down. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Colombia: The Currency Will Be A Release Valve The structural long-term outlook for Colombia is positive, as a combination of pro-market orthodox policies and reform initiatives amid positive tailwinds from demographic should ensure a reasonably high potential GDP growth rate. In the first round of presidential elections held last weekend, the gap between right wing candidate Ivan Duque and left-wing candidate Gustav Petro came out large enough to make a Duque victory highly likely in the second round to be held on June 17. His election would entail a positive backdrop for the reform agenda and business investment over the coming years. Yet despite the positive structural backdrop, Colombia is still facing a major imbalance - excessive reliance on oil in sustaining stable balance of payments (BoP) dynamics. The trade balance deficit - including oil - is $8 billion, while excluding oil it stands at $20 billion, or 7.5% of GDP (Chart III-1). Hence, if oil prices drop materially in the second half of this year - as we expect - Colombia's balance of payments will be strained. Consequently, the currency will come under depreciation pressure. The peso is presently fairly valued as the real effective exchange rate based on unit labor costs is at its historical mean (Chart III-2). Chart III-1Colombia's Achilles' Hill: Trade Balance Excluding Oil Chart III-2The Colombian Peso Is Fairly Valued The central bank has adopted a "hands-off" approach toward the exchange rate, and is likely to allow the peso to depreciate if the BoP deteriorates. Weak economic conditions will likely prevent it from hiking interest rates to bolster the peso: Even though the central bank has reduced its policy rate by 350 basis points since the end of 2016, lending rates remain restrictive when compared with the nominal GDP growth rate (Chart III-3, top panel). Fiscal policy has been tight, with government expenditures subdued and the primary deficit narrowing (Chart III-3, bottom panel). This is unlikely to change for now if conservative candidate, Ivan Duque, wins the election. Consumer and business demand has failed to pick up, and shows little sign of recovery (Chart III-4). Non-performing loans (NPL) continue to rise, forcing banks to raise their NPL provisioning (Chart III-5). Weak nominal GDP growth suggests provisions may rise further. Chart III-3Colombia: Little Sign Of Recovery Chart III-4Colombia: Little Sign Of Recovery Chart III-5Colombian Banks: NPL And NPL Provision Continue Rising Overall, banks' balance sheets remain impaired, hampering their ability to extend loans. Investment Recommendations Despite a favorable structural outlook, Colombia's cyclical growth and financial market outlooks remain poor. Chances are that the peso will come under selling pressure as the external environment deteriorates - i.e., the currency will act as a release valve. We recommend staying neutral on Colombian stocks and local bonds relative to their EM peers, and to overweight Colombian sovereign credit within an EM credit portfolio. The basis is that sound and tight fiscal policies and a continuation of supply side reforms will benefit this credit market. To capitalize on potential currency depreciation while hedging for the uncertainty of oil price decline, we recommend shorting the peso against the Russian ruble. Although Colombia's structural outlook is more promising than Russia's, the latter's BoP dynamics is healthier and its cyclical growth outlook is better than Colombia's. Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Dear Clients, Please note that next week's report will be a joint effort with our geopolitical team, focused on North Korea. The report will be sent to you two days later than usual, on Friday June 8. Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Highlights Most episodes of negative relative Chinese equity performance this year have been driven by global stock market selloffs or related to the trade dispute with the U.S. Since Chinese ex-tech stocks have continued to outperform their global peers during this period, we recommend against downgrading China for now, barring hard evidence of a pernicious global slowdown or that severe protectionist action from the U.S. will indeed occur. Our list of charts to watch over the coming months highlights, among several other important points, that monetary conditions are not overly restrictive and that financial conditions are not tightening sharply. This is in spite of a recent clustering in corporate bond defaults that has concerned some investors. Besides broad-based stimulus in response to an impactful trade shock, a sustained pickup in housing construction remains the most plausible catalyst for an acceleration in domestic demand. For now tepid sales volume casts doubt on this scenario, but investors should continue to watch Chinese housing market dynamics closely. Feature There have been several developments affecting Chinese and global stock markets over the past two weeks. On the trade front, Secretary Mnuchin's statement on May 20 that the U.S. would be "putting the trade war" with China on hold was greeted by a material pushback from Congressional Republicans, particularly the administration's plan to ease previously announced sanctions on ZTE Group. The administration's trade rhetoric has since become more hawkish, as evidenced by yesterday's statement from the White House that referenced specific dates for the imposition of tariffs and the announcement of new restrictions on Chinese investment. This uptick in tough language sets the scene for Secretary Ross' Beijing visit this weekend to continue negotiations. More recently, a political crisis in Italy has caused euro area periphery bond yields to rise sharply, roiling global financial markets. The Italian President's rejection of Paolo Savona as proposed finance minister by the anti-establishment Five Star Movement (M5S) and Euroskeptic Lega has led to the installation of a caretaker government until the fall, when new elections are set to take place. The sharp tightening in financial conditions for Italy and Spain over the past week has exacerbated concerns about a potential growth slowdown in Europe, and has fed a relative selloff in emerging market equities that began in late-March. Despite the recent turmoil, our recommendation to investors is to avoid making any major changes to their allocation to Chinese ex-tech stocks within a global portfolio. Unless presented with hard evidence that the slowdown in the global economy is more than a simple deceleration from an above-trend pace, or that protectionist action from the U.S. will occur in a severe fashion, Table 1 suggests that investors should stay overweight Chinese ex-tech stocks (with a short leash). The table highlights that most episodes of negative relative Chinese ex-stock performance since the beginning of the year been driven by global stock market selloffs or related to the trade dispute with the U.S., despite the ongoing slowdown in China's industrial sector that we have repeatedly flagged. Since Chinese ex-tech stocks have continued to outperform their global peers during this period, our interpretation is that investors are well aware of the deceleration in China's economy, but do not yet regard it as a material threat to ex-tech equity prices. Table 1YTD Weakness In Chinese Stock Prices Has Been Driven By Global Events Clearly, however, this assessment on the part of global investors can change, underscoring that the situation in China merits continual re-assessment. With the goal of providing investors with a toolkit to continually monitor the state of the Chinese economy and the resulting implications for related financial asset prices, this week's report presents a list of 11 charts "to watch" across five categories of analysis. In our view these charts span key potential inflection points for the economic and profit outlook, and will serve as an important basis for us to update our view on China over the months ahead. Monetary & Fiscal Policy Chart 1: The Policy Rate Versus Borrowing Rates Chart 1Borrowing/Policy Rate Divergence Should Not Last,##br## But Is Worth Monitoring An interesting divergence has occurred lately between the 3-month interbank repo rate (currently the de-facto policy rate) and both corporate bond yields and the average lending rate. While the repo rate fell non-trivially after it became apparent in late-March that the PBOC would extend the deadline for the implementation of new regulatory standards for asset management products, corporate bond yields have recently risen sharply and China's weighted-average lending rate ticked higher in Q1. As we highlighted in last week's Special Report, the recent clustering of corporate bond defaults does not (for now) appear to be a source of systemic risk. First, by our estimation, the recent defaults cited above account for only 0.09% of outstanding corporate bonds. Second, the latest PBOC monetary report changed the tone from emphasizing "deleveraging" to "stabilizing leverage and restructuring", which shows that regulators are as concerned about the stability of the economy as they are about reducing excessive debts. But the possibility remains that the ongoing crackdown on China's shadow banking sector will cause some degree of persistence in the recent divergence between the interbank market and actual borrowing rates, implying that investors should continue to watch Chart 1 over the months for signs of materially tighter financial conditions. Chart 2: The Correlation Between Sovereign Risk And The Repo Rate We noted in a February Special Report that investors could use the rolling 1-year correlation between the 3-month interbank repo rate and the relative sovereign CDS spread between China and Germany as a gauge of whether Chinese monetary policy has become too restrictive for its economy.1 Despite the fact that actual sovereign credit risk in China is extremely low, Chart 2 shows that the relative CDS spread has acted as a good bellwether for growth conditions in the Chinese economy. It shows that the correlation between this spread and the 3-month interbank repo rate was initially positive in late-2016 (representing concern on the part of investors that monetary policy is restrictive), but has since come back down into negative territory. Interestingly, the correlation was consistently positive from mid-2011 to mid-2014, when average lending rates averaged 7% or higher and the benchmark