Economy
Highlights The current U.S.-China trade skirmish is essentially the beginning of a new cold war. The U.S. and China are engaged in a struggle for supremacy, so trade conflicts will persist. The conflict could evolve into a "game of chicken" - the most dangerous type of game. The U.S. needs Europe's help against China - but an adventure in Iran could cost it that help. Geopolitical risks will cap the rise in bond yields over the next six months, push up oil, and give a tailwind to global defense stocks. Feature The opening salvo of the U.S.-China trade war has caught the investment community by surprise as the market is quickly repricing the odds of a global trade war.1 Nervousness over the breakdown of globalization comes at the same time as our key China view - that Beijing's structural reforms will constrain growth - are beginning to have an impact on global growth (Chart 1).2 Chart 1China Reforms Dragging On Global Growth Fortuitously, we found ourselves in Asia at the onset of "hostilities" and were thus able to see regional investors' reactions in real time. Our clients focused their questions on the economic impact of the announced tariffs (yet to be determined, in our view), constraints facing President Trump (minimal as well), and potential Chinese retaliation (understated). The focus, however, should be on the big picture. The March 23 U.S. announcement of tariffs on around $50 billion worth of Chinese imports is not just the opening salvo of a trade war. Rather the emerging trade war is the opening salvo of a new cold war, a global superpower competition between the U.S. and China that will define the twenty-first century. Put simply, the U.S. and China are now enemies. Not rivals, competitors, or sparing partners. Enemies. It will take the market some time for investors to internalize this idea and price it properly. Meanwhile, in the short term, fears of a full-born global trade war are overblown. The trade tensions are really only about two countries, with uncertain global implications. Investors are right to be cautious, but risks to global earnings are overstated at this time. How Did We Get Here? The ongoing trade tensions are not merely a product of a nationalist Trump administration that decided to call out China for decades of unfair trade practices. They are also the product of the geopolitical context, which we have defined through three "big picture" themes. These three themes allowed us to correctly forecast that the defining feature of the twenty-first century would be a Sino-American conflict. We would be thrilled to see this culminate merely in a trade war. The themes are: Multipolarity (Chart 2)3 Apex of globalization (Chart 3)4 The breakdown of laissez-faire economics (Chart 4)5 Chart 2Multipolarity Is Messy And Volatile Chart 3When Hegemony Declines, Globalization Declines Chart 2 elucidates a key lesson of history: the collapse of British hegemony at the end of the nineteenth century ushered in two world wars. Political science, game theory, and history teach us that periods of multipolarity are rarely peaceful.6 Today's world is not exactly multipolar, as the U.S. remains the preeminent global power. However, regional powers - such as China, the EU, Russia, India, Japan, Iran, and perhaps Turkey and Brazil - have a lot more room to maneuver within their spheres of influence. This means that global rules written by the U.S. at the conclusion of the Second World War are being rewritten for regional contexts. Normatively there is nothing wrong with this process. But practically, multipolarity means that "challenger powers" - such as China today or the German empire in the late nineteenth century - seek to undermine rules and norms of behavior that they had little or no say in setting up. And such rules are necessary to underpin geopolitical stability and grease the wheels of globalization. As Chart 3 shows, trade globalization peaked in the past when the hegemon could no longer enforce global rules. We have therefore emphasized to clients since 2014 that, if we are right that the world is multipolar, then we are essentially at the apex of globalization. A parallel process has seen the breakdown of the laissez-faire consensus, which underpinned the expansion of trade in goods, labor, and capital across sovereign borders. Economic globalization has lifted many boats around the world, but outsourcing - combined with technological innovation - has seen the lower middle class in developed nations face diminishing returns (Chart 4). Chart 4Globalization: No Friend To Developed-Market Middle Class That said, a revolt against globalization and "globalists" is thus far mainly an Anglo-Saxon phenomenon, and particularly an American one. Why? Because the particularities of the U.S. laissez-faire economic model, with its scant social protections, laid its middle class bare to the vagaries of globalization and technological change (Chart 5). However, there is no guarantee that other DM countries will not succumb to the same pressures down the line. Chart 5The 'Great Gatsby' Curve: Or, How Anglo-Saxons Turned Against Laissez Faire This background is important for investors because merely blaming a nationalist Trump administration or a mercantilist Beijing for today's tensions ignores the underlying context. President Trump can change his mind on a dime, but the geopolitical context can only evolve slowly.7 Mercantilism is here to stay; it is a feature, not a bug, of a multipolar world. Contrast today's tensions with those of the 1970s and 1980s between the U.S. and its major trade partners. The 1971 Smithsonian Agreement and the 1985 Plaza Accord ended overt trade protectionism by the U.S. (in 1971), and threats thereof (in 1985), by securing the compliance of these trade partners with Washington's currency and trade demands. Japan further conceded to U.S. demands in 1989 after a two-year trade war. Today, the U.S. and China are not geopolitical allies huddled under the same nuclear umbrella for protection against an ideologically fueled rival. They are ideological rivals. The reason it took a decade for the conflict to erupt is two-fold. First, the U.S. became entangled in the global war on terror after 9/11, which took its focus off of its emerging competitor in Asia. Second, the consensus view - that China would asymptotically approach a Western democracy as it embraced capitalism - has proven to be folly.8 Bottom Line: The China-U.S. trade conflict is a product of today's particular geopolitical context. At heart, it is a conflict for geopolitical primacy in the twenty-first century and thus unlikely to end quickly. Sino-American Conflict Is Intractable The current U.S.-China trade tensions are more of a skirmish than a war. We think that there is considerable room for a step-down in tensions over the next 12 months. First, the Trump administration has not launched an economic war against China. Not only has the U.S. restricted its list of Chinese goods under tariff consideration to just $50 billion of imports - roughly 12% of total Chinese exports to the U.S. - but it has decided to bring a case against China to the World Trade Organization (WTO). The latter is hardly a move by a mercantilist administration dead-set on across-the-board economic nationalism. Second, China has responded almost immediately by offering several concessions, including renewing pledges to open its economy to inward investment and to protect intellectual property (IP) rights. While these may seem like boilerplate concessions that Beijing has floated before, the current context of trade tensions and domestic structural reforms makes it more likely that Chinese policymakers will follow through on their promises. As such, we can see the current round of tensions tapering off, especially after the U.S. midterm elections. However, we doubt that the structural trajectory of Sino-American relations will be significantly altered even if current tensions subside. First, from China's perspective, its extraordinary economic ascent (Chart 6) is merely the return of the millennium's status quo (Chart 7). The last 180 years - roughly from the beginning of the First Opium War in 1839 to today - were the aberration. During this short period of Chinese weakness, the West - with Britain and then the U.S. at the helm - conspired to restructure global rules and norms of geopolitical and economic behavior without input from the Middle Kingdom. Chart 6China's Economic Rise Has Been Extraordinarily Fast... Chart 7China Sees Its Success As A Return To The Status Quo As such, China's influence in key post-WWII economic institutions like the WTO and the IMF is limited while its military has second-class status even in its own "Caribbean Sea," the South China and East China Seas. From the U.S. perspective, China's growth over the past two decades was made possible by U.S. hegemony. The U.S. secured the global rules and norms that enabled China to integrate seamlessly into the global marketplace and then compete its way to the top. Not only did the U.S. allow China to access its credit-fueled markets, but the U.S. Navy protected China's maritime trade, including vital energy supplies transiting from the Middle East. As a thank you for these efforts, China reneged on its WTO commitments, periodically suppressed its currency, stole American intellectual property, and withheld market access from U.S. corporations via tariff and non-tariff barriers to trade. Washington policymakers, and not only Trump's hawkish advisors, are turning against China. There is an emerging consensus among the U.S. foreign policy, defense, intelligence, and economic policy elites that: Sino-American economic symbiosis is over (Chart 8); Chart 8U.S.-China ##br##Symbiosis Is Dead Chart 9The U.S. Is Least##br## Exposed To Trade Chart 10China's Share Of Global##br## Exports Has Skyrocketed The U.S. can afford to confront China over trade because it is the least exposed major economy to global trade (Chart 9); The Chinese have acquired a massive share of global exports without a commensurate opening of their domestic market (Chart 10); Arresting Chinese technology transfer and intellectual property theft is a national security issue (Chart 11); The U.S. can confront China because it has emerged victorious from every global conflagration in the past (Chart 12). Chart 11China Imports Conspicuously Little U.S. IP Chart 12America Is Chaos-Proof Fundamentally, American policymakers want to see China's rapid economic growth slow, they want to see China's capital markets and companies constrained by openness to global competition, and they want to put a leash on China's catch-up in the technological and manufacturing value chain (Chart 13). This is not their stated objective as it would imply that the U.S. wants to see China weakened, and the Chinese leadership miss its decade and century economic development goals. But this is precisely what the U.S. establishment wants. As such, the political and economic visions of American and Chinese policymakers are directly at odds with one another. What does this mean for investors? Over the past several years we have developed a reputation of being sanguine about geopolitics. While many of our peers in the political analysis industry overstate the probability of geopolitical risk, we have (successfully) bet against the worst-case scenario in several prominent crises.9 We like to think that this is because we combine game theory with an understanding of the underlying power dynamics. By emphasizing constraints, we have successfully identified how power dynamics constrain the worst-case outcome.10 When it comes to Sino-American tensions, however, we have always been alarmists. This is because we believe the constraints to conflict are overstated, not understated. Furthermore, the potential market impact of a new cold war is unclear and potentially very large. Both the U.S. and China fundamentally think they can win a trade war. This means that they are engaged in a "regular game of chicken," named after the 1950s practice of racing hot rods head-on in order to prove one's manhood.11 Game theory teaches us that a game of chicken is