lending rate exceeded the IMF's Taylor Rule estimate by about 1%.2 For now the correlation remains negative (as it was when we published our February report), meaning that it currently supports our earlier conclusion that monetary conditions are not overly restrictive and that financial conditions more generally are not tightening sharply (despite the recent rise in corporate bond yields). Chart 2No Sign Yet That Monetary Policy Is Overly Restrictive Chart 3Watch For Signs Of Fiscal Stimulus Chart 3: The Fiscal Spending Impulse Chart 3 presents the Chinese government's budgetary expenditure as an "impulse", calculated as expenditure over the past year as a percent of nominal GDP. Panel 2 shows the year-over-year change in the impulse. When compared with a similar measure for private sector credit, cyclical fluctuations in China's government spending impulse are relatively small. For this reason, BCA's China Investment Strategy service has not strongly emphasized fiscal spending as a major driver of China's business cycle. However, we also noted in a recent report that fiscal stimulus stands out as one of the "least bad" options available to policymakers to combat a negative export shock from U.S. protectionism, were one to occur.3 The potential for broader stimulus from Chinese authorities in response to an impactful trade shock raises the interesting possibility of another economic mini cycle in China, since the economy accelerated meaningfully in response to the last episode of material fiscal & monetary easing. As such, investors should closely watch over the coming months for signs that fiscal spending is accelerating, particularly if combined with potential signs of easing monetary policy. External Demand Chart 4: Global Demand And Chinese Export Growth Chart 4For Now, Resilient Exports ##br##Are Supporting China's Economy We have noted in several recent reports that a resilient export sector remains the most favorable pillar of Chinese growth. Besides the clear risk to Chinese trade from U.S. protectionism, two other factors have the potential to negatively impact the trend in export growth. The first (and most important) of these risks is a reduction in global demand, which some investors have recently been concerned about given the decline in global manufacturing PMIs. However, Chart 4 highlights that our global PMI diffusion indicator has done an excellent job of leading the global PMI over the past few years, and has barely registered a decline over the past few months. From our perspective, the odds are good that the recent deceleration in the PMI has been caused by sudden caution (even in developed countries) over the Trump administration's protectionist actions, and does not reflect a material or long-lasting slowdown in the global economy. But we will be closely watching the PMI releases over the coming months to rule out a more painful slowdown in global demand. Importantly, we have also highlighted that stronger exports may actually presage a further slowdown in China's industrial sector if it emboldens policymakers to intensify their reform efforts over the coming year. We argued in our May 2 Weekly Report that China's reform pain threshold is positively correlated with global growth momentum,4 meaning that the external sector of China's economy may have less potential to counter weakness in the industrial sector than many investors believe. In this regard, extreme export readings (to the up and downside) should be regarded by investors as a potentially problematic development. Chart 5: The Competitiveness Impact Of A Rising RMB Chart 5 highlights the second non-protectionist risk to Chinese export growth, namely the significant appreciation in the RMB that has occurred since mid-2017. The chart shows the percentile rank of three different trade-weighted RMB indexes since 2014, and highlights that all three are between their 70th & 80th percentiles (with our BCA Export-Weighted RMB index having risen the most). Importantly, the 2015-high shown in Chart 5 represents the strongest point for the currency in over two decades, suggesting that further currency strength may exacerbate the significant deceleration in export prices that has already occurred. Chart 5A Surging RMB Could Undercut Competitiveness Housing Chart 6: Housing Sales Versus Starts We have presented a variation of Chart 6 several times over the past few months, but it is important enough that it deserves to be continually monitored by investors over the coming year. Chart 6 tells the story of China's housing market from the perspective of an investor who is primarily interested in the sector because of its implications for growth. The chart highlights that residential floor space started, our best proxy for the real contribution to growth from residential investment, has fallen significantly relative to sales since 2012-2014. This appears to have occurred because of a significant build up in housing inventories, which has since reversed materially (even though the level remains elevated). To us, this suggests that the gap between housing sales and construction that has persisted for the past several years may finally be over, suggesting that the latter may pick up durably if sales trend higher. For now sales volume remains tepid, but this will be a key chart for investors to watch over the coming year given our view that housing is a core pillar of China's business cycle. The Industrial Sector Chart 7: The BCA Li Keqiang Leading Indicator And Its Components Chart 7 presents our leading indicator for the Li Keqiang index (LKI), which we developed in a November Special Report.5 There are six components of the indicator, all of which are related to changing monetary/financial conditions, and the growth in money and credit. Chart 6Housing Construction Could Accelerate##br## If Sales Pick Up Chart 7A Downtrend In Our LKI Leading Indicator, ##br##Within A Wide Component Range The indicator is at the core of our view, and we have been presenting monthly updates of the series in our regular reports since late last year. However, Chart 7 looks at the indicator from a different perspective, by showing it within a range that identifies the weakest and strongest components at any given point in time. Two points are noteworthy from the chart: While the overall LKI indicator has been trending down since early-2017, there is currently a wide range between the components. This gap is in stark contrast to the very narrow range that prevailed from 2014-2015, when the economy slowed considerably. This could mean that some of the components of the indicator are unduly weak, which in turn could imply that the severity of the slowdown in China's industrial sector will be less intense than the overall indicator would otherwise suggest. At least one component provided a lead on the subsequent direction of the overall indicator from late-2011 to late-2012, the last time that a significant gap existed between the components. This is in contrast to the situation today, in that all of the components are currently in a downtrend (albeit with differing paces as well as magnitudes). The key point for investors from Chart 7 is that all of the components of our indicator are moving in the same direction, which suggests with high conviction that China's economy is slowing. However, the wide range among the components suggests that indicator's message about the intensity of the slowdown is less uniform than it has been in the past, meaning that investors should be sensitive to a sustained pickup in the top end of the range. Equity Market Signals Chart 8: The Beta Of Our BCA China Sector Alpha Portfolio Chart 8 revisits a unique insight that we presented in our May 16 Weekly Report.6 The chart shows the rolling 1-year beta of our BCA China Investable Sector Alpha Portfolio versus the investable benchmark alongside China's performance versus global stocks, and suggests that the former may reliably lead the latter. While we noted in the report that drawing market-wide inferences from the beta characteristics of risk-adjusted performers is a not a conventional approach, finance theory is supportive of the idea. If investors are seeking to maximize their risk-adjusted returns and are engaging in tactical allocation across sectors, then it is entirely possible that beta-adjusted sector returns reflect the risk-on/risk-off expectations of market participants. For the purposes of China-related investment strategy over the coming year, our emphasis on Chart 8 will increase markedly if we see a sharp decline in the beta of our Sector Alpha Portfolio. As we noted in our May 16 report, the model is for now sending a curiously bullish signal, which we see as partial validation of our view that investors should have a high threshold to cut exposure to China within a global equity portfolio. Chart 8Watch For A Decline In The Beta Of ##br##Our Sector Alpha Portfolio Chart 9Decelerating Earnings Growth Could##br## Undermine Investor Sentiment Chart 9: Ex-Tech Earnings Versus The Li Keqiang Index We noted above that predicting the Li Keqiang index (LKI) is at the core of our view, and Chart 9 highlights why. The chart shows that a model based on the LKI closely fits the year-over-year growth rate of Chinese investable ex-tech earnings and, crucially, provides a lead. While the chart does not suggest that an outright contraction in ex-tech earnings is in the cards over the coming year, it does show that earnings growth is about to peak. This is potentially problematic, and warrants close attention, for two reasons: First, our leading indicator for the LKI suggests that it will decelerate further over the coming year, which could push our earnings growth estimate towards or below zero. Second, the peak in earnings growth could dampen investor sentiment towards Chinese ex-tech stocks, especially since bottom up analyst estimates for 12-months forward earnings growth have recently moved higher and are currently above what is predicted by our model. Chart 10: The Alpha Of Chinese Banks By now, the narrative surrounding Chinese banks is well known among global investors. The enormous leveraging of China's non-financial corporate sector is viewed by many as a clear sign of capital misallocation, meaning that a (potentially material) portion of the loan book of Chinese banks will have to be written off as bad debt. The ultimate scope of the bad debt problem in China is far from clear, but these longstanding concerns about loan quality suggest that Chinese bank stocks are likely to materially underperform their global peers if China's shadow banking crackdown begins to pose a significant threat to growth via restrictions on the provision of credit to the real economy. As such, we recommend that investors monitor Chart 10 over the coming year, which shows the rolling 1-year alpha significance for Chinese banks vs their global peers. While the rolling 1-year alpha of small banks has become less positive over the past few weeks, it remains in positive territory, similar to that of investable bank stocks. So, for now, this indicator supports our earlier conclusion that recent divergence between the interbank market and actual borrowing rates highlighted in Chart 1 is not heralding a material tightening in Chinese financial conditions. Chart 10Investors Should Monitor Chinese Bank Alpha ##br##For Significant Declines Chart 11No Technical Breakdown (Yet) In Ex-Tech Relative Performance Chart 11: The Technical Performance Of Ex-Tech Stocks BCA's approach to forecasting financial markets rests far more on top-down macroeconomic assessments than it does on technical analysis. However, technical indicators do contain important information, particularly when our top-down macro approach signals that a change in trend may be imminent. In this regard, technical indicators can provide valuable opportunities to enter or exit a position. To the extent that the technical profile of Chinese ex-tech stocks is informative in the current environment, Chart 11 shows that it is telling investors to stay invested despite the myriad risks to the economic outlook. This message is consistent with that of Table 1, namely that the negative performance of Chinese ex-tech stocks has been in response to global rather than idiosyncratic, China-specific risk. From our perspective, a technical breakdown in relative Chinese ex-tech stock performance in response to China-specific news would serve as a strong basis for a downgrade within a global equity portfolio, and we will be monitoring closely for such a development over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Seven Questions About Chinese Monetary Policy", dated February 22, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Monetary Tightening In China: How Much Is Too Much?" dated January 18, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Question That Won't Go Away", dated April 18, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "China: A Low-Conviction Overweight", dated May 2, 2018, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 6 Please see China Investment Strategy Weekly Report, "The Three Pillars Of China's Economy", dated May 16, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Portfolio Strategy A near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to lift the S&P homebuilding index to neutral. Troughing health care outlays versus overall PCE, minor cracks in small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest that managed health care relative share prices are as good as they get. Recent Changes Book profits of 24% and augment the S&P Homebuilding Index to a benchmark allocation. Downgrade the S&P Managed Health Care Index to neutral, locking in profits of 28%. Take the S&P Telecom Services Index off the high-conviction underweight list for a gain of 10% (please see the Insight Report on May 24, 2018). Table 1 Feature Stocks held on to their early-May gains and are on track to end the month with handsome returns. While the SPX is not out of the woods yet, still shaking off the early-February tremor, our cyclically upbeat view remains intact. Recent data suggest that earnings will remain healthy, and we expect this will propel the S&P 500 to a fresh all-time high in the back half of the year. It's true that elevated corporate debt levels are a cause for concern, as we detailed in a recent Special Report titled 'Til Debt Do Us Part', and this week we highlight that the Bank for International Settlements (BIS) private non-financial business sector debt-to-GDP ratio confirms the Fed data we presented in that report (Chart 1). Similarly, BIS's debt service ratio1 for non-financial corporates also confirms the Datastream Worldscope stock market data of a deteriorating interest coverage ratio (EBIT/interest expense) for non-financial equities (Chart 1). While we are closely monitoring unfolding debt dynamics, high debt levels are probably a longer-term problem (beyond the next 9-12 months) for the U.S. equity market. Higher interest rates are required in order for a debt crisis to unravel. With that in mind we were pleasantly surprised to notice that net bond ratings migration is moving in the right direction i.e. upgrades are outpacing downgrades. This is impressive as the V-shaped recovery following the late-2015/early-2016 manufacturing recession is already reflected in the data and the most recent uptick likely represents a fresh/different mini credit cycle (downgrades minus upgrades as a percent of total shown inverted, bottom panel, Chart 2). Chart 1Saddled With Debt... Chart 2...But Ratings Migration Moving In The Right Direction Either bond rating agencies are lowering their standards or euphoric rating agencies just reflect the recent fiscal policy easing, extremely low starting point of interest rates and an overall recovery in animal spirits. We side with the latter, and the implication is that SPX momentum will reaccelerate in the coming months, if history at least rhymes (bottom panel, Chart 2). Other indicators we monitor corroborate the positive equity backdrop suggested by the ratings migration data. For example, tracking tax revenue provides an excellent near real-time gauge on corporate sector cash flows. Federal income tax receipts have spiked into double-digit territory. Even state and local government tax coffers are surging, although this dataset is quarterly and trails the monthly released Federal series by four months. Government tax receipt growth has either led or coincided with previous major and sustainable overall profit recoveries (Chart 3). This suggests that S&P 500 second quarter earnings growth will surprise to the upside, despite an already high bar, in-line with our still expanding EPS growth model; the ISM, interest rates, the U.S. dollar and house prices comprise our four factor model (Chart 4). Nevertheless, the latest bout of EM currency weakness spreading beyond the 'fragile five' is a risk to our sanguine EPS growth view, especially in the back half of the year and into 2019. In other words, if this episode mostly resembles the 2013 'taper tantrum' induced devaluations then most of the damage is already done (Chart 5). However, if all of a sudden China falls off a cliff and is forced to devalue à la 2015 then all bets are off and a 'risk off' phase will ensue leading to a spike in the U.S. dollar. Chart 3Money Flowing Into Government Coffers Takes##br## A Real Time Pulse Of Corporate Profits Chart 4Q2 Profits Will Likely ##br##Surprise To The Upside... Chart 5...But A U.S. Dollar##br## Spike Is A Risk As a reminder, the greenback is a key input to our EPS growth regression model and any sustained gains will eventually weigh on SPX profits. This is clearly a risk, but our sense is that there are more parallels with 2013 than with 2015 and one big difference is the bond market's response. The third panel of Chart 5 shows that spreads have not blown out to an alarming level, at least not yet, and signal that a generalized emerging market currency crisis will be averted. Finally, another big difference with the 2015 episode is that the commodity complex is not reeling (bottom panel, Chart 5). This week we are acting on two alerts, one downgrade and one upgrade, and crystalizing outsized gains in a defensive subsector and also taking profits in a niche early cyclical sub-index. Enough Is Enough, Upgrade Homebuilders To Neutral We put the niche S&P homebuilding index on upgrade watch in late-March,2 and today we recommend pulling the trigger and monetizing our 24% relative gains since the late-November 2017 inception. Three main reasons underpin our upgrade to a benchmark allocation: 1. Bond market selloff taking a breather 2. Housing fundamentals remain robust 3. Compelling valuations reflect most, if not all, of the bad news In March we posited that "any rise above 3.05% on the 10-year Treasury yield in a short timeframe would likely prove restrictive for the U.S. economy".3 Fast forward to today and BCA's U.S. Bond Strategists believe that the likelihood of a near-term pullback in U.S. Treasury yields has increased on the back of largely discounted Fed rate hikes, extended net short positioning and the recent moderation in economic data. This backdrop should, at the margin, give some breathing room to this interest rate-sensitive index. True, refinancing mortgage application activity has nearly ground to a halt, but the MBA's mortgage purchase index continues to climb to fresh cycle highs defying rising 30-year fixed mortgage rates (top panel, Chart 6). The MBA weekly survey is nearly exhaustive as it "covers over 75 percent of all U.S. retail residential mortgage applications".4 Importantly, examining the relative volume of purchase activity is instructive. Currently, purchase applications comprise over 2/3 of total applications. There is a positive correlation between interest rates and the purchase share of overall mortgage activity as the middle panel of Chart 6 clearly depicts. This is because refinancing takes the back seat as mortgage rates rise, whereas first time home buyers are less sensitive to the level of interest rates. Wage growth and job security are most important when undertaking the first mortgage. Put differently, a pick up in economic growth that is synonymous with higher interest rates entices rather than dissuades would-be first time home buyers. The U.S. economy is currently at full employment, underscoring that the unemployment rate should move inversely with the purchase share of mortgage activity. Indeed, empirical evidence confirms this negative correlation (bottom panel, Chart 6). Similarly, the firming economic backdrop should also lead to a renormalization of the residential housing market. Household formation is still running at a higher clip than housing starts, signaling that there is little slack in the residential housing market (middle panel, Chart 7). Homebuilder confidence is as good as it gets and home prices are expanding at a healthy pace (bottom panel, Chart 7). Chart 6Housing Fundamentals... Chart 