the most unpredictable game because it can create an equilibrium in which all rational actors have an incentive to keep driving head on - to stick to their guns - despite the risks. In Diagram 1, we can see that continuing to drive carries the greatest risk, but also the greatest reward, provided that your opponent swerves. Chart 13China's Steady Climb Up##br## The Value Ladder Continues Diagram 1A Regular ##br##Game Of Chicken Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. In the current context, this means that the U.S. assumes that China is driven by economic rationality and will not dare face off against the U.S., which has far less to lose given its modest exposure to global trade. Chinese policymakers, however, also think they can win. They look over the Pacific and see a country riven by political polarization (Chart 14) where half of the country thinks the other is "a threat to the nation's well-being" (Chart 15).12 China, meanwhile, has just consolidated its political leadership and feels confident enough in its domestic stability to dabble with growth-constraining economic reforms. Beijing can use any trade tensions with the U.S. to further justify painful reforms. Chart 14Inequality Fuels Political Polarization Chart 15Live And Let Die Who is right? We do not know. And that scares us as it means that the most sub-optimal equilibrium - the bottom-right quadrant of Diagram 1 - is more probable than people think. An important difference maker, one that would alter Beijing's risk calculus considerably, is Europe. Despite being highly leveraged to China's growth, the EU still exports nearly double the value of goods to the U.S. than China (Chart 16). In addition, Europe's trade surplus with the U.S. mostly pays for its deficit with China (Chart 17). Chart 16The EU Exports More To U.S. Than China Chart 17EU Surplus With U.S. Pays For Deficit With China Over the next several months, investors will be able to gauge whether the Trump administration is filled with ideological nationalists who believe in Fortress America or wily realists who know how to get things done. The key question is whether Trump will embrace America's traditional transatlantic alliance with Europe and harness it for the trade war with China. If he embraces it, we will predict that the combined forces of U.S. and Europe will successfully force China to concede to the pressure. If Trump fails, however, we could have a prolonged U.S.-China trade war. Early indications are optimistic. The U.S. gave the EU an exemption from tariffs on steel and aluminum imports on March 22, a delay that will end on May 1. This followed a March 21 meeting between EU Commissioner for Trade Cecilia Malmström and U.S. Secretary of Commerce Wilbur Ross. We suspect, but have no evidence, that the U.S. asked the EU to join in its effort to force China to change its trade practices at the WTO. As an exporting bloc, the EU has a lot more to lose from attacking China than the U.S. But it also has much to lose from unabated Chinese mercantilism and technological theft, and much to gain if China opens its doors wider. As such, we posit that Europe will, in the end, join the U.S. and Japan in a concerted effort to pressure China. This will increase the probability that Beijing ultimately gives in to trade pressure. In the long term, it will also ensure that President Trump does not break the critical transatlantic alliance with Europe, which would be paradigm shifting. But, on the other hand, it will set China and the West on a collision course. China's and the West's suspicions of each other will ossify. Bottom Line: In the short term, trade tensions are likely overstated as U.S. actions against China are largely muted and restrained. In the long term, the U.S.-China trade war could potentially devolve into a "game of chicken," the most dangerous type of conflict. The key variable will be whether the U.S. administration is savvy enough to arrange European collaboration against China. If the U.S. treats the EU harshly and ignores its transatlantic ally on other issues - such as conflict with Iran, discussed below - we could be in for a wild ride in the coming months and years. Either way, Europe stands to gain from a conflict between China and the U.S. Both sides are likely going to try to enlist the EU on their side. As such, we are opening a long Europe industrials / short U.S. industrials trade. Meanwhile, growing trade tensions, policy-induced slowdown in China, and repricing of geopolitical risks in East Asia and the Middle East should cap global bond yields over the next six months. We take 50.4bps and 54.4bps profits on our short U.S. 10-year government bond vs. German bund and short Fed Funds December 2018 futures trades. Iran: The Next Target Of Trump's "Maximum Pressure" Policy President Trump's North Korea policy worked brilliantly in 2017. The policy of "maximum pressure" combined military maneuvers, economic sanctions, and extremely bellicose rhetoric to convince Pyongyang and regional powers that the U.S. has lowered its threshold for full-scale war on the Korean peninsula. China reacted swiftly, starving North Korea of hard currency through economic sanctions (Chart 18). The result was a declaration by Pyongyang in late November that it had finally completed its quest to obtain a nuclear deterrent (an exaggeration at best), an olive branch for the Olympics, and an offer by Supreme Leader Kim Jong Un to meet with President Trump. Chart 18China Gives Kim To Trump The policy of "maximum pressure" yielded such extraordinary results with North Korea that President Trump is now eager to trademark the process and apply it to Iran and potentially other global issues. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has replaced two establishment advisors with hawks. Secretary of State Rex Tillerson has been replaced with CIA Director and noted Iran-hawk Mike Pompeo. Meanwhile, National Security Advisor H.R. McMaster has been replaced by conservative pundit (and former U.S. Ambassador to the UN) John Bolton. Bolton is on record arguing that the U.S. should bomb Iran. The role of the national security advisor varies with the president. Some presidents rely on the position more than others. However, given this administration's inexperience with foreign policy, the role is critical in shaping the White House worldview. The national security advisor manages the staff of the National Security Council (NSC), whose role is to coordinate with the vast network of U.S. intelligence agencies and filter information to the president. Given how large America's foreign, defense, and intelligence establishment is, and given the nature of human and signals intelligence, U.S. presidents often have to act upon diametrically opposing pieces of intelligence. As such, the national security advisor and the NSC can play a critical role in deciding what intelligence makes it to the president's desk and in what context. Staffers in the National Security Council (NSC) are often apolitical. We have been told that several current experts are leftovers from the Obama administration. It is likely that an ideological pundit like John Bolton, who served briefly in the George W. Bush administration, will set out to quickly eliminate non-partisan staffers on the NSC and tilt the information flow away from the empirical to the conspiratorial. With Bolton and Pompeo effectively in charge of U.S. foreign policy it is possible that the U.S. will misapply "maximum pressure" policy to Iran and bungle the complicated coordination with geopolitical allies on China. In particular, the U.S. has to endear itself to the EU if it wants a global economic alliance against China. But the EU also does not want to renegotiate Iran sanctions. Abrogating the 2015 nuclear deal - the Joint Comprehensive Plan of Action (JCPA) - would throw the tentative Middle East equilibrium into chaos. While Iran has played a role in preserving the regime of Bashar al-Assad in Syria, it has largely kept its vast network of Shia militias and allies in check, particularly in Lebanon and Iraq. Ironically, it was the Obama administration's "flawed" JCPA that has allowed Trump to focus on China in the first place. As we argued when the deal was signed, the conservative critics of the deal itself were correct. The JCPA did not degrade Iran's nuclear capability but merely arrested it.13 The point of the deal was implicitly to give Iran a sphere of influence in the Middle East so that the U.S. could extricate itself and focus on China. The Obama administration assessed, in our view non-ideologically, that the U.S. cannot fight two wars at the same time. If the Trump administration decides not to waive sanctions on May 12, it will be in abrogation of the deal. Unlike North Korea, however, Iran has multiple levers it can deploy against the U.S. and its allies' interests in the region. As such, the policy of "maximum pressure" will create much greater risks when applied to Iran. At the very end, it could be as successful as when applied to North Korea, but our conviction view is much lower (and to remind clients, we were optimists about the strategy when applied to North Korea!).14 Furthermore, and again unlike North Korea, Iran is beset with domestic risks. This actually makes it less likely that Tehran will cooperate with the U.S. North Korea is a simple domestic political system where Kim Jong Un can alter policy on a whim without much domestic pushback. In Iran, the dovish and moderate President Hassan Rouhani has to contend for power with hawks who have been critical of the JCPA. Meanwhile, the restive youth population could rise up at the first sign of elite division or weakness. This complicated domestic dynamic is why we cautioned clients back in January that Iran would likely add geopolitical risk premium to the oil markets.15 Bottom Line: It appears that President Trump, motivated by the success of his "maximum pressure" strategy against North Korea, now thinks he can apply it as successfully to Iran. This raises the prospect that Trump will discontinue the waiver of economic sanctions on May 12, effectively re-imposing a slew of economic sanctions against Iran and foreign companies looking to conduct business with it. Geopolitical risks are likely to rise in the Middle East as a result of U.S.-Iran tensions. As we go to publication, Saudi authorities have intercepted another Houthi missile heading towards Riyadh just days after Saudi Crown Prince Mohammad Bin Salman visited Washington, D.C. The White House appears to relish the opportunity to fight a war on two fronts, a trade war with China and a geopolitical war with Iran. Expect volatility and an elevated geopolitical risk premium in oil markets. Stay overweight global defense companies across markets. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 6 Please see John Mearsheimer, The Tragedy Of Great Power Politics (New York: Norton, 2001). 7 Would President Hillary Clinton have avoided a trade war with China? We do not think so. Secretary Clinton was considered a "China Hawk" while at the State Department and pushed for the "Pivot to Asia." Jennifer Harris, the lead architect of Clinton's economic statecraft agenda in the U.S. State Department, recently penned a book that called for greater use of economic tools for geopolitical ends. The book, War By Other Means, introduces the term geoeconomics and calls for the U.S. to use economic instruments to promote and defend national interests. Please see BCA Geopolitical Strategy Blog, "We Read (And Liked)... War By Other Means," dated July 13, 2016, available at gps.bcaresearch.com. 8 In 2000, while campaigning on behalf of China's WTO entry, President Bill Clinton remarked, "economically, this agreement (China's WTO entry) is the equivalent of a one-way street. It requires China to open its markets ... to both our products and services in unprecedented new ways. All we do is to agree to maintain the present access which China enjoys ..." Please see "Full Text of Clinton's Speech On China Trade Bill," dated March 9, 2009, available at nytimes.com. 9 To name just a few: the risk of an Israeli attack against Iran, the risk of a full-scale Russian invasion of Ukraine, the risk of Euro Area collapse, the risk of Saudi-Iranian war, the risk of Russian-Turkish war, etc. 10 For the best example of how game theory is combined with our constraint-based paradigm, please see BCA Geopolitical Strategy Special Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 11 See James Dean in Rebel Without A Cause. 12 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, "North Korea: Beyond Satire," dated April 19, 2017, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, and "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com.