7...Remain On A Solid Footing Importantly, new home prices have exited the deflation zone versus existing home prices which is significant for the relative profitability of homebuilding stocks (third panel, Chart 8). The tightness in the new home market is also evident in the relative sales backdrop: new home sales are outshining existing home sales which is conducive to a further increase in relative top line growth and thus relative share prices (top and second panels, Chart 8). Finally, relative valuations have undershot the historical mean on a price-to-sales basis with homebuilders trading at a 50% discount to the broad market (bottom panel, Chart 8). We deem that most of the bad news is likely reflected in cheap valuations and the message is that it no longer pays to be bearish the niche S&P homebuilding index. Nevertheless, we refrain from swinging all the way to an above benchmark allocation as spiking building material costs are starting to bite, according to the latest NAHB sentiment survey (middle panel, Chart 9). Moreover, long-term EPS euphoria pushing 30%, or twice the rate of the SPX, has hit a level that typically marks relative share price tops, not troughs (bottom panel, Chart 9). Were lumber prices to give way either courtesy of a rising U.S. dollar and/or a positive resolution in the NAFTA negotiations we would not hesitate to boost this index to an overweight stance. Chart 8Firming Top And Bottom Line Growth Prospects Chart 9Surging Building Supply Costs Are A Big Risk Netting it all out, a near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to move to a neutral stance in the S&P homebuilding index. Bottom Line: We are acting on our upgrade alert and booking gains of 24% in the S&P homebuilding index and lifting exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Managed Health Care: Don't Overstay Your Welcome Relative share price gains for the S&P managed health care index are nearly exhausted. We are acting on our late-March downgrade alert and taking profits of 28% versus the S&P 500 since inception. At the margin, macro drivers have turned from a tailwind to a mild headwind. Long-term trends in HMOs move in distinct cycles tied with overall health care spending. When overall health care outlays begin to accelerate relative to total consumption the pressure increases on payers of medical services (i.e. health insurance) relative to the providers of those services. The opposite is also true (relative health care outlays shown inverted, Chart 10). Chart 10Rising Relative Health Care##br## Outlays Weigh On HMOs If relative health care spending has troughed for the cycle, then there are high odds that the decade long relative bull market has run its course and a major top is in place. Industry top-line growth is also fraying around the edges. The second panel of Chart 11 shows that the hiring plans subcomponent of the NFIB survey of small business owners has sunk recently. Despite an overall stable and growing employment backdrop, this letdown is disconcerting as roughly 65% of all net new job gains occur in the SME space.5 The implication is that enrollment may also be nearing a peak. Meanwhile, on the input cost front, a softer than expected blow to drug pricing practices revealed in the President's recent speech was music to the ears of Big Pharma executives, but cacophony to HMO CEOs. While no bill has been drafted yet and we are awaiting more details, at the margin, this is a net negative for managed health care profits. Historically, our medical care cost proxy has been inversely correlated with industry operating margins and the current message is that the mini margin expansion phase may be short-circuited (middle panel, Chart 12). Tack on a tick up in HMO labor costs and profits will likely underwhelm analysts' optimistic forecasts: the sell-side expects S&P managed health care index profits to outperform the SPX by 330bps in the coming twelve months (bottom panel, Chart 12). We deem it a tall order. Finally, the recent industry M&A frenzy is ebbing, signaling that the M&A premia may soon come out of this health care sub-group (top panel, Chart 13). Importantly, all this euphoria is likely reflected in relative valuations with the relative forward P/E trading one standard deviation above the historical mean (middle panel, Chart 13). Chart 11Early Signs Of... Chart 12...Margin Pressures Chart 13M&A Frenzy Fully Priced Into Expensive Valuations In sum, we do not want to overstay our welcome in the HMO space that has added considerable alpha to our portfolio since our overweight inception in April 2016. Troughing health care outlays versus overall PCE, minor cracks in the small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest relative share prices are as good as they get. Bottom Line: Downgrade the S&P managed health care index to neutral for a gain of 28% since inception. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 "The DSR reflects the share of income used to service debt, given interest rates, principal repayments and loan maturities," https://www.bis.org/statistics/dsr.htm. 2 Please see BCA U.S. Equity Strategy Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 3 Ibid. 4 https://www.mba.org/2018-press-releases/may/mortgage-rates-increase-applications-decrease-in-latest-mba-weekly-survey 5 https://www.stlouisfed.org/publications/regional-economist/april-2011/are-small-businesses-the-biggest-producers-of-jobs Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights The Fed Vs. The Market: The market believes the Fed will deliver on its "gradual" rate hike pace in a status quo economic scenario. But investors also view the odds of the Fed slowing the pace of hikes as greater than the odds of it hiking more quickly. Dovish Catalysts: The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. Hawkish Catalysts: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Feature In last week's report we recommended that nimble investors should position for a near-term (0-3 month) decline in Treasury yields.1 Since then, the 10-year Treasury yield has fallen from 3.06% to 2.93% but we are not yet ready to remove our recommendation. The two criteria we named in last week's report - extended net short bond positioning and a high likelihood of negative data surprises - remain in place. As such, we expect bond yields to fall further in the near-term, though we remain bond bears on a cyclical (6-12 month) investment horizon. This week we turn to Fed policy, and specifically the following three questions: What does the Fed mean when it says it will make "further gradual adjustments" to the stance of monetary policy? How do "gradual adjustments" relate to what is currently priced in the market? What factors would cause the Fed to deviate from its "gradual" path, leading to either a faster or slower pace of tightening? The Market Trusts The Fed...To A Point We have noted in previous reports that the Fed's "gradual" pace of rate hikes is quite clearly defined as one 25 basis point rate hike per quarter. The Fed has tightened policy at this pace since December 2016, with the exception of last September when it announced the winding down of its balance sheet in place of a hike. It seems to us that the Fed's policy intentions have rarely been more transparent. The Fed will continue to lift rates by 25 bps per quarter until either (i) something breaks in the economy causing the Fed to slow down, or (ii) inflation pressures mount causing the Fed to speed up. But what about market pricing? To be consistent with the Fed's "gradual" pace of one hike per quarter the market would need to be priced for 50 bps of tightening during the next six months, 100 bps of tightening during the next 12 months, etc... Chart 1 shows that the market believes the Fed will deliver on its "gradual" pace for the next six months, but that it will fall somewhat short during the next year. Looking beyond the next 12 months, the market is not priced for the Fed to deliver on its "gradual" hike pace during the next 18 or 24 months either (Chart 2). Chart 1The Fed Versus The Market Part I Chart 2The Fed Versus The Market Part II A more realistic interpretation of Charts 1 and 2 is that while the market believes the Fed will deliver on its "gradual" hike pace in a status quo economic scenario, investors also view the odds of something breaking in the economy as greater than the odds that inflation will force the Fed to move faster. We also agree that the odds of something breaking are greater than the odds that inflation will force the Fed's hand. However, we would still favor a cyclical (6-12 month) below-benchmark duration stance because the market is not priced for the most likely status quo / "gradual" rate hike environment. Identifying Breaking Points How will we be able to tell if something is breaking in the economy that will cause the Fed to slow its pace of hikes? Candidate 1: Domestic Economic Growth One way is to simply monitor leading indicators of U.S. economic growth, particularly the contribution of cyclical spending to overall GDP (Chart 3). The cyclical sectors of the economy (consumer spending on durable goods, residential investment and investment on equipment & software) are most sensitive to interest rates and often provide an early warning sign for the overall economy. At the moment we see no evidence that cyclical spending is poised to slow meaningfully. Recent data showed solid gains in April retail sales, while consumer sentiment remains near its all-time high (Chart 4, panel 1). On the investment side, core durable goods orders were stronger than expected in April and the regional manufacturing PMIs that have been released so far in May (Philadelphia, New York, Richmond and Kansas City) have all increased (Chart 4, panel 2). Recent housing data have been more disappointing relative to expectations, but even here we continue to see steady growth in building permits and a continued contraction in outstanding supply. Supply increases typically precede a decline in construction activity (Chart 4, bottom panel). Chart 3Domestic Economy Looks Strong Chart 4Focus On Cyclical Sectors Candidate 2: The Financial Markets Even if U.S. economic growth is robust, it is conceivable that a sharp tightening of financial conditions - a falling stock market, widening credit spreads and/or an appreciating dollar - could cause the Fed to slow its pace of hikes. After all, the Fed would interpret a large enough tightening of financial conditions as a signal that economic growth will slow in the future. To assess this risk we turn to our Fed Monitor (Chart 5). Our Fed Monitor is a composite of many different variables that fall into one of three categories (i) economic growth, (ii) inflation and (iii) financial conditions. It is constructed in such a way that a reading above zero means the Fed should be tightening policy and a reading below zero means the Fed should be easing. Chart 5Fed Monitor Recommends Tighter Policy The bottom panel of Chart 5 shows that we have in fact seen a relatively large tightening of financial conditions since the equity market sold off in February. However, our overall Fed Monitor has barely ticked down, and remains solidly above zero. There is an important message here. The Fed can tolerate more tightening in financial conditions when economic growth and inflation are higher. When a similar tightening of financial conditions occurred in 2015, it did in fact drive our overall Fed Monitor below zero. This is because the economic growth and inflation components of the Monitor provided less of an offset (Chart 5, panels 3 & 4). Now, with stronger readings from those components, the Fed will need to see a much larger tightening of financial conditions before reacting. We will pay close attention to our Fed Monitor going forward for any signs that a sell-off in financial markets might be severe enough to spook the Fed. Another financial market signal that bears monitoring is the slope of the yield curve (Chart 6). It is no secret that an inverted yield curve always precedes a recession, and the Fed could interpret a very flat curve as a signal that monetary policy is becoming restrictive. In fact, Atlanta Fed President Raphael Bostic said two weeks ago that: Chart 6Not Flat Enough To Worry The Fed I have had extended conversations with my colleagues about a flattening yield curve. It is my job to make sure that [yield curve inversion] doesn't happen. In contrast, the minutes from the May FOMC meeting reveal a more balanced tone from the committee as a whole. "Several" participants thought "it would be important to monitor" the slope of the curve, while "a few" thought that the slope of the curve could be less important this cycle because of several special factors. These factors include: depressed term premiums because of large central bank balance sheets and reductions in investors' estimates of the longer-run neutral real interest rate. Our sense is that the yield curve is a good economic indicator simply because it reflects market expectations about the path of the fed funds rate. When the curve is inverted, and long-maturity yields are below short-maturity yields, it means that investors expect rate cuts to occur in the future. In contrast, a very steep yield curve indicates that the market expects a large number of rate hikes. When the stance of monetary policy is perceived to be close to neutral, investors will expect very little future movement in the fed funds rate and the yield curve will be very flat.2 In an ideal world, the Fed will move the funds rate close to its neutral level by the time that inflation stabilizes around its 2% target. In other words, the Fed will not be overly concerned with a very flat yield curve as long as inflation is close to its target. A very flat curve will only worry policymakers if it coincides with below-target inflation, because that would suggest that the market does not believe that the Fed will hit its inflation goal. With inflation already close to the Fed's target, we don't think a flat yield curve will cause the Fed to turn dovish any time soon. Candidate 3: Foreign Economic Growth One final factor that could eventually cause the Fed to slow its pace of rate hikes is weak foreign economic growth. Here we already see mounting signs of stress. Chart 7 shows that while the U.S. Leading Economic Indicator is the strongest it has been in several years, our Global Leading Economic Indicator excluding the U.S. has begun to contract. This divergence in growth between the U.S. and the rest of the world is reminiscent of the 2014/15 period when the dollar came under strong upward pressure. Not surprisingly, the dollar is once again starting to appreciate (Chart 7, panel 2). Much like in 2014/15, a strengthening dollar is already putting pressure on Emerging Markets where CDS spreads are widening and currencies are weakening (Chart 7, bottom panel). As an aside, while USD-denominated Sovereign bond spreads have widened, they remain expensive compared to similarly-rated U.S. corporate bonds (Chart 8). We continue to recommend an underweight allocation to USD-denominated Sovereign debt. Turning back to U.S. monetary policy, the key reason the Fed might concern itself with weak foreign economic growth is that the resultant strengthening of the dollar will eventually cause financial conditions to tighten and domestic economic growth to slow. This is exactly what occurred in 2014/15, though unfortunately the Fed waited until the strong dollar culminated in a sell-off in equity and credit markets before it adopted a more dovish policy stance (Chart 9). We would once again expect the Fed to wait for divergent growth between the U.S. and the rest of the world (and the resultant stronger dollar) to be reflected in financial conditions indexes and domestic equity and credit markets before it responded by slowing the pace of hikes. Chart 7Global Growth Divergences##br## Are Back Chart 8Sovereigns Still##br## Expensive Chart 9Growth Divergences Led To ##br##Market Turmoil In 2014/15 Bottom Line: The Fed would slow its pace of rate hikes if the cyclical sectors of the U.S. economy started to slow, financial conditions tightened significantly, or if the slope of the yield curve moved close to zero while inflation was below the Fed's target. The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. What Would Make The Fed Hike More Quickly? The most obvious factor that would make the Fed increase its pace of rate hikes to greater than 25 bps per quarter would be if inflation rose above its 2% target and continued to accelerate. It is unclear how much of an inflation overshoot the Fed is willing to tolerate before it increases the pace of hikes, but our sense is that it's fairly substantial. The Fed has gone out of its way in recent months to stress the "symmetric" nature of its 2% inflation target and, as long as inflation expectations remained well contained, we think the Fed would stick with its "gradual" rate hike pace as long as core PCE inflation is below 2.5%. Inflation pressures in the economy would have to change dramatically for core PCE inflation to break above 2.5%. Chart 10 shows two hypothetical scenarios for year-over-year core PCE inflation. One scenario where core PCE inflation rises 0.2% every month going forward, and another where it rises 0.15% every month. In the 0.2% per month scenario, year-over-year core PCE inflation eventually levels off at around 2.4%. In the 0.15% per month scenario it levels off at 1.8%. Monthly core PCE inflation has only printed above 0.2% seven times since 2015 (Chart 11), meaning that we would need to see a huge shift in the inflation data for it to start worrying policymakers. Chart 10How Much Overshoot Will Fed Tolerate? Chart 11Prints Above 0.2% Have Been Rare Another important factor that we have flagged in recent research is the price of gold.3 We noted that the gold price tends to rise when Fed policy eases and fall when it becomes more restrictive. We also observed that Fed policy can ease/tighten in two ways: The Fed can alter market expectations about the pace of rate hikes The market can revise its assessment of the equilibrium (or neutral) fed funds rate Chart 12Gold Has Led The Fed Notice that the decline in the gold price between 2013 and 2016 foreshadowed downward revisions to the Fed's estimate of the long-run equilibrium fed funds rate, and that those estimates have leveled-off alongside the price of gold since then (Chart 12). It follows that an upside break-out in the price of gold would be a signal that monetary policy is becoming easier, and that current estimates of the equilibrium fed funds rate need to be revised up. This is another signal we are monitoring that could lead to a quicker pace of rate hikes from the Fed. Bottom Line: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 In practice, the term premium in long-dated Treasury yields will lead to a slightly positive yield curve slope when monetary policy is perceived to be neutral. 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The prospects for U.S. economic and earnings growth remain solid but overseas growth is rolling over. The U.S. economic surprise index is poised to turn negative but inflation surprise is headed the in the opposite direction. The Fed remains vigilant on financial stability issues. The minutes of the May FOMC meeting provided an update on the Fed's views of inflation, fiscal and trade policy. In addition, financial stability and the Fed's forward guidance were discussed. Feature Economic data released in recent weeks reinforce BCA's view that the U.S. economy is accelerating while the global economy is decelerating. Chart 1 (panel 1) shows that the index of leading economic indicators (LEI) is gaining strength in the U.S., but slowing in the rest of the developed economies (panels 2 through 6). However, the U.S. Purchasing Managers Index (PMI, solid line) is rolling over, along with the PMIs in the E.U., Japan, Canada and Australia, albeit from a high level. Still, the Treasury and currency markets are focused on the LEIs and not the PMIs, driving up both Treasury bond yields and the dollar (Chart 2). Chart 1U.S. Growth##BR##Stands Out Chart 2Treasury Yields And The Dollar##BR##Responding To Growth Differentials The fallout from political turmoil last week in both North Korea and Italy spilled over into U.S. financial markets, driving U.S. risk assets and Treasury yields lower. Of the two, the situation in Italy is the more significant threat to our view that the U.S. stock-to-bond ratio will continue to move higher this year. BCA's Global Fixed Income Strategy service notes that while investors are right to be worried about a new populist government in Italy, slowing economic growth is an even bigger immediate problem for debt sustainability concerns.1 Our Geopolitical Strategy service's baseline expectation calls for the new coalition government in Rome to back off from its most populist proposals.2 However, this will first require the pain of higher bond