Highlights Fixed Income Asset Allocation: Global growth indicators remain solid, while inflation pressures continue to build. Central banks will remain focused on those factors, and not news-driven market volatility spikes, until the trends change. The cyclical environment still favors a below-benchmark duration stance for bond investors, favoring credit over government debt, but with lower risk-adjusted return expectations. U.K. Gilts: Bank of England hawkishness is increasing, but policymakers will be hard pressed to tighten more than is currently priced. Stay overweight Gilts in hedged global government bond portfolios. Position for a steeper Gilt curve by going long the 5yr in a 2yr/5yr/10yr butterfly trade. Feature Chart of the WeekStill A Bond-Bearish Backdrop Higher financial market volatility remains the most important investment theme for 2018, as investors continue to be fed a steady diet of worrisome headlines. Threats of a U.S. - China trade war, widening LIBOR-OIS spreads in the U.S., the ascent of trade and foreign policy hawks in the White House, troubles at Facebook hitting the market-leading technology stocks - all are just the latest reasons for investors to become more cautious on taking risk. Yet the ability of markets to shrug off, or succumb to, growing uncertainty will be related to two things - the momentum of global economic growth and the future direction of global monetary policy. On the former, the latest data releases have shown some moderation in the strong coordinated global growth upturn witnessed over the past year. Our aggregate measures such as the global PMI and global ZEW indices have dipped lower in the first few months of 2018. These indicators remain at levels suggesting growth is still in decent shape, even with some worsening in expectations (Chart of the Week). On the latter, the BCA Central Bank Monitors are still showing a growing need to tighten monetary policy further in the major developed economies. This continues to put upward pressure on government bond yields through rising inflation expectations and a higher expected path of short-term interest rates. Until there is evidence of a more meaningful downturn in global growth, bond yields will keep on drifting higher. We continue to recommend a below-benchmark overall portfolio duration stance for fixed income investors, favoring spread product over government bonds, while running below-average portfolio risk (i.e. tracking error) given more elevated levels of market volatility. The "TINA Trade" Is Now The "TISNA Trade" - There Is STILL No Alternative Central bankers remain on a path to normalize the extraordinary monetary accommodation of the past several years, led by their steadfast belief in the Phillips Curve at a time of low unemployment in most countries. Against this backdrop, government bond yields cannot fall enough to limit the damage from rapid equity market selloffs without much softer growth or inflation data that would alter the expected trajectory of policy rates. This implies a higher structural level of market volatility now relative to previous years, as we discussed in a recent Global Fixed Income Strategy Weekly Report.1 Yet despite the signs of greater nervousness among investors, there is still a strong level of positive sentiment towards equities and bearish sentiment towards bonds according to the Market Vane indices (Chart 2). The latest edition of the widely-followed Bank of America Merrill Lynch Investor Survey also revealed a disconnect between the opinions of investors (worries over protectionism, trade wars, higher inflation and softer global growth) and actual positions (large equity overweight's favoring cyclical growth stocks).2 Investors seem to be "nervously complacent", staying long risk assets (equities, credit) and underweight safe havens (government bonds) but with a growing list of concerns. For now, this appears to be the most appropriate allocation, for the following reasons: Global growth is still generally strong. Our global manufacturing PMI remains close to the cyclical highs, although there was some pullback seen in the "flash estimates" for March in the euro area, Japan and the U.K. (Chart 3). The breadth of the current cyclical global upturn remains strong, with all eighteen countries in the composite index having a PMI in the "growth zone" above 50 (top panel). Chart 2Pro-Risk Sentiment,##BR##Despite More Volatile Markets Chart 3Global Growth##BR##Still Looks Good The OECD global leading economic indicator continues to accelerate, while the Citigroup global inflation surprise index is also picking up (Chart 4). These are pointing to continued upward pressure on global bond yields through higher real yields and faster inflation expectations, respectively. The global cyclical backdrop is boosting inflation. 75% of OECD countries are operating beyond full employment while capacity utilization rates in the developed economies are approaching 80% - the highest level since mid-2008 (Chart 5, top panel). Global oil prices should continue to grind higher, with BCA's commodity strategists now expecting the benchmark Brent oil price hitting $80/bbl in one year's time (middle panel). Also, global export price inflation is showing no signs of slowing, suggesting that global headline inflation should continue moving higher (bottom panel). Chart 4Upward Pressure On##BR##Real Yields AND Inflation Chart 5A More Inflationary##BR##Global Backdrop Central bankers are still biased towards becoming less accommodative. This was seen last week with the U.S. Federal Reserve hiking the fed funds rate and raising its growth and interest rate projections (Chart 6), while the Bank of England (BoE) gave a strong indication that an interest rate increase was coming in May. This comes as the European Central Bank continues to signal a tapering of its asset purchase program later this year. The latter point is critical for markets, as tighter global monetary policy has diminished the ability for investors to ignore sources of potential uncertainty. Take the current concern over trade tensions between the U.S. and China, for example. A Google Trends search of the phrase "China Trade War" shows, unsurprisingly, a huge recent spike in interest in that topic (Chart 7, top panel). There was also a big increase in such online searches around the time of Donald Trump's election victory in November 2016 and his inauguration in January 2017. At that time, however, global monetary policy was still accommodative, with the real fed funds rate well below the neutral "r-star" estimate (middle panel) and central bank balance sheets in the major developed economies expanding at a 20% annual rate (bottom panel). Chart 6The Fed Will Keep On Hiking Chart 7Expect More Vol Spikes While CBs Tighten The easy monetary settings helped keep market volatility low despite the shock of Trump's election win and what it meant for the implementation of his more aggressive campaign promises, like raising tariffs on U.S. imports from China. Fast forward to today and the real fed funds rate is now at neutral and central banks are buying bonds at a much slower pace. This means that markets will have a tougher time ignoring greater uncertainty, as was witnessed in last week's equity market selloff following President Trump's announcement of $60 billion in Chinese import tariffs. Going forward, without the soothing balm of very low interest rates and plentiful central bank liquidity expansion, volatility spikes like the ones seen in early February and last week will become more frequent. The implication is that volatility-adjusted returns on risk assets will be lower, even if the global growth backdrop remains reasonably supportive. A pro-risk investment bias, but playing with fewer chips on the table, is still appropriate over at least the next six months. Bottom Line: Global growth indicators remain at elevated levels, while inflation pressures continue to build. Central banks will remain focused on those factors, and not news-driven market volatility spikes, until the trends change. The cyclical environment still favors a below-benchmark duration stance for bond investors, favoring credit over government debt, but with lower risk-adjusted return expectations. U.K. Update: Sticking With Our Overweight Call On Gilts Chart 8Mixed Messages On U.K. Growth The BoE kept interest rates unchanged at last week's policy meeting, but sent clear signals that a rate hike would be very likely in May. Two members of the Monetary Policy Committee (MPC), Michael Saunders and Ian McCafferty, actually voted a rate hike last week, which was a surprise. The BoE's increasing hawkishness continues a process that began in autumn of 2017, when policymakers began shifting their language in advance of a November rate hike - the first BoE rate increase since May 2007. The central bank had been worried more about the risks to the U.K. growth outlook since the July 2016 Brexit vote, while ignoring the currency-driven overshoot of its inflation target. Now, the BoE seems a bit more comfortable with the U.K. growth outlook, even amid the ongoing Brexit uncertainty, as was noted in the official policy statement from last week's MPC meeting: Developments regarding the United Kingdom's withdrawal from the European Union - and in particular the reaction of households, businesses and asset prices to them - remain the most significant influence on, and source of uncertainty about, the economic outlook. In such exceptional circumstances, the MPC's remit specifies that the Committee must balance any significant trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity. The steady absorption of slack has reduced the degree to which it is appropriate for the MPC to accommodate an extended period of inflation above the target. We find it a bit of a surprise that the BoE would seek to switch to inflation-fighting mode now, for two reasons: U.K. growth momentum may be slowing. The flash estimate for the March manufacturing PMI fell to an 8-month low, while the leading economic indicators (LEIs) from both the OECD and Conference Board have clearly rolled over (Chart 8). The BoE did highlight the recent pickup in wage inflation, with year-over-year growth in average weekly earnings now up to 2.8% in nominal terms. This has pushed real wage growth back into positive territory (3rd panel), which appears to be feeding through into a slight pickup in consumer confidence (bottom panel). Although the modest increase in February retail sales suggests that a consumer spending revival may be slower to arrive than the BoE is hoping for. U.K. inflation momentum is slowing. The surge in U.K. inflation following the decline in the British Pound after the 2016 Brexit vote is in the process of unwinding. The trade-weighted currency is up 9% from the 2016 low, which has sliced imported goods price inflation from 10% to 2% over the same period (Chart 9). Headline CPI inflation, which rose from near 0% to 3.1% in November 2017, now sits at 2.7%. The upturn in core CPI inflation has also stabilized. While both CPI inflation measures remain above the 2% BoE target, the momentum has clearly peaked and pipeline price pressures continue to decelerate. Investors have listened to the signals sent by the BoE, pricing in 45bps of hikes over the next year and pushing the 2-year Gilt yield to 0.9% - the highest level since May 2011 (Chart 10). At the same time, market-based inflation expectations have dipped a bit and the U.K. data surprise index has fallen back to the zero line (bottom panel). Chart 9U.K. Inflation Has Peaked Chart 10A Rapid BoE Repricing At The Wrong Time? Conflicting signals can also be seen in the slope of the Gilt curve. The nominal 2-year/10-year Gilt curve now sits at 55bps, just above the 2016 post-Brexit lows. The real Gilt curve (the nominal curve minus the 2-year/10-year U.K. CPI swap curve) is sitting at the flattest levels last seen since 2015/16 (Chart 11, top panel) when the BoE base rate was above zero in real terms (2nd and 3rd panels). Now, the real base is deeply negative around -2%, suggesting that the Gilt curve may already be discounting higher real BoE policy rates. At the same time, the U.K. inflation expectations curve is steepening, with 2-year CPI swaps falling faster than 10-year CPI swaps, as was the case during that 2015/16 episode (bottom panel). U.K. money markets are now pricing in an increase in the base rate to 1% over the next year. Given the slowing trends in the U.K. LEIs, the manufacturing PMI and realized inflation rates, we remain doubtful that the BoE will be able to deliver more hikes than are currently discounted. We continue to view U.K. Gilts as a "defensive" overweight within dedicated global government bond portfolios, especially given our recommendation to also stay defensive on overall duration exposure. The primary trend in the performance of U.K. Gilts relative to the Barclays Global Treasury Index, on a currency-hedged basis, is broadly correlated (inversely) to the ratio of the U.K. OECD LEI to the overall OECD LEI (Chart 12, top panel). Thus, we feel comfortable sticking with our call to expect U.K. Gilt outperformance in the next 6-12 months as long as the U.K. LEI continues to underperform - especially with the yield betas of Gilts to U.S. Treasuries and euro area government bonds now well below 1 (middle panel). Chart 11The Gilt Curve##BR##Looks Too Flat Chart 12Stay O/W Gilts & Add Go Long##BR##The Belly On A 2/5/10 Butterfly Given the recent flattening of the Gilt curve, which appears a bit extreme, we are adding a new trade to our Tactical Overlay this week: going long the belly (5-year) of a 2-year/5-year/10-year (2/5/10) Gilt butterfly. The current level of that 2/5/10 butterfly is 9bps, and we are targeting a move down to the -10bp to -15bp range. This trade is mildly negative carry, with -0.75bps of flattening per month already discounted in the forwards over the next year (bottom panel), but we anticipate the 2/5/10 butterfly to compress at a faster rate than the forwards in the coming months. Bottom Line: BoE hawkishness is increasing, but policymakers will be hard pressed to tighten more than is currently priced. Stay overweight Gilts in hedged global government bond portfolios. Position for a steeper Gilt curve by going long the 5yr point in a 2yr/5yr/10yr butterfly trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6th 2018, available at gfis.bcaresearch.com. 2 https://www.bloomberg.com/news/articles/2018-03-20/cracks-in-bull-case-emerge-yet-stubborn-investors-not-moving Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Economy: There is no imminent danger of a significant deterioration in global growth, but the rate of improvement is peaking. The result of the more moderate pace of economic growth and the mounting threat of protectionism is that there is more two way risk in both bond yields and spreads than there has been for some time. Fed: The message from last week's Fed meeting is that the committee recognizes that the outlook for U.S. growth and inflation has improved. Going forward, we anticipate a more hawkish Fed that is somewhat less responsive to tightening financial conditions. This will keep a floor under Treasury yields and impart volatility to credit spreads. Leveraged Loans: Leveraged loans have not yet started to outperform fixed rate junk bonds, but this will change as we approach the end of the credit cycle and loan coupons follow interest rates higher. Feature Yet another down week for risk assets, and all of a sudden 2018 is shaping up to be a pretty miserable year for spread product (Chart 1). High-Yield corporate bonds have underperformed duration-equivalent Treasuries by 29 basis points year-to-date, and investment grade corporates have underperformed by 90 bps. Meanwhile, the sell-off in Treasuries has also paused and the 10-year yield is now 12 bps below its 2018 peak. Chart 1Annual Excess Returns To Credit What exactly is going on? We identify two catalysts for the recent market moves and consider each in turn. Questioning The Synchronized Global Recovery Market moves during the past few weeks have, to some extent, been driven by investors starting to question the sustainability of the so-called "synchronized global recovery". The strong pace of global growth has been a key driver of higher bond yields and risk asset outperformance, and most indicators suggest this trend remains intact. The Global Manufacturing PMI is high compared to recent years, and our PMI diffusion index shows that only 1 out of 36 countries has a PMI below the 50 boom/bust line (Chart 2). Our Global Leading Economic Indicator is similarly elevated, and has a diffusion index that has mostly been in positive territory since mid-2016 (Chart 2, panel 2). But last week we received some evidence that this rapid pace of growth may not persist. Flash PMIs predict that the Eurozone Manufacturing PMI will fall to 56.6 in March, down from a recent peak of 60.6 (Chart 2, panel 3). Similarly, the Japanese PMI is predicted to fall to 53.2 in March, down from a recent peak of 54.8 (Chart 2, bottom panel). There is no Flash PMI data for China, the country with the largest weighting in the Global PMI index, but leading indicators suggest that Chinese PMI will also moderate in the months ahead. This is a risk we have flagged in several recent reports.1 Granted, these are all strong PMI readings that are still well above the 50 boom/bust line, but the pace of improvement has clearly moderated and this sort of marginal change often causes investors to extrapolate weaker growth into the future. This appears to be exactly what is happening. The Global ZEW index, a survey of investors' economic sentiment, fell in March (Chart 3). The BCA Carry Canary Indicator, a composite measure of emerging market currency trades geared to global growth, has also weakened (Chart 3, panel 2). Meanwhile, cyclical equity sectors (excluding technology) have not managed to outperform defensives even as Treasury yields have risen, a break from the prior correlation (Chart 3, panel 3). Of the four market-based indicators that most closely track the 10-year Treasury yield, only our Boom/Bust Indicator is not currently pointing to lower yields in the near-term (Chart 3, bottom panel). As usual, we turn to our 2-Factor Treasury Model to assess the impact of moderating global growth on the 10-year Treasury yield. At present, the model - which is based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar - pegs fair value for the 10-year Treasury yield at 2.96% (Chart 4). However, if we assume that Flash PMI readings for the U.S., Eurozone and Japan are accurate, and also that PMIs in the rest of the world and dollar sentiment stay flat at current levels, then the fair value reading from our model will drop to 2.85% when the final March PMI data are released next week. This is not far from the current yield level, and could even be an optimistic forecast if the Chinese PMI starts to roll over, as we expect. Chart 2Global Recovery Still Intact Chart 3Global Growth Warning Signs Chart 42-Factor Treasury Model Of course the global economy also has to contend with the possibility of an escalating trade war between the U.S. and China. Markets reacted last week as the U.S. government ramped up the pressure by announcing a 25% tariff on $50-$60 billion worth of trade with China. While the immediate economic impact of these measures is highly uncertain, our Geopolitical strategists view an escalating trade war as a real possibility during the next 1-2 years.2 Bottom Line: There is no imminent danger of a significant deterioration in global growth, but the rate of improvement is peaking. The result of the more moderate pace of economic growth and the mounting threat of protectionism is that there is more two way risk in both bond yields and spreads than there has been for some time. Stay tuned. A Less Supportive Fed Chart 5Fed Versus Market The second catalyst driving bond markets at the current juncture is that the Fed is providing markets with a less accommodative monetary back-drop. Faced with a firmer outlook for U.S. growth and inflation, the Fed is now somewhat less responsive to tighter financial conditions than it has been during the past few years. This hawkishness will put a floor under Treasury yields going forward, and is also the most immediate risk to credit spreads, as we have explained in several recent reports.3 Chart 6The Fed's Phillips Curve Model Case in point, the Fed went ahead with a rate hike at last week's FOMC meeting despite the recent turbulence in financial markets. Not only that, but FOMC participants generally revised up their projections for both economic growth and the fed funds rate. The same number of participants (6) now expect four rate hikes this year as expect three. Last December only four participants expected four or more rate hikes in 2018. Further, the committee's median projection for the fed funds rate at the end of 2019 rose from 2.7% to 2.9%, the median for the end of 2020 rose from 3.1% to 3.4%, and even the median federal funds rate expected to prevail in the longer run rose from 2.8% to 2.9%. The market has moved a long way towards the Fed's dots in recent months, but is still somewhat more pessimistic. The overnight index swap curve is priced for slightly more than three rate hikes in 2018 (including last week's), but is below the Fed's median projection for 2019, 2020 and the longer run (Chart 5). As mentioned above, the Fed also revised up its projections for economic growth and the pace of labor market tightening. The Fed is now looking for an unemployment rate of 3.6% by the end of next year, well below its estimated 4.5% natural rate. At the same time, however, the Fed left its projections for core inflation largely unchanged leaving some to question whether the Fed is re-assessing its commitment to the Phillips curve. In fact, the following question was asked to Chairman Powell at last week's post-meeting press conference:4 Question: Interesting changes in the forecast. A higher growth forecast [...]. Lower unemployment, [...]. And yet, very little change in inflation. What does that say about what you and the Committee believe about the inflation dynamic? Answer: [...] that suggests that the relationship between changes in slack and inflation is not so tight. [...] It has diminished, but it's still there. In other words, the Chairman refused to dismiss the Phillips curve framework altogether but acknowledged that the slope is very flat. The implication is that the labor market will have to run hot for the next couple of years for the Fed to achieve its inflation target. By our assessment, the Fed's projections for the unemployment rate and inflation seem fairly reasonable. Chart 6 shows an expectations-augmented Phillips curve model of core inflation that we re-created from a 2015 Janet Yellen speech.5 Using the Fed's median projections for the unemployment rate, and also holding relative import prices and inflation expectations flat, the model projects that core inflation will rise during the next two years, but will remain slightly below the Fed's target. In other words, the Fed's inflation forecasts seem to agree with the empirical data. In Search Of A More Robust Phillips Curve One of the reasons that the Phillips curve is so flat is that while core PCE inflation includes some prices that respond briskly to labor market slack, it also includes many prices that are less driven by labor slack and more by idiosyncratic factors. The price of imported goods being a prime example. Recent research from the San Francisco Fed splits out those prices that are more sensitive to labor slack - procyclical inflation - from those that are less sensitive to labor slack - acyclical inflation.6 Interestingly, it is the acyclical components that have caused core inflation to run below the Fed's target in recent years, while procyclical inflation has been well above 2% (Chart 7). This framework is helpful because it allows us to estimate a more robust Phillips curve on just the components of inflation that are most sensitive to tightness in the labor market. For example, when we estimate a Phillips curve relationship on just procyclical inflation (excluding housing), the model shows that this component of inflation will rise by 0.18% for every percentage point decline in the unemployment rate. When we estimate the Phillips curve model on overall core PCE we find that a 1 percentage point decline in the unemployment rate only raises core PCE inflation by 0.09%. The top panel of Chart 8 shows that if the unemployment rate follows the path predicted by the Fed, then procyclical inflation (ex. housing) will rise during the next two years, and should stay above the Fed's 2% target. Our own model of housing inflation also shows that its deceleration should reverse in the coming months (Chart 8, panel 2). Chart 7Acyclical Components A Drag On Inflation Chart 8TCore Inflation Will Move Higher As for the acyclical components of inflation, in a prior report we discussed why health care inflation should rise during the next two years, and this has so far been confirmed by strong producer price data (Chart 8, panel 3).7 For the remaining acyclical components, of which 41% are goods and 59% are services, we would expect that at least the goods component will rise in response to the recent acceleration in non-oil import prices (Chart 8, bottom panel). In conclusion, there is reason to expect some upside in each component of core inflation. We anticipate that core inflation will move higher in the coming months and that the Fed will respond with continued gradual rate hikes. Bottom Line: The message from last week's Fed meeting is that the committee recognizes that the outlook for U.S. growth and inflation has improved. Going forward, we anticipate a more hawkish Fed that is somewhat less responsive to tightening financial conditions. This will keep a floor under Treasury yields and impart volatility to credit spreads. Leveraged Loan Update Chart 9Loan Coupons Will Rise We continue to recommend that investors favor floating rate leveraged loans over fixed rate high-yield bonds in their credit portfolios. The two main reasons for this recommendation are that (i) loans will benefit from higher coupons as the Fed lifts rates and LIBOR resets higher and (ii) loans will benefit from higher recoveries than bonds when the next default cycle occurs. However, somewhat puzzlingly, as 3-month LIBOR has increased during the past few years the coupon return on the S&P Leveraged Loan index has not kept pace. In fact, leveraged loans only started to outperform fixed rate junk a couple of months ago (Chart 9). There are two reasons for this. First, many leveraged loans have LIBOR floors at around 1%, so initial increases in LIBOR in 2016 had no impact on leveraged loan coupons. But 3-month LIBOR is now well above 1%, and yet leveraged loan coupons are still not rising. This is because issuers have been aggressively refinancing loans at lower spreads as LIBOR has increased. This spread compression has kept coupon payments low, but history tells us that this dynamic cannot persist. Eventually, as credit spreads stop tightening near the end of the credit cycle, issuers will not be able to reduce their interest costs through refinancing and will be forced to accept higher coupon payments as interest rates rise. Notice that even though the average price on the S&P Leveraged Loan index was higher between 2004 and 2006 than it is today, that did not prevent loan coupons from rising alongside LIBOR, after some initial lag (Chart 9, bottom panel). Bottom Line: Leveraged loans have not yet started to outperform fixed rate junk bonds, but this will change as we approach the end of the credit cycle and loan coupons follow interest rates higher. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 2 https://gps.bcaresearch.com/blog/view_blog/460 3 Please see U.S. Bond Strategy Weekly Report, "Brainard Gives The Green Light", dated March 13, 2018, available at usbs.bcaresearch.com 4 A full transcript of the post-meeting press conference: https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180321.pdf 5 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 6 https://www.frbsf.org/economic-research/files/el2017-35.pdf 7 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights After the March FOMC Meeting, market pricing for short-term rates is largely consistent with the Fed's forecasts. For investors and the Fed, the health of the economy and earnings matter more than Trump's political woes. However, the U.S. / China trade disputes will now take center stage. How can investors prepare for the trough in Citigroup Economic Surprise Index? Investors remain skeptical that the unemployment rate can fall to 3.5% and wonder what pace of monthly payroll growth would be required to get it there. Feature The S&P 500 fell more than 2% last Thursday after President Trump announced a new round of tariffs aimed at China. Treasury yields drifted modestly lower, and the trade weighted dollar fell 1%. Credit spreads widened. The trade tensions and the softer dollar drove gold up by nearly 3%. Meanwhile, another drawdown in oil inventories drove WTI oil nearly 5% higher. The VIX climbed last week, and has more than doubled since the start of the year. The market largely ignored last week's FOMC meeting. Fed Chair Powell stuck to the script at his first post-meeting press conference, but noted that trade was a topic of discussion. The "...For Inflation" section of this week's report provides more detail on Fed's view of the economy and rates. U.S. risk assets also sold off last week as market participants reacted negatively to Trump's political woes and trade policies. BCA's view is that investors should fade the former and focus on the later. We discuss Trump's political situation, as well as the trade tensions in the second section of this week's report ("...For the Next Tweet"). Nearly all the data in last week's sparse economic calendar exceeded expectations. At 1.8%, the Atlanta Fed GDPNow estimate for Q1 finished the week where it started. An unusual run of harsh winter weather in the Northeastern U.S. in March will keep downward pressure on the Citigroup Economic Surprise Index for the next month or so. We provide more detail on the Citigroup Economic Surprise Index and the performance of risk assets as the index rises and falls in the "...For The Washout" section of this week's report. Moreover, in the final section of the report ("...For The Labor Market"), we discuss how the unemployment rate can get to BCA's target of 3.5% in the next 12 months. ... For Inflation As widely expected, the FOMC last week delivered its sixth rate hike of the cycle and Fed members were more optimistic on the economic outlook. However, U.S. trade policy is a cloud over the outlook. The Fed downgraded its assessment of current economic conditions, but upgraded the outlook. The current pace of economic activity was described as "moderate" and opposed to "solid" in the previous FOMC statement. This reflects some disappointing data releases, which is also apparent in the Atlanta Fed's GDPNow model forecasting just 1.8% growth in Q1. But the Fed does not expect the softness to persist and noted that "the economic outlook has strengthened" (details below in "...For the Washout"). This was reflected in the updated economic projections. GDP growth forecasts were revised to 2.7% and 2.4% for 2018 and 2019, respectively (Chart 1). That's up from 2.5% and 2.1%, and comfortably above the Fed's 1.8% estimate for potential growth. As a consequence, the Fed expects the unemployment rate to drop to 3.6% in 2019, which would be well below the Fed's revised 4.5% estimate of full employment (details below in "...For the Labor Market"). Despite growth being above-trend and the jobless rate falling far below NAIRU, FOMC participants are not forecasting a major acceleration in inflation. From 1.9% in 2018, core PCE inflation is seen fairly steady at 2.1% in 2019 and 2020. To some degree, the upward pressure on inflation will be mitigated by a higher path for the Fed funds rate. Although the median projection remains for three rate hikes this year, the Fed expects slightly faster rate hikes in 2019 and 2020 (Chart 2). The Fed funds rate is now expected to end 2020 at 3.375%, up from 3.125% expected in December. This will put monetary policy on the tighter side of the Fed's 2.875% estimate of the neutral rate. Chart 1The FOMC'S Latest Forecasts Chart 2Market And The Fed In Agreement On Rates Of course, the path of the Fed funds rate will depend on the degree of slack in the economy and the resulting inflationary pressures. The Fed could be underestimating the inflationary pressures associated with a jobless rate that will be nearly 1% below NAIRU. Alternatively, a rising participation rate could slow the decline in the unemployment rate, or the Fed's estimate of NAIRU could get revised much lower. Finally, while the fiscal stimulus is behind the Fed's more optimistic outlook, U.S. trade policy is a growing downside risk (details below in "...For the Next Tweet"). During his press conference, Fed Chair Powell said that FOMC members were aware of the risk, but it was not incorporated into their forecasts. President Trump announced tariffs on China last week. China may then retaliate with its own tariffs. As we've said before, nobody wins from trade wars. Economic activity will be weaker and prices will be higher. A full blown trade war could jeopardize the Fed's rosy forecasts. Bottom Line: Market pricing for short-term rates is largely consistent with the Fed's forecasts. Therefore, the outcome of last week's FOMC meeting is not very market relevant. Investors are more focused on trade policy for now. ... For The Next Tweet BCA is looking beyond any market volatility induced by President Trump's political scandals.1 The decision to impeach President Trump is a purely political decision that rests with the House of Representatives. Under GOP control, Trump will not likely be impeached if he continues to fire his White House aides or members of his cabinet. That is his purview as President. However, relieving Special Counsel Mueller of his duties would probably be a red line for House Republicans and lead to impeachment. That said, it is very difficult to see the impeachment in the House lead to Trump's removal by the Senate, given his elevated approval ratings among GOP voters (Chart 3). Trump's support with GOP voters, our Geopolitical Strategy service's critical measure of whether Trump can stay in power, is back at 2016 election levels with GOP voters (Chart 3). Furthermore, conviction in the Senate (and removal from office), requires 67 votes. If the Democrats take the House, they are likely to impeach Trump in 2019. But even if the Democrats retake the Senate this fall, they would fall far short of that 67-vote threshold for conviction. For investors and the Fed, the health of the economy and earnings matter more than Trump's political woes. Equity markets performed well when the economy and earnings backdrop was favorable during presidential scandals in the 1920s and the 1990s. In the early 1970s, amid soaring inflation and the worst recession since the Great Depression, there was a bear market in equities (Chart 4A). Likewise, surges in equity market volatility amid political scandals were related more to economic and financial events than politics (Chart 4B). Chart 4AFor Markets,##BR##Economy Matters More Than Politics Chart 4BMarket Volatility During##BR##U.S. Political Scandals Today's environment - while not as robust as in the 1920s or late 1990s - provides support for higher stock prices, above-trend economic growth, escalating inflation, three more Fed rate hikes this year, and higher Treasury bond yields. Moreover, none of the issues that investors care about (tax cuts, deregulation, lifting of the spending caps, etc.) can be reversed by Trump's impeachment. Even a Democratic wave in this fall's mid-term Congressional elections will not deliver the opposition party a veto-proof majority (Chart 5). Thus, in the current economic cycle, we expect pro-market forces at the legislative and executive branches of government to persist. Chart 5Democrats's Lead in Generic Congressional##BR##Ballot Has Moved Lower This Year However, Trump's political scandals may cost the GOP the House in this fall's mid-term elections. Table 1 and Chart 6 show that political gridlock is not positive for stock prices after controlling for important macro factors.2 The average monthly return on the S&P 500 is considerably higher when the executive and legislative branches are unified. The worst outcome for equity markets, by far, is when the President faces a split legislature. BCA's Geopolitical Strategy service noted that while the market has cheered the limited scope of tariffs imposed earlier this month, investors may be underestimating the political shifts that underpinned Trump's move. There is little reason to think that protectionism will fade when Trump leaves office. The Administration's decision late last week to introduce sanctions aimed at China represents another escalation of the trade spat initiated in early March. Increased trade tensions with China represent a near-term risk to the markets.3 However, BCA's Geopolitical Strategy team notes that the latest round of tariffs suggests that Trump has made a bid to increase negotiation leverage with China rather than launch a protectionist broadside. This is good news in the short term, relative to the worst fears given Trump's lack of legal/constitutional constraints. But in the long term, Trump's latest move on trade policy support's our view that geopolitical risk is moving to East Asia and the U.S. / China conflict is a high-risk scenario that markets are now going to have to start pricing in.4 Table 1Divided Government Is, In Fact, Bad For Stocks Chart 6A Unified Congress Is A Boon For Stocks Bottom Line: Investors should dismiss the risk of domestic political scandals interrupting the market-friendly policy back drop. However, U.S. / China trade disputes will take center stage. China is motivated to prevent a trade war through significant compromises that Trump can advertise as wins to his audience this November. If Trump accepts these concessions, then the risk of a trade war with China will likely be removed until the next race for President in 2020. ... For The Washout The U.S. economic data have disappointed so far this year, as illustrated by Citigroup Economic Surprise Index (Chart 7). The Index peaked at 84.5 in December 2017 and subsequently has moved lower for 64 days. Since early 2011, there were six other episodes when the Surprise Index behaved similarly. These phases lasted an average of 86 days; the median number of days from peak to trough was 66 days. The implication is that the trough in the Citigroup Economic Surprise reading may be a month or two away. However, the relatively low economic expectations at end-2017 suggest that the disappointment may be truncated. On the other hand, the Tax Cut and Jobs Act of 2017, along with the lifting of budgetary spending caps in early 2018, have likely raised economists' near-term projections. Chart 7U.S. Financial Markets As Economic Surprise Index Declines The performance of key financial markets and commodities since the Economic Surprise Index crested in December 2017 matches the historical record, with a few notable exceptions (Table 2 and Charts 7 and 8). As the Index rolled over in late 2017, stocks beat bonds, credit outperformed Treasuries and the dollar fell, matching previous episodes. However, counter to the historical trend, gold and oil prices have increased and small caps have underperformed in the past three months. Table 2Financial Market Performance As The Economic Surprise Index Falls Chart 8Economic Surprise Approaching A Turning Point Based on BCA's research,5 tactical investors should add to their risk positions as the Citigroup Economic Surprise Index bottoms and begins to climb. As the Economic Surprise Index rises, stocks beat bonds by an average of 8700 bps and in six of the seven episodes since 2011 (Table 3). Furthermore, the performance of stock-to-bond ratio is better when the Economic Surprise Index is accelerating. Table 3 again shows that all asset classes also perform better when the Index climbs. After briefly moving above zero in early 2017 - indicating that inflation data was stronger than analysts projected - the Citigroup Inflation Surprise index rolled over again (Chart 9, top panel) through year end 2017. Reports on the CPI, PPI and average hourly earnings continued to fall short of consensus forecasts despite tightening of the labor and product markets. The disappointment on price data relative to consensus forecasts is not new. Although there were brief periods when prices exceeded forecasts in 2010 and 2011, the last time that inflation exceeded market consensus in this business cycle was in late 2009 and early 2010. In the last few years of the 2001-2007 economic expansion through 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. Table 3Financial Market Performance As The Economic Surprise Index Rises Chart 9The Fed Cycle And Inflation Surprise Moreover, the Citigroup Inflation Surprise index escalated during previous tightening regimes when the economy was at full employment and the Fed funds rate was in accommodative territory (Chart 9). The last time those conditions were in place, which was in 2005, the Fed was wrapping up a rate increase campaign that began in mid-2004. An increase in the Citigroup Inflation Surprise Index also accompanied most of the Fed's rate hikes from mid-1999 through mid-2000. In late 2015, as the current set of rate hikes commenced, the inflation surprise index was on the upswing, the economy was close to full employment and the Fed funds rate was accommodative. Bottom Line: The disappointing run of economic data will not end for another few months. The unusually harsh winter weather in March in the Northeastern exacerbates the situation. However, the weakness in the economic data is not a sign that a recession is at hand. We expect that the inflation surprise index will continue to grind higher, as unemployment dips further into 'excess demand' territory (details below in "...For The Labor Market"). After the Citigroup Economic Surprise Index 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. ... For The Labor Market BCA expects the unemployment rate to hit 3.5% by late 2018 or early next year, the first time since December 1969. Our base case assumes that the economy will generate 200,000 nonfarm payroll jobs per month and that the labor force participation rate will remain at 63%. The unemployment rate was 4.1% in February 2018 and bottomed at 4.4% in 2006 and 2007; the rate reached a 30-year low at 3.8% in 2000. As noted in the first section of this week's report, at the conclusion of last week's meeting, the FOMC nudged down its view of this year's unemployment rate to 3.8%. The FOMC also slightly adjusted its long-term forecast of the unemployment rate to 4.5%. The implication is that BCA and the FOMC expect the U.S. economy to continue to run below full employment this year. Nonetheless, investors remain skeptical that the unemployment rate can fall to 3.5% and wonder what pace of monthly payroll growth would be required to get it there. In Table 4 we look at various scenarios (monthly increases in payrolls, annual percentage change in participation rate) to show when the unemployment rate will dip below 3.5%. In the past three months, total nonfarm payroll employment increased by 242,000 per month, and in the past year, the average monthly increase was 190,000. The participation rate was 63% in February, little changed from a year ago as an improved labor market offset demographic factors that continue to drive down this rate. Our calculations assume that the labor force will expand by 0.9% per year, matching the growth rate in the past 12 months. Chart 10 shows the history of the unemployment rate and several scenarios in the next two years that assume the participation rate stays at 63%. Table 4Dates When 3.5% Unemployment Rate Threshold Is Reached Chart 10The Unemployment Rate Under Various Monthly Job Count Scenarios Bottom Line: BCA's view is that the FOMC's forecast for the unemployment rate at the end of 2018 (3.8%) is too high and only marginally lower than the current 4.1% rate. This is inconsistent with real GDP growth well in excess of its supply-side potential. The macro backdrop will likely justify the FOMC hiking more quickly than the March 2018 dots forecast. The risks are skewed to the upside. BCA expects the 2/10 Treasury yield curve to steepen through mid-year and then flatten by year-end, spending most of 2018 between 0 and 50 bps. Stay underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Policies Are Stimulative Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report "The South China Sea: Smooth Sailing?," dated March 28, 2017, available at gps.bcaresearch.com. 5 Please see BCA U.S. Investment Strategy Weekly Reports, "Solid Start," dated January 8, 2018 and "The Revenge Of Animal Spirits," dated October 30, 2017. Both available at usis.bcaresearch.com.
Highlights Two big distortions in the euro area economy arose because Germany depressed its wages for a decade, and then Italy failed to fix its broken banks for a decade... ...but both distortions are now correcting. Long-term property investors in Europe should seek out undervalued gems on the Greek islands, Portuguese Atlantic coast, Italy and German second-tier cities. Steer clear of Scandinavia, France and central London. Stay overweight a basket of German real estate stocks. Maintain a long basket of German consumer services versus a short basket of exporters comprising autos, chemicals and industrials. Feature In Germany and Italy, real house prices are at the same level today as they were in 1995 (Chart of the Week). Germany and Italy share another similarity. Through the past two decades, they have delivered their workers the same subpar real wage growth (Chart I-2). Chart of the WeekThe Mirror Image Journeys Of German ##br##And Italian House Prices Chart I-2The Mirror Image Journeys Of ##br##German And Italian Wages However, while the point-to-point growth rates for both house prices and wages look identical, the journeys that Germany and Italy have travelled have been mirror images of one another. Germany's journey has been a decline followed by rapid ascent; Italy's journey has been a rapid ascent followed by decline. These mirror image journeys encapsulate the two big distortions within the euro area economy. The Euro Area's Two Big Distortions The euro area's first distortion arose from Germany's labour market reforms at the start of the millennium. Germany's labour reforms were putatively to boost productivity. In fact, the reforms' main impact was to depress German wages for a decade. The consequent boost in competitiveness caused symmetrical distortions: a bubble in German exports, and an anti-bubble in German household incomes. Before Germany joined the euro, such a distortion would have been impossible. An appreciating deutschemark would have arbitraged away any rise in export competitiveness. But an exchange rate appreciation could no longer happen once Germany was sharing its currency with other economies that were not replicating Germany's wage depression strategy. Hence, German household incomes - and house prices - have been one of Europe's biggest losers in the single currency era. Conversely, Germany's export-oriented companies - and their shareholders - have been amongst the biggest winners (Chart I-3). Just consider, the Siemens dividend is up almost one thousand percent! The euro area's second distortion arose because Italy failed to fix its broken banks for a decade. After a financial crisis such as in 2008, the golden rule is to nurse the financial system back to health as quickly as possible. Which is precisely what all the major economies did. All the major economies, that is, apart from Italy (Chart I-4). Chart I-3Distortion 1: Germany Depressed##br## Its Wages For A Decade Chart I-4Distortion 2: Italy Failed To Fix Its ##br##Broken Banks For A Decade Italy procrastinated because its government is more indebted than other sovereigns and because its dysfunctional banks did not cause an acute domestic crisis. Nevertheless, Italy's reluctance to fix its banks is the central reason for its decade-long economic stagnation, and declining real house prices. The good news is that the euro area's two big distortions are now correcting. Germany is allowing its wages to adjust rapidly upwards. Meanwhile, in the space of just a year, Italy has raised almost €50 billion in equity capital for its banks. Italian bank solvency and loan quality have improved sharply. This raises an interesting question: do the German and Italian housing markets now offer compelling long-term investment opportunities? European Housing Markets: The Good, The Bad, And The Ugly Property investments offer income via rents. Over time, these rents should increase in real terms. Items such as a litre of milk or a London commuter train journey do not increase in quality. If anything, the London commuter train journey has decreased in quality! By contrast, accommodation does increase in quality. For example, kitchens and bathrooms, home security, and heating and cooling systems should all get better over time. In essence, the quality of accommodation benefits from productivity improvements, so real rents rise. Of course, such improvements require investment expenditure. But a property investor requires a return on this investment. Therefore, property income - even after expenses - should and does increase in real terms. What about capital values? In the long term, we would expect capital values to have some connection to rising real rents. So if real house prices have not increased over several decades, then it signals a very likely undervaluation. Conversely, if real house prices have increased an implausibly large amount over several decades, then it raises a red flag for a likely overvaluation (Chart I-5, Chart I-6, and Chart I-7). Chart I-5German Real House Prices Are No Higher Than In 1995 Chart I-6Scandinavian Real House Prices Have Trebled Since 1995 Chart I-7Italy, Portugal And Greece Offer Good Opportunities For Property Investors On this evidence, we expect the long-term returns from the housing markets in France, Netherlands, Belgium and Finland to be bad. More worrying, we expect the long-term returns from the housing markets in Sweden and Norway to be ugly. Real house prices have more than trebled since 1995. For this, blame the central banks. In recent years, Sweden's Riksbank and the Norges Bank have had to shadow the ECB's ultra-loose policy to prevent a sharp appreciation of their currencies. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So the ECB's policy may indeed have generated credit-fuelled bubbles... albeit in Sweden and Norway. Chart I-8London House Prices Have Rolled Over We are also reluctant to own London property. London house prices have rolled over, and headwinds persist (Chart I-8). Theresa May wants to drag the U.K. out of the EU single market and customs union, which cannot be a good thing for London. On the other hand, if parliament forces May to soften her Brexit stance, it could fracture a precarious truce between hard and soft Brexiters in her cabinet and topple the government. Thereby, it could pave the way for a Jeremy Corbyn led Labour government and the spectre of a high-end 'land value' tax. So where are long-term returns likely to be good? We repeat that where house prices have shown no real increase from 25 years ago, it bodes very well for the long-term investment opportunity. This describes the situation for the housing markets in Germany, Italy, Portugal and Greece. To summarise, if you are looking for a long-term investment property in Europe, steer clear of Scandinavia, France and central London. And seek out undervalued gems on the Greek islands, Portuguese Atlantic coast, Italy and German second-tier cities. What Is The Related Opportunity In Equity Markets? Real estate holding and development companies and REITS are the equity market plays on real estate. The trouble is that the stocks are too few and too small for a meaningful investment in Greece, Italy and Portugal. However, in Germany, stay overweight the basket of real estate stocks which we first introduced a few years ago. The basket has outperformed by 50%, but the outperformance isn't over. In Germany, the catch-up of house prices is closely connected to the catch-up of household incomes. As Germany continues to reduce its export-dependence and rebalance its economy towards domestic demand, the catch-up has further to run. Chart I-9German Consumer Services Will ##br##Outperform Consumer Goods It is possible to play this structural theme in the equity market via an overweight in consumer services versus consumer goods. Consumer services tend to have more domestic exposure compared to the consumer goods sector which is dominated by autos. Understandably, during the era of German export-dominance, the German consumer services sector strongly underperformed consumer goods. But in recent years, as the German economy has rebalanced, the tables have turned. German consumer services have been outperforming German consumer goods (Chart I-9). We expect this trend to persist. Our preferred expression is to maintain a long basket of German consumer services versus a short basket of exporters comprising autos, chemicals and industrials. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week's recommendation is a commodity pair-trade: short nickel / long lead. The pair trade's 65-day fractal dimension is at the lower bound which has signalled several reversals in recent years. Set a profit target of 8% with a symmetrical stop-loss. We are also pleased to report that all of the four other open trades are comfortably in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Economy: Some of the economic data that feed into GDP have weakened during the past two months, but the fundamental drivers of economic growth remain strong. We continue to expect GDP growth close to 3% in 2018. Markets & Inflation: Bond yields fell during the past few weeks, but so far there is no suggestion that the bond bear market has been derailed. Expect yields to rise in the coming weeks, driven by higher inflation. State & Local Governments: State & local governments still have work to do to repair their fiscal situations. While this process will lead to continued improvement in municipal bond credit quality, it also means that state & local government spending will not provide a significant boost to economic growth. Money Markets: LIBOR/OIS spread widening does not reflect a re-assessment of credit risk in the financial system, but it does present an opportunity for U.S. investors to increase their returns by investing in foreign bonds. Feature Chart 1Growth Scare 2018? A consensus appears to have formed around the outlook for U.S. economic growth. The expectation is that growth, which was already on a solid footing in late-2017, will kick into an even higher gear this year on the back of more stimulative fiscal policy. In fact, Bloomberg consensus forecasts already called for 2018 U.S. GDP growth of 2.3% last October and have ramped up to 2.78% since then. We think it's safe to say that both investors and the Fed have bought into this view, and this makes it concerning that some data have challenged the prevailing narrative in recent weeks. Specifically, a series of disappointing data releases have caused the Atlanta Fed's GDP tracking estimate for first quarter growth to fall to 1.8% (Chart 1). A month ago this same model was calling for growth of 5.4%! Growth Scare 2018? First, we should note that while the Atlanta Fed's GDP tracking estimate for Q1 has declined, as of last Friday, the New York Fed's similar estimate remains at 2.73% (Chart 1). Further, our simple estimate for U.S. GDP growth derived from labor market data shows that growth is tracking close to 3% so far this year.1 Both our simple measure and the New York Fed's model suggest that U.S. growth is running significantly above its 2.2% average since 2010, while the Atlanta Fed's 1.8% estimate suggests it has fallen below its average post-crisis pace. The weakness in the Atlanta Fed model appears to be driven by some hard data - retail sales, durable goods orders and building permits - that have weakened during the past couple months. In general, we note that these measures are still growing more quickly than they were last year, and that the fundamental factors underpinning each component of growth remain strong. We consider each component of growth in turn. Consumer Spending The biggest reason to be pessimistic about consumer spending growth in the first quarter is that core retail sales have been weak for three months in a row.2 Core retail sales contracted in December and January, and increased by only 0.1% in February. However, taking a step back we see that retail sales accelerated sharply between September and November 2017. Even after the recent weakness, the year-over-year growth rate in core retail sales is still above levels observed throughout most of 2016 and 2017 (Chart 2). But more importantly, the fundamentals underpinning consumer spending remain strong and have not corrected at all during the past three months. Disposable income growth is trending higher and recently received a boost from tax cuts. Employment growth has also been strong - averaging +190k during the past 12 months - despite an already tight labor market. These factors have led to a rising trend in our real consumer spending model (Chart 2, panel 2). Finally, while the savings rate is already low and unlikely to fall further, it is also unlikely to rise significantly while consumer sentiment is elevated. The University of Michigan Consumer Sentiment Index hit 102 in March, its highest reading since 2004 (Chart 2, bottom panel). Chart 2Consumer Spending Chart 3Nonresidential Investment Non-Residential Investment Much like with retail sales, new orders for core durable goods have also contracted in each of the past two months, but the year-over-year growth rate is still high compared to the past few years. Meanwhile, our composite indicator of new orders surveys suggests that the recent decline will quickly reverse (Chart 3). Inventories have also been a drag on GDP growth in recent quarters but, according to our model, should increase going forward (Chart 3, bottom panel). Residential Investment The Atlanta Fed model expects residential investment to contribute negatively to GDP growth in the first quarter. This is largely due to the fact that single family building permits declined in January and February. But once again, so far there is no indication that this downtrend will persist. First, housing inventories continue to contract (Chart 4). Inventories typically increase prior to meaningful downturns in residential investment. Second, while higher mortgage rates have certainly dented housing affordability, homes are still much more affordable than prior to the financial crisis, and so far higher rates have not caused mortgage applications to roll over (Chart 4, panel 2). Household formation, the driver of demand for residential investment, is still in a multi-year uptrend and will continue to rise as long as income growth remains strong (Chart 4, panel 3). Fundamentally, it is difficult to see how residential investment can fall meaningfully when household formation is rising and home inventories are already low. Homebuilders appear to agree with this sentiment and are reporting levels of confidence near all-time highs (Chart 4, bottom panel). Chart 4Residential Investment Chart 5Net Exports Net Exports The Atlanta Fed's model projects that net exports will subtract 0.55% from GDP growth in Q1. This is driven mainly by February's sharp deterioration in the trade balance (Chart 5). While net exports are not the most important driver of U.S. growth, this is one area where that could see more downside in the long-run, depending on how much of the government's anti-trade rhetoric turns into law. In the short-run, dollar depreciation should provide at least some positive offset (Chart 5, bottom panel). Financial Conditions Financial conditions are another important driver of economic growth. A few months ago both the BCA Boom/Bust Indicator and the Financial Conditions component of our Fed Monitor were calling for a sharp acceleration in U.S. GDP. This is no longer the case, and the indicators are now consistent with stable or slightly higher GDP growth (Chart 6). However, we should also note that the Financial Conditions component of our Fed Monitor has not actually tightened. It has merely leveled-off at extremely easy levels (Chart 6, bottom panel). Since it is the change in financial conditions that impacts GDP, the leveling-off is consistent with relatively stable GDP growth. Chart 6Financial Conditions Government Spending In a prior report we noted that the combination of tax cuts and the recent spending bill will add 0.8% to GDP this year and 1.3% in 2019. This is a sharp swing from the -0.5% fiscal impulse that was expected prior to the legislative changes.3 Federal government spending will certainly contribute positively to GDP growth this year. But we expect much less of a growth boost (if any at all) from state & local governments. This is discussed further in the section titled "State & Local Governments Still Cautious" below. Bottom Line: Some of the economic data that feed into GDP have weakened during the past two months, but the fundamental drivers of economic growth remain strong. We continue to expect GDP growth close to 3% in 2018. Bond Market Still Taking Cues From Inflation While the outlook for economic growth is always important, recently bond markets have been more driven by inflation, a topic where there is much less consensus in the investment community. Most recently, the 10-year Treasury has fallen 5 basis points since March 9th, with 4 bps of that decline concentrated in the inflation component. The 10-year real yield has fallen by only a single basis point. As we explained in a recent report, the first stage of the cyclical bond bear market is being driven by the re-anchoring of inflation expectations.4 The 10-year TIPS breakeven inflation rate is currently 2.08% and we think it will eventually settle into a range between 2.3% and 2.5%. The decline in the TIPS breakeven rate of the past few weeks is partly explained by a drop in oil prices, but we note that broader commodity indexes have not rolled over (Chart 7). This suggests that weakness in the oil price is not evidence of a broader demand shock and should prove transitory. But even more importantly, the actual inflation data are starting to rebound. Last week's CPI release showed that the 12-month rate of change in core CPI ticked up slightly to 1.85%, but also that the annualized 3-month rate of change jumped sharply above 3% (Chart 8). Further, shelter - the largest component of core inflation - had been trending lower during the past couple years, but leading indicators now suggest a reversal. The rental vacancy rate fell in the fourth quarter of last year for the first time since Q2 2016 (Chart 8, panel 3), and the rate of appreciation in home prices has accelerated (Chart 8, bottom panel). The biggest near-term risk to the bond bear market is that investor over-optimism with regards to the growth outlook leads to a period of negative data surprises. We have previously noted a strong correlation between whether the economic surprise index is above or below zero and whether bond yields rose or fell during the preceding month.5 We also created a model to get a sense of the surprise index's average pace of mean reversion (Chart 9). At the moment, our model forecasts that the surprise index will be close to +20 one month from now. So for now there is no imminent signal that the bond bear market will be derailed, but we will closely monitor data surprises to see if that message changes. Chart 7Breakevens Still Trending Higher Chart 8Inflation Coming Back Chart 9Data Surprises Are Mean Reverting Bottom Line: Bond yields fell during the past few weeks, but so far there is no suggestion that the bond bear market has been derailed. Expect yields to rise in the coming weeks, driven by higher inflation. State & Local Governments Still Cautious As was stated earlier, state & local governments are unlikely to follow the example of the federal government when it comes to spending. In fact, state governments have once again started to raise taxes and reduce budgets. Data for the 2018 fiscal year are shown in Chart 10, and the message is that states have enacted significant revenue increases compared to prior years, and more states are once again raising taxes than are cutting taxes. Further, the National Association of State Budget Officers has noted that of the states that have already announced their 2019 budgets, most have called for another year of slow spending growth and a few states are actually penciling-in declines in general fund spending.6 This should not be too surprising, even nine years into the economic recovery state & local governments are still barely bringing in enough revenue to cover their interest expenses (Chart 11), though they have made considerable progress re-building rainy day fund balances (Chart 12). As for the implications for municipal bond investors, as long as governments maintain focus on improving their fiscal situations than the outlook for credit quality will continue to improve. Our Municipal Health Monitor is still deep in "improving health" territory, a signal that is consistent with ratings upgrades outpacing downgrades for the time being (Chart 13). Chart 10State & Local Government Spending Chart 11Not Much Revenue Buffer Chart 12Rainy Day Funds Rebuilt Chart 13Muni Credit Quality Is Strong Bottom Line: State & local governments still have work to do to repair their fiscal situations. While this process will lead to continued improvement in municipal bond credit quality, it also means that state & local government spending will not provide a significant boost to economic growth. Wider LIBOR/OIS Spread An Opportunity For U.S. Investors Chart 14LIBOR / OIS Spread Widening Explained One trend that has caught investors' attention in recent weeks is the impressive widening in the spread between LIBOR (the cost of unsecured U.S. dollar financing for banks) and the overnight index swap (OIS) rate (the purest measure of the market's fed funds rate expectations). Traditionally, we think of the LIBOR/OIS spread as a measure of credit risk in the financial system. This is because LIBOR is an unsecured agreement between two banks, therefore in theory, it embeds some risk that the counterparty bank will default. But it's important to note that the LIBOR/OIS spread can also rise for idiosyncratic reasons related to the supply and demand for U.S. dollars. For example, when U.S. dollars are scarce, investors are willing to pay more to acquire them and this pressures the USD LIBOR rate higher relative to the OIS rate. In a completely efficient market, competition would then entice counterparties to offer lower LIBOR rates until they eventually only reflect the perceived credit risk of the banking system. However, there is a strong case to be made that strict post-crisis regulations, by making it costly for banks to hold low-margin assets on their balance sheets, have made the market less efficient at arbitraging movements in the LIBOR/OIS spread. This appears to be what is going on at the moment. In recent weeks a confluence of idiosyncratic events have led to both a lower supply and higher demand for U.S. dollars. First, the U.S. government raised the debt ceiling until 2019. The Treasury department is therefore using this breathing room to re-build its cash balance. It accomplishes this by issuing T-bills. As more T-bills are issued U.S. dollars are drained from the market, putting upward pressure on LIBOR. Notice that the spread between the 3-month T-bill rate and the 3-month OIS rate is widening in concert with the LIBOR/OIS spread (Chart 14). Second, companies' new ability to repatriate cash that had been held overseas has a similar impact on LIBOR. That overseas cash had been a source of demand in money markets, but it is now being re-deployed in the form of increased dividends or share buybacks (Chart 14, bottom panel). This is akin to draining U.S. dollars out of the market. Third, the Fed continues to shrink its balance sheet. As this process plays out the Treasury will have to ramp up its issuance, some of which will come in the form of T-bills that will drain even more U.S. dollars out of the market. Going forward, the Treasury department will eventually re-build its cash balance to a level it deems acceptable. This will cause T-bill issuance to taper off, though it will still remain quite strong due to rising deficits and the run-off of the Fed's balance sheet. Similarly, the one-time effect of corporate repatriation will ease over time, though companies may also be less enticed to hold overseas cash balances in the future. All in all, we would expect the widening in LIBOR/OIS to ease in the coming months, but it may take a very long time before it returns to its prior lows, if it gets there at all. A large enough easing of bank capital requirements would likely cause the LIBOR/OIS spread to return to its recent lows, but this does not appear to be an imminent risk. Then, to complicate matters even further, we also have to reckon with the fact that LIBOR is being phased out during the next few years. In fact, the Fed will start publishing its Secured Overnight Financing Rate (SOFR) next month. The SOFR rate will eventually replace LIBOR as the U.S. dollar benchmark for financial contracts, and over time more and more instruments will be tied to SOFR and fewer will be tied to LIBOR. We also would not rule out the possibility that SOFR replaces the fed funds rate as the Fed's target policy rate at some point down the road. The Implication For U.S. Investors Chart 15An Opportunity For U.S. Investors A wider LIBOR/OIS spread has one very important implication for U.S. investors. U.S. investors can take advantage of the scarcity of U.S. dollars in the financial system by swapping their dollars for foreign currencies over short time horizons. In other words, a U.S. fixed income investor can invest in a 10-year foreign government bond, and then increase the received yield by hedging the currency risk. For example, a U.S. investor can receive a yield of 3.3% on a 10-year German bund if they hedge the currency risk on a 3-month horizon. This is a greater yield than they would earn on a 10-year U.S. Treasury note. Without the wider LIBOR/OIS spread the hedged yield would not be nearly as high. If we assume the LIBOR/OIS spread is zero, then the hedged yield on a 10-year German bund falls to 2.80%. Chart 15 shows that as the return from currency hedging increases, U.S. investors earn more from hedged positions in foreign bonds than in domestic bonds. A wider LIBOR/OIS spread gives U.S. investors an extra incentive to put on these global trades. Bottom Line: LIBOR/OIS spread widening does not reflect a re-assessment of credit risk in the financial system, but it does present an opportunity for U.S. investors to increase their returns by investing in foreign bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 For further details on this estimate please see U.S. Bond Strategy Weekly Report, "Brainard Gives The Green Light", dated March 13, 2018, available at usbs.bcaresearch.com 2 Core retail sales exclude building materials, auto dealers and gas stations. 3 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 6 http://budgetblog.nasbo.org/budgetblogs/blogs/brian-sigritz/2018/01/12/governors-begin-releasing-fiscal-2019-budget-propo?CLK=7543618f-810a-4ac4-90e2-01a4b310c649 Fixed Income Sector Performance Recommended Portfolio Specification