yields. BCA's view is that the dollar will continue to climb as the Fed boosts rates more than the market expects and as U.S. domestic growth outpaces its global counterpart.3 BCA's U.S. Bond Strategy service maintains that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. In addition, spread product returns should continue to beat Treasuries, but the window for outperformance is closing.4 Investors' positioning in Treasuries and our view that the Citigroup Economic Surprise Index (CESI) may soon drop below zero,5 suggest that there is a near-term risk of a countertrend rally in Treasury prices. Assessing The Cycle BCA's view is that the next recession will be sparked by the Fed overtightening in 2019 and 2020 as it finds itself behind the curve on inflation. Chart 3 shows that the odds of a recession in the next 12 months are low. Moreover, the traditional recession signals we track are not flashing red (Chart 4). At 45 bps, the 10/2 Treasury curve remains positive (panel 2). BCA expects the 2/10 curve to remain around 50bps until the inflation breakevens are re-anchored between 2.3% and 2.5%. We anticipate that upward pressure on the short end from Fed rate hikes will be offset by the upward thrust of the breakevens on the long end.6 Panel 3 shows that the LEI crosses below zero when a recession is imminent. The April LEI rose by 6.42% year-over-year. Initial claims for unemployment insurance in the week ending May 18 were 17K below their mid-November 2017 reading. Panel 4 shows that a 6-month increase in unemployment claims of between 75,000 and 100,000 is associated with a recession. Chart 3Odds Of A Recession Remain Low Chart 4No Recession Signals Here Credit spreads also indicate that the economic expansion remains in place. Charts 5 and 6 show that the corporate bond market often warns of an approaching major top in the stock market and/or a recession. Spreads barely budged during February's spike in financial market volatility. Chart 5Credit Spreads On Both Investment Grade... Chart 6... And High Yield Debt Signal That The Expansion Has Legs Financial conditions remain supportive of above-potential growth in the final three quarters of 2018. The January peak in equity markets and troughs in investment- grade and high-yield spreads marked the recent zenith in BCA's Financial Conditions Index (FCI). Nonetheless, the FCI in the U.S. remains more expansionary than it was a year ago and our research7 shows that financial conditions lead the U.S. economy by six to nine months (Chart 7). As a result, U.S. economic growth is poised to accelerate even more in 2018. This will further push down the unemployment rate below NAIRU and ultimately force up wage and price inflation. Chart 7Lagged Effect Of Easier Monetary##BR##Conditions Will Boost Growth Bottom Line: The prospects for U.S. economic and earnings growth remain solid, aided by the lagged effect of easy financial conditions, the ongoing benefits of the 2017 Tax Cut and Jobs Act and other doses of fiscal stimulus enacted in the past six months. Moreover, several of the geopolitical risks that we flagged earlier this year have ebbed. However, as noted above, the political situation in Italy warrants investors' attention. Nonetheless, the period of synchronous global growth that lifted risk assets in 2017 and in early 2018 has ended. Chinese growth is slowing, and other emerging market economies and financial markets are under duress as U.S. rates escalate. Moreover, the U.S. economy is in the late part of the cycle. Lofty valuations implied that equity returns will be well below-average in the next five to seven years. Stay overweight stocks versus bonds for now. However, investors with longer horizons should begin to prepare for lower real returns in the 2020s after a recession early in that decade. Surprise Surprise Citi's Economic Surprise Index (CESI) is poised to turn negative (Chart 8) after hitting a four-year high, 110 days ago, in late 2017. Since then, a colder and wetter winter and early spring across the U.S., coupled with elevated expectations after the tax bill, saw most economic data fall short of expectations. Chart 8Economic Surprise Poised To Move Lower Our late March 2018 report8 noted that since 2011, there were six other episodes when the CESI behaved similarly. These phases lasted an average of 96 days; the median number of days from peak to trough was 66 days. Moreover, we stated in our March 2018 report that a trough in the Citigroup Economic Surprise reading may be a month or two away. Based on BCA's research,9 tactical investors should add to their risk positions as the Citigroup Economic Surprise Index bottoms and begins to climb. On the other hand, the inflation surprise index is about to turn positive for the first time since 2011. Chart 9 shows that the last time reports on the CPI, PPI and average hourly earnings consistently exceeded consensus forecasts was in late 2009 and early 2010. Moreover, from the last few years of the 2001-2007 economic expansion through to early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Typically these periods when inflation surprise is positive are associated with higher wage and compensation metrics and higher realized core inflation. Moreover, Chart 9 shows that sustained episodes where the inflation surprise index is above zero occurred when the economy was at full employment (panel 2) and when the Fed funds rate was above neutral (panel 3). The implication is that inflation indices are poised to move higher in the coming year, and prompt the Fed to continue to raise rates gradually at first, but then more aggressively starting in mid-2019. Nonetheless, inflation due to cyclical factors remains muted for now. Chart 10 shows that pro-cyclical inflation decelerated through March 2018, while acyclical inflation accelerated. Late last year we discussed this measure of inflation and its origins at the San Francisco Fed.10 Chart 9Inflation Surprise Vs.##BR##Realized Inflation And Slack Chart 10Noncyclical Sources Still##BR##Driving Inflation Lower Bottom Line: The disappointing run of economic data is not over. Treasury bond yields will likely dip as the CESI turns negative. However, the weakness in the economic data does not signal recession. We expect that the inflation surprise index will continue to grind higher, while unemployment dips further into excess demand territory and oil prices rise. After the CESI forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb. Stay overweight stocks versus bonds, long credit and underweight duration. On The MOVE Both equity and bond market volatility (measured by the VIX and the MOVE indexes respectively) climbed in late January and early February, but have since eased (Chart 11). However, in the past 9 weeks, bond volatility surged relative to equity vol. Looking ahead, the subdued readings from the Chicago Board Options Exchange VVIX index, which measures the implied volatility of VIX options, indicate that the VIX can continue to head lower in the coming weeks. The implication is that bond-to-stock volatility ratio will move higher. Periods when bond volatility is rising faster than equity volatility are associated with turning points in the stock-to-bond ratio, and both real and nominal Treasury yields (Chart 12). That said, we are not making the case that the current upward thrust of the stock-to-bond ratio is about to change direction. Since 1990, both the stock-to-bond ratio and real bond yields rose in six of the eight periods when the MOVE/VIX rose; nominal yields climbed in all but one of these episodes. Moreover, small cap equities tend to outperform large when the MOVE index is increasing faster than the VIX. Chart 11Equity Vol Vs. Bond Market Vol Chart 12Is The MOVE/VIX Ratio On The Rise Again? Bottom Line: The increase in both equity and bond market volatility will impact the way the Fed conducts monetary policy in the coming years. Financial stability, or the lack thereof, is now top of mind among policymakers, and even more so as policy turns restrictive. The Fed's Third Mandate Revisited Chart 13FOMC Is Closely Monitoring##BR##Financial Stability BCA views financial stability as a third mandate11 for the central bank, along with low and stable inflation, and full employment. Financial stability was discussed at the May meeting by both Fed staff and voting FOMC members, but it was not on the agenda at March's meeting. Nonetheless, we expect Fed Chair Jay Powell to follow the former chair's lead on this issue. At the May meeting, Fed staff continued to characterize financial vulnerabilities of the U.S. financial system as moderate on balance. This overall assessment incorporated the staff's judgment that asset valuations remain elevated. Fed staff appraised vulnerabilities as low from financial sector leverage and maturity and liquidity transformation, low-to-moderate from household leverage, and elevated from leverage in the non-financial business sector (Chart 13). In May the Fed also provided an assessment of foreign financial stability for the first time since November 2017. The central bank's economists and analysts characterized overall vulnerabilities to foreign financial stability as moderate while highlighting specific issues in some foreign economies, including elevated asset valuation pressures, high private or sovereign debt burdens and political uncertainties. Fed staff made the same assessment in November 2017. In a report last month we highlighted research from the Federal Reserve Bank of San Francisco which found that a more restrictive monetary policy could pose risks to financial stability.12 Bottom Line: The Fed will remain vigilant about financial stability, but this means that rates will increase only gradually despite below-target inflation. The central bank must find the optimal pace to encourage employment and stable prices while guarding against financial excesses if policy stays too loose for too long. Counting The Minutes Inflation appeared to be a key topic at the May 1-2 Federal Open Market Committee (FOMC) meeting.13 Moreover, at least a few members indicated that the Fed is willing to tolerate inflation above the central bank's 2% target. Trade and fiscal policy, the labor market, financial stability, the yield curve and the Fed's communication plan were also discussed. Fed economists recently updated their quantitative assessments of the FOMC's minutes.14 The note provides a guide (Table 1 in the Fed paper and Table 1) to the number of quantitative descriptors in the minutes (one, a couple, a few, etc.). We use this rubric to assess the FOMC's latest views. Table 1FOMC Minutes Rubric Tables 2 and 3 evaluate the Fed's latest thinking on inflation and its outlook. Most FOMC participants viewed the recent firming in inflation as reassurance that inflation is on track to hit the central bank's 2% target, while some thought inflation may overshoot. Several opined that the underlying inflation trend had changed little (Table 2). There was wide disagreement on the inflation outlook. Table 3 shows that many participants agreed that the Fed's goal was to return inflation to the 2% target. Many participants cited the tight labor and product markets, and stable inflation expectations, to support their views that inflation would remain near 2% this year. This approach is in line with BCA's inflation stance. A few participants worried about the impact of higher oil prices on inflation, but a similar number expressed concern that inflation would not stay at the Fed's 2% goal. Table 2FOMC Assessment Of Current Inflation Table 3FOMC Assessment Of Inflation Outlook There were extensive comments from both Fed staff and FOMC participants about the impact of fiscal policy and trade on the economy and inflation. Chart 14 presents the IMF's estimate of the impact of fiscal policy on the U.S. economy in the next few years. Fed staff continued to assume that the tax cuts would boost real GDP growth moderately in the medium term, but noted that fiscal policy may not provide a boost to growth if the economy is operating above full employment. Several FOMC participants noted the challenges in assessing the influence of fiscal policy on both the demand and supply side of the economy. We discussed the impact of fiscal policy on the supply side in last week's report.15 Chart 14U.S. Fiscal Stimulus Will##BR##Support Growth In '18 And '19 On trade, some FOMC participants noted that there was a wide range of outcomes for economic activity and inflation depending on what actions were taken by the U.S. and how U.S. trading partners responded. A few noted that the uncertainty around trade could dampen business sentiment and spending. In a recent report,16 we stated that the Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the latest Beige Book (April 18); there were only 3 mentions in the March edition. The FOMC also discussed factors contributing to the flat yield curve, citing the expected gradual rise of the federal funds rate, the downward pressure on term premiums from the Fed's still-large balance sheet as well as asset purchase programs by other central banks, and a reduction in investors' estimates of the longer-run neutral real interest rate. Notably, only a handful of participants said that the curve was not a reliable signal of future economic activity, while several endorsed the idea that an inverted curve indicated an increased risk of recession. On financial stability, a couple of participants noted that after the bout of financial market volatility in early February, the use of investment strategies predicated on a low-volatility environment may have become less prevalent, and that some investors are more cautious. However, they also noted that asset valuations across a range of markets and leverage in the nonfinancial corporate sector remained elevated relative to historical norms, leaving some borrowers vulnerable to unexpected negative shocks. Several noted that regulatory reform since the crisis had contributed to stronger capital positions, while only a few emphasized the need to build additional buffers in the financial system. The key takeaway from the FOMC's discussion on its communication policy is that the Fed may soon alter the forward guidance in its post-meeting statement to acknowledge that policy will not remain accommodative indefinitely. Bottom Line: The minutes of the May FOMC meeting indicate that the Fed is gearing up to raise rates again next month, but it is not signaling a more hawkish path than what is discounted. At the same time, the Fed is not trying to drive market expectations for the future path of short-term interest rates sharply higher. Fed officials noted that a temporary overshoot of the 2% inflation target would not be a disaster. In other words, the Fed is not willing to deviate from its path of "gradual" rate hikes. This is defined as one 25bps rate hike per quarter, which is mostly in line with current market pricing. We maintain our base case scenario: the FOMC will continue to monitor financial stability under Powell and raise rates four times in 2018. However, the FOMC will have to become more aggressive when realized inflation climbs and inflation expectations approach 2.3 to 2.5%. At that point another vol shock is likely, given that the Fed would target slower growth to curb inflation. This would be a negative signal for risk assets. Stay underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny or Mostly Cloudy?", published May 22, 2018. Available at gfis.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Italy: Growth Cures All Ills...For Now", February 21, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Global Investment Strategy Weekly Report, "Swan Song", published May 18, 2018. Available at gis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", published May 22, 2018. Available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", published October 31, 2017. Available at usbs.bcaresearch.com. 6 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Back To Basics", published April 17, 2018. Available at usbs.bcaresearch.com. 7 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear", published October 4, 2017. Available at gfis.bcaresearch.com. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Waiting...", published March 26, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Reports, "Solid Start", published January 8, 2018 and "The Revenge Of Animal Spirits", published October 30, 2017. Both available at usis.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "2018: Synchronized Global Growth: Drives U.S. Economy And Markets", published December 4, 2017. Available at usis.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", published July 24, 2017. Available at usis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Short-Term Caution Warranted", published April 23, 2018. Available at usis.bcaresearch.com. 13 https://www.federalreserve.gov/monetarypolicy/fomcminutes20180502.htm 14 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm 15 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Too Soon For Stagflation?", published May 21, 2018. Available at usis.bcaresearch.com. 16 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Stressing The Housing And Consumer Sectors", published May 7, 2018. Available at usis.bcaresearch.com.
Highlights Last year's broad-based global growth recovery has given way to slower growth and increasing differentiation in growth rates across economies. The U.S. has gone from laggard to leader in the global growth horse race, helping to drive the dollar to a five-month high. The biggest risk to our cautious view on emerging markets is that China stimulates the economy proactively as an insurance policy against a possible trade war. So far, there is little evidence that this is happening, but we are watching the data closely. The turmoil in Italy's bond markets is a timely reminder that if the European periphery wants more stimulus, this has to happen through a weaker euro rather than through larger budget deficits. Stay short EUR/USD. We expect to take profits at around the 1.15 level. Feature From Convergence To Divergence 2017 was the year of synchronized global growth. For the first time since 2007, all 46 countries tracked by the OECD experienced positive GDP growth. The euro area economy surprised on the upside, recording real GDP growth of 2.3%. This was slightly above U.S. levels, despite the fact that trend growth is about half a percentage point lower in the euro area. Growth in Japan nearly doubled to 1.7% from the prior year. Emerging markets, which succumbed to a broad-based slowdown starting in 2015, came roaring back. The U.S. dollar tends to perform poorly when global growth is accelerating and the composition of that growth is shifting away from the United States. This was precisely the setting that the global economy found itself in last year, which is why the greenback came under pressure. Things are looking sharply different this year. Global growth has cooled, as evidenced by both the PMIs and economic surprise indices (Chart 1). Euro area growth was sliced in half in the first quarter; U.K. growth decelerated further; and Japanese growth fell into negative territory for the first time since 2015. In contrast, the U.S. has held up relatively well. While growth did dip to 2.3% in Q1, the latest tracking estimates suggest a rebound in the second quarter. Retail sales accelerated in April. The Philly Fed PMI also surprised on the upside, with the new orders component reaching the highest level since 1973. The New York's Fed model is pointing to growth of 3.2% in Q2, while the Atlanta Fed's Nowcast is signaling growth of 4.1%. The divergence in growth rates between the U.S. and most major economies has been mirrored in recent inflation prints. U.S. core inflation has moved higher, but has stumbled elsewhere (Chart 2). Chart 1Global Growth Has Cooled With The U.S.##br## Faring Best Chart 2Inflation Is Accelerating In The U.S., ##br##Decelerating Elsewhere The relatively strong pace of U.S. growth has led to a widening in interest-rate differentials between the United States and its peers. The 10-year U.S. Treasury yield has risen by 95 basis points since its September lows, compared to 20 points for German bunds, 47 points for U.K. gilts, and 4 points for JGBs. With the exception of the U.K., the increase in spreads has been dominated by the real rate component (Chart 3). Chart 3Widening Interest Rate Differentials Between The U.S. And Its Peers ##br##Have Been Driven By The Real Component King Dollar Reigns Supreme Conceptually, it is real, rather than nominal, interest rate differentials that ought to move currencies. We noted earlier this year that the dollar's failure to strengthen on the back of rising Treasury yields was an anomaly that was unlikely to persist. Sure enough, the dollar has now begun to recouple with real interest rate differentials (Chart 4). Our sense is that this year's trends can last a while longer. Leading Economic Indicators have continued to move in favor of the U.S., suggesting that U.S. outperformance is not likely to end anytime soon (Chart 5). Fiscal policy should also help prop up U.S. aggregate demand. The U.S. structural budget deficit is set to widen much more than elsewhere over the next few years (Chart 6). Chart 4Dollar Is Recoupling With Rate Differentials Chart 5U.S. Is Outshining Its Peers Chart 6U.S. Fiscal Policy Is More Stimulative The U.S. economy is now back to full employment. For the first time in the 17-year history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), the number of job openings exceeds the number of unemployed workers (Chart 7). Our composite labor survey indicator has continued to move higher (Chart 8). Core PCE inflation has already accelerated to 2.3% on an annualized 6-month basis and 2.6% on a 3-month basis. The New York Fed's Inflation Gauge, which leads inflation by about 18 months, is pointing to higher inflation over the coming quarters (Chart 9). This means that the bar for further gradual rate hikes is quite low. Chart 7There Are Now More Vacancies Than Jobseekers Chart 8U.S. Wage Growth Is Set To Grind Higher Chart 9U.S. Inflation: Upside Risks Recent revelations by Kevin Warsh - who was once the favorite to lead the Federal Reserve - that Trump was dismissive of the Fed's historic independence during their interview, is only likely to strengthen Jay Powell's resolve to avoid being seen as a Trump flunky.1 China: Shifting Into The Slow Lane? Of course, the outlook for the dollar and bond spreads will also hinge on what happens in the rest of the world. We are watching two economies especially closely: China and Italy. The latest data suggest that China has lost some growth momentum. Retail sales and fixed asset investment decelerated in April. Property sales also declined from an elevated level. Sales tend to lead prices. Home prices were flat in most tier 1 cities over the prior year, reflecting elevated inventory levels, tighter lending standards, and stricter administrative controls (Chart 10). Further price weakness is likely, which could dampen construction activity in the months ahead. Industrial production beat expectations in April, but the overall trend in industrial activity remains to the downside. Electricity production, freight traffic, and excavator sales have all been decelerating (Chart 11). Import growth has also come down, which is one reason why GDP growth in the rest of the world has moderated (Chart 12). Chart 10China: Housing Has Cooled Chart 11China: Industrial Activity Is Slowing Chart 12China: Import Growth Has Decelerated Trade War Fears: Will China Overcompensate? In addition to the regular cyclical growth risks, concerns about a trade war loom in the background. The Trump Administration's decision last weekend to defer imposing tariffs on China caused investors to breathe a sigh of relief, but much remains unresolved, including ongoing allegations that China is stealing intellectual property from the U.S. and other countries. Trump's decision to pull out of June's summit with North Korea will only strain America's relationship with China. Considering the damage to China that a full-out trade war would cause, it would be sensible for the government to take out some insurance against a possible downturn. Thus far, any evidence that the authorities are trying to stimulate the economy through either fiscal or monetary means is sketchy (Chart 13). Reserve requirements were cut by 100 basis points in April, but corporate borrowing costs remain elevated. Fiscal outlays are growing at broadly the same pace as last year. The trade-weighted RMB has continued to strengthen. Still, it is hard to believe that the government has not put together a contingency plan that it could roll out if circumstances warrant it. The biggest risk to our fairly cautious view on emerging markets is that China launches a stimulus package in response to a trade war that quickly ends in détente. Similar to what occurred in 2008/09, this would leave China with more stimulus than it actually needed. Italy: From Fiscal Austerity To Bunga Bunga Unlike in China, Italy's incoming coalition government - forged through an uneasy alliance between the populist Five Star Movement (M5S) and the right-leaning League - has made no secret about its desire to ease fiscal policy. The M5S wants more social spending while the League has lobbied for a flat tax. These measures, along with a host of others, would add €100 billion, or 6% of GDP, to the budget deficit. Given that the Italian unemployment rate stands at 11% - 5.3 percentage points above its 2007 low - one could make a compelling case that Italy would benefit from temporary fiscal stimulus. However, the proposed policies are being marketed as permanent in nature. Moreover, several policies, such as the proposal to roll back the planned increase in the retirement age, would actually reduce potential GDP by shrinking the size of the labor force. It is no wonder that bond markets are worried (Chart 14). Chart 13China: No Clear Evidence Of Stimulus ... Yet Chart 14Mamma Mia! Propping Up Demand In Italy Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from a shrinking working-age population and anemic productivity growth, both of which reduce the incentive for firms to expand capacity. Like many other European countries, Italy also suffers from a debt overhang. This is obviously true for government debt but it is also true, to some extent, for private debt. While the ratio of private debt-to-GDP is below the euro area average, it stills stands at 113%, up from 65% in the mid-1990s (Chart 15). The desire to save more in order to pay back debt, coupled with a reluctance to invest in new capacity, has left Italy with what economists call a private-sector financial surplus (Chart 16). Chart 15Italian Private Sector Has Been Taking ##br## On Less Debt Since The Crisis Chart 16Italy: The Private Sector Wants To Save If the private sector earns more than it spends, the excess savings have to be absorbed either by the government through its own dissaving or by the rest of the world through a current account surplus. Both options are problematic for Italy. Running large budget deficits for a prolonged period of time would take the level of government debt-to-GDP to stratospheric levels. Japan has been able to get away with this strategy because it issues debt in its own currency. This is a luxury that is not at Italy's disposal. Despite Mario Draghi's pledge to do "whatever it takes" to preserve the euro area, it is far from clear that the ECB would keep buying Italian debt if the country began to openly skirt the EU's deficit rules. Absent an effective lender of last resort, the Italian bond market could fall victim to a speculative attack - a process in which higher yields lead to even higher yields, and eventually a default (Chart 17). Chart 17When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible This just leaves the option of trying to bolster aggregate demand by exporting excess production abroad via a current account surplus. To its credit, Italy has been able to shift its current account balance from a deficit of 1.4% of GDP in 2007 to a projected surplus of 2.6% of GDP this year. However, some of that surplus simply reflects the fact that a weak economy has suppressed imports. Progress in reducing unit labor costs relative to its euro area peers has been painfully slow (Chart 18). Chart 18Italy: More Work To Be Done To Improve Competitiveness If Italy had a flexible exchange rate, it could simply devalue its currency to gain competitiveness. Since it does not have one, it has to improve competitiveness by restraining wage growth and implementing productivity-enhancing structural reforms. The former requires the presence of labor market slack, while the latter, even in a best-case scenario, will take substantial time to achieve. And neither option is politically popular. Given the difficulty of raising Italy's competitiveness relative to the rest of the euro area, the only realistic short-term solution is to boost it relative to the rest of the world. That requires a weak euro which, in turn, requires a dovish ECB. Investment Conclusions In our Second Quarter Strategy Outlook, published on March 30th, we predicted that the dollar was poised to experience a violent rally as short sellers rushed to cover their positions. This view has played out in spades. As we go to press, the nominal broad-trade weighted dollar has gained 4% since early April. It is up 30% since bottoming in July 2011 and is only 6% below its December 2016 peak (Chart 19). The dollar rally has brought our views closer in line with the market. Notably, EUR/USD is now less than two percent above our target of $1.15. The dollar is an ultra-high momentum currency. Chart 20 shows that a simple strategy of buying the DXY when it was above its moving average and selling it when it was below its moving average would have delivered a sizable profit over the past two decades (the exact moving average does not matter much, but the 50-day seems to work best). As such, while we intend to turn neutral on the dollar if it gains another few percent or so, an overshoot is quite probable. Chart 19The Dollar Has Bounced Back Chart 20The Dollar Trades On Momentum About 80% of EM foreign-currency debt is denominated in dollars. In many cases, dollar borrowers have non-dollar revenue streams. Thus, a stronger dollar automatically hurts their businesses. In the past, this has often ignited a feedback loop where a stronger dollar triggers capital outflows from emerging markets, leading to an even stronger dollar. Our EM strategists strongly feel that such a vicious cycle is fast approaching, especially if China's economy continues to slow. In the late 1990s, brewing EM tensions triggered several brutal equity selloffs. For example, the S&P lost 22% between July 20 and October 8, 1998. However, EM stress also restrained the Fed from tightening too quickly. The resulting dose of liquidity set the stage for a massive blow-off rally between the fall of 1998 and the spring of 2000. A similar dynamic could unfold this time around. We remain overweight global equities for now, but are hedging the risk by being short AUD/JPY, a trade that has gained 5% since we initiated it on February 1st. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Ben White, "How Trump could break from the Fed's independence," Politico, May 9, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades