Economy
Highlights Global credit markets have endured a surprising bit of turbulence over the past month. Credit spreads in a variety of markets, from U.S. High-Yield (HY) to Euro Area Investment Grade (IG) to Emerging Markets (EM) corporate debt, have widened for the first time since August. Outflows from dedicated corporate bond funds helped fuel the sell-off, with a reported $6.8 billion pulled from U.S. high-yield mutual funds and ETFs over the past week according to Reuters.1 Feature This volatility in credit markets spooked other asset classes last week, triggering a few days of equity market weakness. That is no surprise given the reliable and well-known leading relationship between corporate bond spreads and equity values. For markets that are priced for perfection, with tight credit spreads and elevated equity market valuations at a time when global central banks are inching towards a less accommodative policy stance, it may not take much to prompt some nervous selling by investors. Was this risk-off move justified by any renewed deterioration in credit fundamentals? Or was it just a correction in a market that was very overdue for one? To try and answer this, we think this is an ideal time to present an update of our Corporate Health Monitor (CHM) Chartbook. Chart 1Credit Markets Priced For Perfection Our CHMs are composite indicators of balance sheet and income statement ratios designed to assess the financial well-being of the overall non-financial corporate sectors in the U.S., Europe and Emerging Markets (EM). We have developed both top-down (based on profit data from national income/GDP accounts) and bottom-up (based on actual reported financial data of individual companies) versions of the CHM. While there are differences in methodology between the two measures due to data availability and coverage (see Appendix 1 on Page 13 for details), we have found that both are useful in providing a more complete and comprehensive assessment of the state of corporate finances. The broad conclusion from the latest readings on our Developed Markets CHMs paint a mixed picture (Chart 1): Medium-term credit quality in the U.S. continues to deteriorate, especially for high-yield borrowers, although there has been some cyclical improvement on the back of the solid cyclical performance of U.S. profit growth. Euro Area corporate health remains in good shape, supported in no small part by the hyper-accommodative policy stance of the European Central Bank (ECB) that includes corporate bond purchases. Although returns on capital remain poor and leverage has increased in the Peripheral economies. U.K. corporates are enjoying very strong liquidity positions that are boosting overall credit quality despite mediocre underlying earnings performance. With the global economy enjoying a coordinated cyclical upturn that is supporting solid earnings growth, combined with global monetary policy settings that still accommodative, corporate health is not the primary driver of credit market returns at the moment. Yet if the BCA view on global growth, inflation and interest rates plays out in 2018 - all moving higher, especially in the U.S. - then the story is likely to change. Investors who have been piling into credit because of low risk-free interest rates (and spillovers from global central bank asset purchases) will begin to worry more about credit fundamentals than simply chasing higher yields, to the detriment of credit market performance. U.S. Corporate Health Monitors: Still Deteriorating Our top-down CHM for the U.S. has now been in the "deteriorating health" region for thirteen consecutive quarters dating back to the middle of 2014 (Chart 2). The current U.S. economic expansion has boosted corporate earnings growth on a cyclical basis. This has only acted to slow the modest decline in top-down profit margins, and much larger fall in return on capital, since the peak in both ratios three years ago. The reading on the latter from the 2nd quarter of 2017 (the last data available) is only 6%, not far from the lows seen during the past two recessions. The low return on capital during the current cycle is a disturbing development, as it suggests that there has is a surplus of capital on U.S. balance sheets that is largely unproductive and not boosting profits (the numerator in the ratio). This can also be seen in the run-up in corporate borrowing in recent years that has been used strictly to do share buy-backs. If the best investment idea that a company can have is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the internal rate of return on that investment (i.e. the return on capital) must indeed be quite low, which is a longer-term problem for corporate health. Short-term liquidity remains in good shape for U.S. companies, but interest coverage remains near the low end of the historical range of this ratio. This combination suggests that U.S. companies are not facing an imminent cash crunch that could raise downgrade/default risk, but there is less room for error than in years when interest coverage was at higher levels. This can also be seen in the bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4). Interest coverage is at historically depressed levels for the U.S. HY names in our indicator, and has fallen back to just slightly above the levels seen prior to the 2009 recession. Leverage levels are much higher in HY - around 180% debt/equity (at book value) compared to around 100% for IG - with profit margins that are ½ as wide as those of the IG names in our CHM universe. Thus, it is no surprise to see a far worse interest coverage ratio within our HY CHM where most components are near historically "bad" levels for credit quality. Chart 2Top-Down U.S. CHM:##BR##Still Deteriorating Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Still Deteriorating What is rather worrying is the fact that U.S. IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This suggests that the stock of debt has now grown so much after the rapid run-up in leverage (i.e. record bond issuance) that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is robust. This will raise downgrade risk if corporate borrowing rates were to rise significantly or the U.S. experiences a major economic downturn, as interest costs would rise while earnings deteriorate. Given our views on the likelihood of additional Fed rate hikes and higher Treasury yields in 2018, with even a possibility of a Fed-induced recession in 2019 if policy is tightened too aggressively to combat rising inflation, the risks to U.S. corporate debt performance (both IG and HY) will grow over the course of next year. For now, we are still recommending playing the growth phase of the business cycle by staying overweight U.S. corporate debt within global fixed income portfolios (Chart 5). The time to scale back positions will come after there is more decisive evidence that rising realized inflation is boosting inflation expectations, which will give the Fed confidence to tighten policy more aggressively. This will dampen future corporate profit expectations and likely raise risk premiums on U.S. corporate bonds. Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Modest Cyclical Improvement, From Very Bad Levels Chart 5Credit Rally##BR##Losing Momentum? One final point on the U.S. CHMs - in this version of the CHM Chartbook, we are adding some additional charts showing the bottom-up CHMs for some selected corporate bond sectors. These can be found in Appendix 2 on Page 13. We are only showing the charts this time, but we do plan on doing deeper dives on some individual sectors in future Weekly Reports and CHM Chartbooks. Euro Area CHMs: Still O.K., But With Some Mixed Signals Our top-down Euro Area CHM remains in "improving health" territory as it has for the entire period since the Global Financial Crisis. The direction is turning a bit more worrisome, though, as the indicator is now the closest it's been to the zero line since 2013 (Chart 6). By construction, the CHM shows deviations of the indicator from recent trends, in order to more quickly capture turning points in credit quality. Looked in that light, the steady worsening of the top-down CHM is a function of recent declines in profit margins, return on capital and debt coverage. This is offsetting the high and rising levels of short-term liquidity levels and interest coverage. The latter two points are directly related to the easy money policies of the ECB. The combination of zero (and even negative) short-term interest rates, specific liquidity programs aimed to prompt low-cost bank lending, and outright ECB asset purchases of Euro Area corporate debt have all helped drive borrowing rates to record low levels. Perhaps surprisingly, the low return on capital in the Euro Area, around 8%, is still above the return on capital from the U.S. top-down CHM of 6%. This is also confirmed by the bottom-up versions of the Euro Area CHMs for IG corporates (Chart 7) and HY corporates (Chart 8). Return on capital for Euro Area IG issuers (both domestic issuers and foreign issuers in the European bond market) is between 8-10%, a healthy number by any measure and similar to the level in the bottom-up U.S. IG CHM. Even Euro Area HY shows a return on capital of 4-6%, similar to that of U.S. HY. Chart 6Top-Down Euro Area CHM:##BR##Trending In A Bad Direction Chart 7Bottom-Up Euro Area##BR##Investment Grade CHMs: Improving Within the countries of the Euro Area, our bottom-up CHMs show that the credit metrics look better for the Core versus the Periphery (Chart 9). The biggest difference comes from a cyclical improvement in profit margins and interest coverage in the Core that is not being matched in the Periphery. Chart 8Bottom-Up Euro Area##BR##High-Yield CHMs: Looking Much Better Chart 9Bottom-Up Euro Area##BR##IG CHMs: Core Vs. Periphery More broadly, European corporate health seems to be improving when looking at our bottom-up CHMs. This goes against the trend we are seeing in the top-down CHM, although the latter is still in the "improving health" zone. Declining leverage, especially among the HY issuers in our bottom-up universe, appears to be the biggest source of the HY CHM improvement - again, a bit of a surprising result given how low the cost of debt finance currently is in Europe. Looking ahead, the outlook for Euro Area corporate credit looks positive in the near term, but murkier after that. The current powerful cyclical upturn in the European economy is likely to continue in 2018, as is the ECB's highly accommodative monetary policy. But at some point in the middle of next year, the ECB will be having the same discussion with the markets that was conducted over the past few months, regarding the future of the central bank's asset purchase program. This time, we think the growth and inflation data will give the ECB no choice but to announce a full tapering of its bond-buying program by the end of 2018. Interest rate hikes will come after that, but with a lag of at least one full year. European government bond yields will rise as the ECB eventually stops its asset purchases and the market pulls forward the timing of the next ECB rate hiking cycle. This also applies to corporate debt, where the ECB has become a massive buyer over the past three years. As the pace of ECB buying diminishes, Euro Area corporate bond yields should begin to rise and credit spreads will widen (Chart 10). The underlying improvements in our bottom-up Euro Area CHMs suggests that the repricing of European credit post-ECB tapering may be relatively contained. We still prefer to own U.S. corporate credit over Euro Area equivalents at this time, though. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs. Europe (Chart 11). That CHM gap continues to favor U.S. credit, although of late only U.S. IG corporates have outperformed Euro Area corporates. European HY has been outperforming in 2018 (in excess return terms), which may be a sign that investors are seeing the better European credit health that our bottom-up CHM is showing. Chart 10European Credit##BR##Looks Fully Valued Chart 11Relative Top-Down CHMs##BR##Still Favor The U.S. Over Europe U.K. Corporate Health Monitor: No Major Causes For Concern The top-down U.K. CHM has been in the "improving health" zone for the past two years, led by cyclical improvements in profit margins and interest coverage, combined with very strong short-term liquidity (Chart 12). Return on capital is low relative to its history, which is consistent with the trends seen in the U.S. and Euro Area and likely reflects the global low productivity backdrop (although at levels not far off those seen in the U.S. and Europe). U.K. credit has enjoyed the same global liquidity tailwind that other corporate bond markets have enjoyed. This is doubly so because of the specific easy monetary policies of the Bank of England (BoE) after the 2016 Brexit vote. The BoE has already reversed the post-Brexit interest rate cut, although additional hikes are highly unlikely given muddled growth momentum and the lingering uncertainties over the Brexit negotiations. The post-Brexit weakness in the British pound has stabilized, with the trade-weighted exchange rate now in positive territory on a year-over-year basis. This will result in slower inflation rates in the coming months and a BoE that is likely to sit on its hands for a while. An environment of mushy domestic growth and a stand-pat central bank would typically be good for risk assets like corporate credit. Yet at current low yield and spread levels, it is difficult to paint a scenario of additional outperformance of U.K. credit without a catalyst like accelerating growth or monetary easing. The combination of accommodative monetary policy and a solid credit backdrop, as indicated by our U.K. CHM, leads us to maintain our current neutral allocation to U.K. corporate debt, even though valuations do not look particularly cheap (Chart 13). Chart 12U.K. Corporate Health Monitor:##BR##Credit Quality Still Improving Chart 13U.K. Credit Rally Starting##BR##To Lose Steam Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.reuters.com/article/us-markets-flows-baml/investors-yank-6-8-billion-from-high-yield-bonds-third-largest-outflows-baml-idUSKBN1DH1G8 Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the U.S., Euro Area and U.K. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.2 The financial data of a broad set of individual U.S. and Euro Area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. An EM version of the bottom-up CHM was introduced by the BCA Emerging Markets Strategy team in September 2016, which extends the CHM analysis to EM hard-currency corporate debt.3 2 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. 3 Please see BCA Emerging Markets Strategy Special Report, "EM Corporate Health Is Flashing Red" dated September 14 2016, available at ems.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors 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 The recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Credit spreads would need to widen significantly more to signal that a recession is imminent. What asset classes would benefit if the curve steepens and oil prices rise? Risk assets tend to do better the year before a tax cut than they do the year after. Feature BCA's view is that global growth is on solid footing. EPS growth in the U.S. is in the process of peaking, but will be relatively robust through the end of 2018. If our view is correct, U.S. stocks will outperform bonds in the next 12 months. Nonetheless, last week investors took profits in oil, the dollar, high-yield bonds and U.S. equities as the 2/10 Treasury curve flattened to just 65 bps, the lowest reading in 10 years (Chart 1). The risk aversion occurred amid concern about global growth, waning prospects for the GOP tax cut, and higher odds of a Fed policy mistake. Moreover, financial conditions tightened last week. Chart 1BCA Expects The Curve To Steepen In The Next 12 Months Even so, the recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Junk bonds have sold off in recent weeks, along with EM credit and currencies. In general, credit trends lead the stock market. Moreover, a recent Bank of America Merrill Lynch Survey found that a record share of fund managers are overweight risk assets. Any delay in passage of the tax plan could be the trigger for a correction. BCA's U.S. Equity strategists' views on financial and energy sectors run counter to the recent market action.1 Our position is that financials will benefit from a steeper yield curve and that a drawdown in inventories and robust global oil demand will allow oil prices to rise and energy shares to outperform the S&P 500. Later in this report, we will examine how other risk assets perform as the yield curve steepens and oil prices climb. We also investigate the efficacy of using the high-yield bond market to time equity market pullbacks and recessions. In addition, with investors concerned about the GOP tax bill, we evaluate the performance of U.S. financial market assets, commodities and earnings before and after stimulative fiscal policy is enacted. Slack Is Disappearing The health of the U.S. economy in Q4 is not a concern. Data released last week was solid on October's retail sales, small business optimism and industrial production. Moreover, the November readings on the Empire State and Philadelphia Fed's manufacturing indices support BCA's view that the output gap is narrowing. However, some of the bright readings on the economy in October may reflect a snap back from Hurricanes Harvey and Irma. The November 17 readings on Q4 real GDP from both the Atlanta Fed's GDP Now (+3.4%) and the New York Fed's Nowcast (+3.8%) show the economy is running hot. Inflation-adjusted GDP growth of 3.0% or more in Q4 indicates year-over-year GDP growth is well above the Fed's view of both potential GDP growth (1.8%) and its estimate for 2017 (2.4%). Above-potential economic expansion will ultimately lead to higher inflation, given the ever tightening labor market. Despite tightening in the past week, financial conditions have eased in the past year. The implication is that GDP growth in the U.S. is set to accelerate in the coming quarters (Chart 2). The October CPI data provide the Fed with enough reason to bump up rates again next month. The annual core inflation rate ticked up to 1.8% from 1.7%. However, it is still below the roughly 2.4% pace that would be consistent with the core PCE deflator reaching the Fed's 2% target. While inflation is still below-target, there were two encouraging signs in the report. First, BCA's CPI diffusion index nudged back above the zero line. Secondly, core services (ex-shelter and medical care) are showing signs of accelerating. This sub-component of core CPI is the most correlated with wages (Chart 3, panel 4). Fed officials will get one additional reading each on CPI (December 13), the PCE deflator (November 30), and wage inflation (December 8), before the end of the December 12-13 FOMC meeting. Chart 2Easier Financial Conditions Will Boost U.S. Growth Chart 3October CPI Provides Cover For The Fed Bond Market Message The recent widening of credit spreads is not a signal that a recession is imminent. Chart 4 shows that peaks in key credit market metrics are lagging indicators of recession. While the recent spread widening is worrisome on its own, spreads would need to widen significantly more to signal that a recession is imminent. BAA quality spreads, the prepayment and liquidity risk spread (AAA corporate bond yield less 10-year Treasury) and the default risk spread (BAA minus AAA quality spread) are at or close to multi-decade lows.2 BCA does not believe that the spike in all these metrics in late 2015 was a signal that the economy was in or just exiting recession. Rather, the spread widening was related to the collapse in oil prices between mid-2014 and early 2016. BCA's Commodity & Energy Strategy service forecasts oil prices to rise as high as $70 per barrel in 2018.3 Chart 4Spreads Would Need To Widen Significantly More To Signal A Recession That said, these spreads tend to trough just prior to the onset of a recession. In longer expansions in the '60s, '80s, and '90s, bottoms in spreads occurred in mid-cycle. Credit spreads bottomed at the onset of recessions in the early 1960s, late 1960s, mid-1970s and early 1980s. The BAA quality spread and the prepayment and liquidity risk spreads bottomed six months before the onset of the 2007-2009 recession. However, the default risk spread formed a bottom in late 2004, three years before the end of a cycle (Chart 4). Spreads on lower-rated high-yield debt provide slightly earlier signals than those listed above. In the mid-1990s, spreads on BB- and CCC-rated U.S. corporate debt troughed in late 1998 as Russia defaulted, oil prices collapsed and LTCM failed. The signal came more than two years before the onset of the 2001 recession. In the mid-2000s, these spreads formed a bottom in late 2004/early 2005, three years before the 2007-2009 recession. The CCC- and BB-rated OAS spreads in this cycle initially bottomed in mid-2014 as oil price peaked. BB-rated spreads are below their mid-2014 trough, but spreads on CCC-rated debt are not (Chart 5). Chart 5HY Credit Still Outperforming Treasuries Investors question if the widening of spreads is a signal for other markets, especially the equity market. BCA finds that signals from the credit markets for equity markets are short-lived. Table 1 shows that the 13-week change in high-yield OAS is coincident to changes in S&P 500 prices. Often, stocks have already changed direction before any significant sell-off in the high-yield market. Rising spreads of more than 100 basis points tend to last for an average of 16 weeks and are accompanied by a 6% drop in the S&P 500. The only episode when a peak in spreads was not associated with a drop in equity prices occurred in 2001, as the S&P 500 rebounded in the wake of the 9/11 terrorist attacks. Table 1Stock Market Warning? Rising default rates are a necessary pre-condition for a prolonged interval of escalating spreads. Chart 6 shows the peaks in high-yield OAS spreads, along with the S&P, the VIX and Moody's trailing and forward default rates. In seven of the eight periods, spread widening occurred alongside a rising default rate. The only exception was in 2002 when spreads widened despite a fall in the default rate as accounting scandals rocked corporate America. Today, the default rate is low and falling. BCA's U.S. Bond Strategy team expects the default rate to move modestly lower in the next 12 months.4 Chart 6Spread Widening, Recessions, S&P 500 And Vol Bottom Line: The recent widening in credit spreads is one of the factors driving our cautious tactical stance on the U.S. equity market. Despite our near-term concern, BCA favors investment-grade credit and high-yield bonds over Treasuries in the next 12 months. Rising Oil And A Steeper Yield Curve BCA expects that oil prices will move 25% higher to $70/bbl in the next 12 months and that the yield curve will steepen. Above potential economic growth, tightening labor markets and rising inflation expectations will push up the long end of the Treasury curve, while the Fed lags the inflation upturn, leading initially to a steeper curve. What other asset classes would benefit if BCA's call is accurate? Chart 7 and Chart 8 show periods when oil prices rise and the yield curve steepens along with the performance of several key financial markets. Since 1970, there were five periods when oil prices moved higher and seven when the curve steepened. There are several years when both occurred at the same time, and many of these intervals also overlapped with recessions. Chart 7Lessons From Periods Of Rising Oil Prices Chart 8Lessons From Periods Of A Steepening Yield Curve The stock-to-bond ratio climbs when oil prices are rising, including the most recent episode. The S&P 500 outperformed the 10-year Treasury between 2009 and 2014 alongside oil prices, in the second half of the 1998-2008 run up in prices, and in the mid-1980s. However, during the rally in oil in the mid-to-late 1970s, stocks and bonds performed similarly. Both investment-grade and high-yield bonds outpace Treasuries as oil prices escalate. Investment-grade corporates outperformed in each of the five periods. Junk bonds struggled in the late 1980s as oil prices rose and then cruised in the 1990s, but trailed Treasuries in the first half of the 1998-2008 oil boom, finally catching up late in the cycle. The peak in both investment-grade and high-yield's performance versus Treasuries came in June 2007, providing a 12-month advance warning that oil prices had peaked for the cycle. Credit outpaced Treasuries in both oil rallies since the end of the 2007-2009 recession. Small cap performance during oil price rallies is mixed. Small caps beat large caps in the late 1970s, but underperformed in the mid-1980s. Small caps trounced large caps in the first half of the 1998-2008 energy price rally; large caps ran up and then back down again as the tech bubble swelled and then burst. Small caps only kept pace with large as energy prices soared between 2005 and 2008. Small caps eked out modest gains versus large between 2009 and 2014, and since 2016. Today, the energy sector's weight in the small cap sector is 3%, but it has ranged from 2% (2015) to 13% (2008) since 2001. Gold performs well as energy prices increase, aided in part by a weaker dollar. Gold climbed and the dollar fell during all five periods of expanding oil prices. There were several phases (mid-to-late 1980s, early 2000s and earlier this year) when the dollar mounted along with oil prices. Gold moved sideways at times as oil rose, but ultimately gold trended higher. BCA's stock-to-bond ratio generally moves lower as the curve steepens. Nonetheless, there are a few distinct but brief stages (late 1970s, mid 2000s, and 2009-10) when stocks beat bonds. There is not much difference between the performance of either investment-grade or high-yield credit in each of the six periods of curve steepening, but several shifts in a few of these cycles that overlapped with recessions are notable. Credit underperformed Treasuries in the early 1990s, early 2000s and mid-2000s as the economy entered recession, but then outperformed as the recession ended and the curve continued to steepen. Small cap performance as the curve steepens is mixed. As with credit, small caps underperform large on the way into recession as the curve steepens, but outperform after the recession ends. Recessions were not a significant factor in the performance pattern for gold and the dollar during curve steepening. Gold climbed in four of the seven periods of curve steepening, but changed little in the late 1980s/early 1990s episode. Gold declined sharply along with inflation and inflationary expectations in the early 1980s. The dollar moved significantly higher in just one of the seven periods (early 1980s) and was mixed-to-lower in the others. Bottom Line: BCA's bullish stance on the energy and financials sectors in the next 12 months is driven by our view that oil prices will continue to rally and that the Treasury yield curve will steepen as U.S. economic growth accelerates and inflation moved back to the Fed's 2% target. Stocks typically beat bonds as oil prices rally, but stocks generally underperform as the curve steepens. Gold advances under either scenario, while the dollar moves lower when the curve steepens and oil prices rise. The performance of credit and small caps in these episodes is sensitive to the business cycle. Hooray For Tax Cuts? BCA's Geopolitical Strategy team expects the GOP to pass a tax cut bill by the end of Q1 2018.5 Furthermore, the bill should provide a small but positive boost for the U.S. economy, and be neutral for EPS in the 10-year lifetime of the cuts. Chart 9 and Table 2 show that there have been seven periods since 1970 when the OECD's measure of "fiscal thrust"6 climbed. On average, stocks underperform bonds, although both are higher on average. Investment-grade corporate debt beats Treasuries, but high-yield underperforms as fiscal stimulus swells. Small caps (relative to large), gold, oil and the dollar, all are winners. Chart 9Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Treasuries are the most consistent performers when fiscal policy boosts the economy, advancing in each of the seven episodes. Small caps beat large and the S&P 500 rises in five of the seven periods. The process to propose, debate, and enact significant fiscal stimulus can be a long one, and in many cases, investors deduce that a fiscal boost is on the way well before it is passed into law. Accordingly, risk assets tend to outperform a year before a tax plan is passed. On average, stocks beat bonds, small caps do better than large caps, and both gold and oil accelerate a year before fiscal thrust starts to intensify. Corporate and high-yield bonds keep pace with Treasuries during these episodes. The S&P 500 jumps nearly 10% a year prior to an increase in fiscal thrust, while the total return on Treasuries rises by 5% and the dollar is flat (Table 3). Table 2 and 3Impact Of Fiscal Policy On Markets, The Dollar And Earnings The most consistent performers as fiscal thrust is priced in are small caps over large, oil prices, the S&P 500 and the 10-year Treasury. Each of these asset classes strengthens in five of the seven periods mentioned above. Chart 10 shows the Trump trades in the past year. The performance matches the historical experience a year before the economy receives a boost from tax and spending legislation. The tax proposal before Congress provides fiscal stimulus via tax cuts, but does not provide any economic lift from an increase in government spending. Therefore, it may be more useful to review asset class performance after personal income tax rates are lowered. The GOP plan also proposes corporate tax cuts, but the historical evidence is scant; corporate tax rates have been lowered only three times in the past 45 years. There is no clear pattern of performance for U.S. financial assets and commodities in the wake of a reduction in the top marginal personal tax rate. Chart 11 shows the performance of the primary U.S. dollar asset classes and financial markets since 1970. Stocks outperformed bonds in the year after the top marginal tax rate fell in only one of the four periods (mid-1980s). The track record for corporate bonds is also mixed at best. Investment-grade either matches or beats the performance of Treasuries in each of the four periods. High-yield outperformed in the mid-1980s, but subsequently underperformed in the wake of the early 2000s tax cut. Gold was the most consistent winner, climbing in three of the four intervals. The dollar was higher in two of the three periods since moving off the gold standard in the early 1970s. There is no consistent pattern for small caps after a decrease in personal tax rates. Chart 10Market Remains Skeptical That Tax Package Will Pass Chart 11Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Bottom Line: BCA's stance is that by the end of Q1 2018 the GOP will pass a tax cut that will provide a small lift to the economy. History shows that investing in risk assets in the year before fiscal thrust passes would provide the best returns. That said, the GOP plan only has tax cuts, and the performance of risk assets is mixed in the year following reduced personal tax rates, at best. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Later Cycle Dynamics", dated October 23, 2017. Available at uses.bcarearch.com. 2 "One component of the Baa-Treasury spread is the prepayment premium (Aaa-Treasury) to investors for the risk that if interest rates fall in the future, borrowers might retire old debt with new debt at lower rates. Another component of the Baa-Treasury spread is a liquidity premium (Aaa-Treasury) that compensates investors for the fact that private instruments are less desirable to hold relative to U.S. Treasuries when financial markets are turbulent and investors are very risk averse. The Baa-Treasury spread also contains a default risk premium (Baa-Aaa) to compensate lenders for the risk that borrowers may not repay, reflecting the amount of default risk posed and the price of risk."; Source: "What Credit Market Indicators Tells US", John V. Duca, Federal Reserve Bank of Dallas, October 1999 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Into The Fire," November 7, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism," November 8, 2017. Available at gps.bcaresearch.com. 6 The change in general government cyclically-adjusted balance as percent of potential GDP, Source: OECD.
Highlights The euro doesn't have the key attributes of a funding or a risk-off currency. This means its behavior is not fixed. While in the past it has behaved as a risk-off currency, this year it has traded as a risk-on one, correlating with key risky assets. The current episode of market volatility will not help the euro. CAD/SEK will benefit if asset-market volatility continues. A global growth deceleration helps the CAD outperform the SEK, especially as this cross trades at a discount to rate differentials. Feature As markets have begun selling off, the euro has once again become well bid. Does this reaction makes sense, or is it a move that should be faded? We are inclined to look the other way, as it is highly unlikely that the euro will benefit from market weakness this time around. The Chameleon Currency Is the euro a risk-off or risk-on currency? We believe it is neither, and that its behavior evolves over time. The reason for this is that the euro is not underpinned by one of the key attributes that offer currencies like the Swiss franc or the yen their strong defensive characteristic: a large positive net international position (NIIP). While Switzerland or Japan have NIIPs in excess of 130% of GDP and 62% of GDP, respectively, the euro area owes the equivalent of 3% of GDP more to the rest of the world than the rest of world owes the Eurozone. This means the euro does not benefit from its investors repatriating funds at home when market turbulences emerge. In other words, unlike Japan or Switzerland, local investors' home bias does not come to the euro's rescue when markets vacillate. Moreover, unlike the USD, the euro is not the key reserve currency global investors seek when turmoil grips the market. The euro represents 20% of allocated global reserves, while the USD still garners 64% of these reserves. Rightly or wrongly, investors do not yet feel that the euro area has the permanence of the U.S., nor that it possesses the military might and the same capacity to control global sea lanes that the U.S. currently enjoys. Lacking these attributes, the euro is a bit of a chameleon. When investors are negative on the outlook for the European economy, the euro is used as a funding currency for carry trades. However, sometimes it is used as the vehicle to bet on a weaker dollar or an improving global economy. These two last bets are often one and the same, as the greenback remains a countercyclical currency, enjoying strength when the global economy weakens (Chart I-1). This is because the U.S. is low-beta economy as it is much less exposed to the vagaries of EM growth - a key source of variation in the global economy and the global industrial cycle - than the euro area is (Chart I-2). This is the case as the manufacturing sector is a much lower contributor to U.S. growth than to the euro area. Chart 1The Dollar Is Countercyclical Chart I-2The U.S. Is A Low-Beta Economy This time around, the euro seems to have been used to bet on stronger global growth and a weaker dollar. This makes sense. There is no doubt that the European economic upswing is based on domestic dynamics, but foreign factors have supercharged the European recovery this year. As Chart I-3 illustrates, French exports to Germany and China have tracked the Chinese Keqiang index - a key measure of Chinese industrial activity. More interestingly, French exports to Germany and China have been correlated with Chinese monetary conditions, suggesting China's economic rebound has filtered through a wide swath of the euro area. The action of the euro only agrees with the macroeconomic observations made above. The euro and copper - a key beneficiary of Chinese reflation - have both been moving together through most of 2017 (Chart I-4). The same holds true for EM stocks. As Chart I-5 shows, the euro has tracked the performance of EM equities relative to U.S. ones since August 2015. Both these observations make sense. A stronger China should benefit EM economies more than it benefits the U.S. A stronger China should help copper as it consumes three times as much of the red metal as the U.S., the euro area, and Japan combined. And stronger EM help Europe more than they help the U.S. Chart I-3The Positive Influence Of China Chart I-4EUR/USD Moves With Copper Chart I-5EUR/USD And EM Relative Performance Yet, as we highlighted last week, cracks are emerging in the global economy that should prove particularly painful for EM economies and EM assets.1 Behind some of these weaknesses lies China itself. After having eased fiscal and monetary conditions through most of 2015 and all of 2016, Chinese authorities are using elevated core CPI and producer price readings to reverse course. Aggregate fiscal spending is slowing massively - pointing to a negative fiscal impulse - and broad money supply is growing at its slowest pace ever (Chart I-6). The tightening in monetary conditions is bearing fruit. Chinese industrial production and retail sales disappointed this month, and the Chinese surprise index has now dipped into negative territory (Chart I-7). The boost to global growth, and EM growth especially, that was caused by Chinese imports lifted by domestic investment is now receding. Chart I-6China: Aggregate Fiscal Spending Growth##br## Is Also Weak China: Broad Money Growth Is At ##br##Record Low Chinese Policy Tightening Chart I-7Chinese Surprises Have ##br## Turned Negative EM assets are not ready for this, as they are priced for perfection. EM assets, which have traded in line with U.S. high-yield bond prices since 2008, are now very expensive relative to this already expensive asset (Chart I-8). A slowdown in Chinese and EM growth is likely to represent a substantially negative shock for EM equities, especially as the slowdown in EM M1 to 9.3% already portends a contraction in EM profit growth. The breakdown in U.S. and EM high-yield bond prices could easily catalyze these risks. Copper, too, is vulnerable. With an almost insatiable love for the red metal, investors are not positioned for a reversal of its bull market (Chart I-9). However, China already has near record-high inventories of copper; slowing public spending and money growth suggest that the construction industry is likely to decelerate, limiting China's intake over the next few quarters. A negative surprise is likely to come. Chart I-8EM Stocks Offer No Protection##br## Against A Slowdown Chart I-9Too Much Love For Copper Equals ##br##High Risk Of Disappointment Falling copper prices and underperforming EM equity prices will thus drive the euro lower, as they will be key symptoms of the waning of a crucial euro support. Moreover, the euro is now overbought, and as we have highlighted before, over-owned (Chart I-10). This picture alone should support the notion that the euro is unlikely to benefit from a short squeeze as global risk aversion rises. How could it? After all, investors did not sell the euro to fund carry trades when global growth was rising and global volatility was falling. They were buying it along with carry trades. Maybe the euro was buoyed by strong GDP prints out of Europe this week, with Germany growing at a 3.2% pace on an annualized basis in the third quarter, faster than the U.S. If this response of the euro were to be durable, it should be associated with a commensurate move in interest rate differentials. Neither the gap in 5-year risk-free rates or 1-year forward, 1-year risk free rates between Europe and the U.S. have moved in favor of the euro in the wake of the release (Chart I-11). However, in the face of the existing gap between the euro and interest rate differentials, to stay stable, the euro will need an increase in the pace of positive surprises relative to the U.S. over the coming months - something that is unlikely to materialize as European financial conditions have greatly tightened relative to the U.S. Chart I-10The Euro Has Not Been Used##br## To Fund Carry Trades Chart I-11If Growth Was The Current Driver, The Euro And ##br##Rate Differentials Would Be Moving Together Instead, we believe that worries regarding the U.S. tax plan may be playing a role in the euro's strength. Investors are worried of a repeat about the Obamacare repeal debacle. Now that Senators Cruz, Rand and Cotton want to add a provision to the tax bill that would eliminate Obamacare's individual mandates, investors worry that Senators McCain, Murkowski and Collins will down the bill. This is a valid concern, but we should not forget that this is only U.S. legal process, and that reconciliation of the House version and the Senate version of the bill will need to take place before it is finalized, suggesting the final bill proposed could be very different from the version currently being discussed. Bottom Line: The euro is unlikely to benefit from a risk-off environment if the current selloff in EM and high-yield bonds continues. The euro area's net international investment position is too small to suggest that fund repatriation by local investors will result in the euro being bid. In fact, the euro has rallied on a similar impulse that pushed EM assets and copper higher: Stronger global growth and Chinese stimulus. Thus, now that the euro is over-owned and overbought, any tightening in EM financial conditions is likely to hurt it as well. Long CAD/SEK: The Rationale Last week, we opened a long CAD/SEK trade. The rationale for this position is rather straightforward. To start, the SEK is a more pro-cyclical currency than the CAD. Our Global Growth Indicator has rolled over and, if history is any guide, when this global growth gauge weakens, this leads to a period of depreciation for the stokkie relative to the loonie (Chart I-12). Stefan Ingves's renewed leadership of the Riksbank makes this risk even more salient. Throughout his tenure, Governor Ingves has emphasized that the Swedish central bank would fight imported deflation. Weakening global growth should result in some deflationary forces in Sweden, even if the domestic economy is experiencing growing resource utilization pressures. Ingves will counterbalance these dynamics by keeping the SEK down. Also, over the past 10 years, when U.S. two-year rates have been rising relative to euro area short rates, CAD/SEK has appreciated (Chart I-13). This is simply because the Canadian economy is tied to the U.S., while Sweden's is tied to the euro area. Thus when U.S. rates rise, this tends to let the Bank of Canada hike as well without putting undue pressure on CAD/USD. The same relationship is true between Swedish and European rates. As such, the current upward bias in U.S. relative to euro area rates is creating an upward drift on Canadian relative to Swedish rates. Chart I-12Growth Rolling Over Leads ##br##To A Stronger CAD/SEK Chart I-13When The Fed Tightens Versus ##br##The ECB, CAD/SEK Rises Some key domestic factors are also favoring the CAD over the SEK. Canadian real retail sales have spiked, growing a record three percentage points faster than Sweden's. Moreover, this development has occurred despite a surge in the Swedish credit impulse relative to that of Canada. The relative credit impulse is now slowly moving in favor of the Canadian economy. If this continues, since the Canadian consumer is already roaring, it will support Canadian aggregate demand relative to Sweden's. With Canadian wages set to pick up as labor shortages intensify, this could stoke additional wage and inflationary pressures (Chart I-14). The BoC is thus likely to continue to hike even if Ingves is hampered by the ECB and EM. Finally, CAD/SEK is trading at a 5% discount to our relative intermediate-term timing model (Chart I-15). This kind of a discount has historically been associated with tradeable rebounds in the loonie relative to the stokkie. We believe that a risk-off period in global capital markets is the likely catalyst required to realize the good value currently present in this cross. Chart I-14Canada Will Experience Rising Wages Chart I-15CAD/SEK Trading At A Discount to Rates This trade is obviously not devoid of risks. The most salient one remains the renegotiation of NAFTA. As Marko Papic, our Chief Geopolitical strategist argues in a Special Report, large swaths of the U.S. population are not in favor of free trade, and feel they have not gained much from globalization. Low social mobility, high income inequality, stagnant middle-class wages and growing difficulty to access debt have fueled this sentiment.2 Since U.S. President Donald Trump and not Congress is ultimately in charge of trade relations between the U.S. and the rest of the world, Trump has much leeway to please his electorate. He can therefore repudiate NAFTA. Such a development would hurt Canada. Exports to the U.S. represent 20% of Canada's GDP. A large share of these exports, especially in the auto sector, could fall under a new trade regime. This means that net exports might become a drag on Canadian growth, but it also means that a lot of capex that should have materialized in Canada will instead be realized in the U.S. This would boost USD/CAD. However, as excess investment in the U.S. is a positive for U.S. rates, it would also lift the USD against the EUR. Considering EUR/USD has a negative 67.3% correlation with CAD/SEK, this would limit the damage to our long CAD/SEK trade created by NAFTA renegotiations. Bottom Line: CAD/SEK should benefit as global growth and global risk assets hit a snag in the coming months. Moreover, the Canadian economy continues to experience growing inflationary pressures, while the Riksbank is likely to prove ultra-sensitive to any weakness in EM. With CAD/SEK trading on the cheap side, such a development is likely to result in a tactical upswing in this cross. The biggest risk to this position is related to an adverse ending to NAFTA renegotiations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Temporary Short-Term Risks", dated November 10, 2017, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Special Report, titled "NAFTA - Populism Vs. Pluto-Populism", dated November 10, 2017, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was generally positive: PPI measures beat expectations, with the headline measure coming in at 2.8% and the core at 2.4%; Core CPI beat expectations, coming in at 1.8%, while headline inflation remained steady at 2%; Continuing jobless claims decreased to 1.86 million, however initial jobless claims increased to 249,000; Net long-term TIC flows increased to USD 80.9 bn, while total net TIC flows are negative at USD -51.3 bn; NFIB Business Optimum Index and the Philadelphia Fed Manufacturing Survey underperformed expectations, coming in at 103.8 and 22.7, respectively; There was, however, a generally bearish rhetoric for the USD this week due to perceived inability of President Trump's administration to push through tax reform. Nevertheless, stronger inflation should lift the dollar in the coming months. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data was generally positive: German GDP accelerated greatly, hitting an annual rate of 2.3%, although this was in line with expectations. However, the quarterly measure of 0.8% beat expectations of 0.6%; European GDP grew in line with expectations of 2.5% on an annual basis; Industrial production increased by 3.3%, beating expectations of 3.2%; CPI across the euro area stayed steady and in line with expectations, with core inflation slowing to 0.9%. Importantly, the euro area core CPI diffusion index is decelerating sharply; As expected, French unemployment increased to 9.7% from 9.5%. The euro experienced a strong week following the release of these data points. However, as we have iterated in the past, the appreciation in the euro has tightened financial conditions, which means that inflation is unlikely to increase much from current levels. Report Links: Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has surprised to the upside in Japan: Industrial production monthly growth was not as weak as expected, only weakening -1%. Meanwhile, yearly growth came in at 2.6%, an acceleration relative to last month. Gross domestic product annual growth also outperformed expectations, coming in at 1.4%. However it is worth to point out that growth slowed from a 2.6% reading last quarter. The yen has appreciated slightly this week, with USD/JPY rising by about 0.4%. Overall we continue to bearish on the yen against the dollar, given that interest rate differentials will continue to be the main determinants of this cross. On the other hand we are more bullish on the yen against commodity currencies like the NZD, given that we expect a temporary growth downshift is likely to cause commodity and EM plays to experience some downside. Report Links: Temporary Short-Term Rates - November 10, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Consumer price inflation underperformed expectations, coming at 3%. Core inflation also surprised to the downside, coming in at 2.7%. However average hourly earnings surprised to the upside, coming in at 2.2%. It is important to note however, that this is a slowdown from last month's number of 2.3%. Moreover, retail sales growth outperformed expectations coming in at -0.3%. Nevertheless, this measure drop sharply from last month's reading of 1.3%. Overall, the GBP/USD has stayed relatively flat this week, while it has depreciated by about 1% against the euro. We believe that the upside for the pound against the dollar from here on is limited, as the BoE has very little incentive to hike any more than what is priced into the SONIA curve given that inflation seems to be stabilizing. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has suffered this week following a slew of mixed data: NAB Business Conditions improved to 21 from 14, but Business Confidence remained steady at 8; Westpac Consumer Confidence was negative at -1.7%; Wage growth remains depressed at 2% annually and 0.5% quarterly, underperforming the expected 2.2% and 0.7%, respectively; Melbourne Institute's Consumer Inflation Expectations declined to 3.7% from 4.3% in November; The participation rate dropped 10 bps to 65.1% and employment grew by only 3,700, below the expected 17,500. However, this was because the decline in part-time employment of 20,700 was offset by the increase in full-time employment of 24,300. While there were some positive developments in the labor market, wages remain depressed, pointing to ongoing underemployment within the economy. This is likely to leave the RBA to stay cautious. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The New Zealand dollar has depreciated by almost 2% this week, as commodities and junk bonds have plunged. We continue to be bearish on this currency against both the dollar and then yen, as we expect a further deterioration in EM financial conditions. This is mainly due to 2 factors: First, monetary tightening in China should cause a worsening in financial conditions, which will weigh on growth and commodity producers. Moreover, market-based expectations of U.S. interest rates could experience some upside as U.S. inflation is slated to pick up. This will put upward pressure on the U.S. dollar, and thus, weigh on commodity prices. Nevertheless, we continue to be bullish on the NZD relatively to the AUD, as the Australian economy is much more sensitive to the dynamics described above. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data has been positive: Manufacturing shipments increased by 0.5% on a monthly basis, beating expectations of -0.3% but they were weaker than the previous release of 1.6%; Foreign portfolio investment in Canadian securities increased to CAD 16.81 bn, above the expected CAD 10.68 bn and also beating the previous figure of CAD 9.77 bn. However, oil weaknesses weighed on the CAD this week. Furthermore, a lack of Canadian data meant that USD/CAD traded mostly off positive U.S. data, which further handicapped the CAD. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Swiss franc has continued to depreciate, with EUR/CHF surging by almost 1% this week. This cross is now roughly 2.5% away from the level at which it was when the Swiss National Bank took off its floor in early 2015. Overall we see very little indication that the SNB will let off their ultra-dovish monetary policy and currency intervention. Speaking with the government on Wednesday, the SNB's president Thomas Jordan said that the Franc is still "highly valued". Although there has been a slight improvement in price inflation and in economic activity, it still too tepid for central bankers to change policy significantly. Thus, the franc will continue to suffer downward pressure, due to FX market intervention. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Gross domestic product growth outperformed expectations, coming in at 0.7%. Moreover core inflation also surprised to the upside, coming in at 1.1%, and increasing from last month's reading of 1%. However headline inflation underperformed substantially, coming in at 1.2% and decreasing from last month's reading of 1.6%. The krone has depreciated slightly against the dollar, as USD/NOK has risen by almost 0.6% this week. In spite of our positive view on oil, we continue to be bullish on USD/NOK, given that this cross is more sensitive to interest rate differentials than it is to oil prices. The Norwegian economy is still plagued with plenty of slack, thus the spread between U.S. and Norwegian rates will continue to widen. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK had a dismal week due to downbeat data: Inflation slowed greatly to 1.7% from 2.1%, even underperforming the expected slowdown of 1.8%. In monthly terms, it contracted by 0.1%; Capacity Utilization fell in Q3 to 0.2% from 0.5%, indicating slack in the economy; The unemployment rate also rose to 6.3%; EUR/SEK traded near 10.0000, appreciating to levels reached last October. These data points will certainly be taken into account by the Riksbank, and a dovish tilt has most likely been priced in by the market. Close EUR/SEK trade Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The current mini-upswing in the global mini-cycle started in May and is likely to end around January. On a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. The contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Feature Key to the medium-term behaviour of markets is the existence of what we call 'mini-cycles' in global activity. The evolution of these perpetual mini-cycles explains much of what has happened, what is happening, and what will happen, to financial markets both in Europe and more broadly. Chart of the WeekExpect A Trend-Reversal In The Metals Market Mini-cycles are not a hypothesis. They are an indisputable empirical fact. Just look at the global bond yield (Chart I-2), metal price inflation (Chart I-3), global inflation (Chart I-4), and the bank credit impulse (Chart I-5 and Chart I-6). The regular mini-cycles shout out at you! Furthermore, given that these clearly observed mini-cycles show the same half-cycle length of about 8 months, Investment Reductionism strongly suggests that there is a common over-arching driver. Chart I-2The Global Bond Yield Exhibits Mini-Cycles Chart I-3Metal Price Inflation Exhibits Mini-Cycles Chart I-4Inflation Exhibits Mini-Cycles Chart I-5The Global Credit Impulse Exhibits Mini-Cycles Chart I-6Individual Credit Impulses Exhibit Mini-Cycles Explaining Mini-Cycles Previously,1 we explained that the distinct mini-cycles are interconnected parts of the same never-ending feedback loop. A lower bond yield accelerates bank credit flows... which boosts economic growth... which pushes up commodity inflation and overall inflation... causing the bond market to raise the bond yield, at which point the cycle reverses. And then the alternate cycles repeat ad perpetuam (see Box I-1). Box I-1The Mathematics Of Mini-Cycles One common question we get is: why focus on bank credit analysis and not on bond-intermediated credit analysis too? The simple answer is that bank credit expands the broad money supply whereas bond-intermediated credit usually does not. When a bank issues a new loan, fractional reserve banking allows it to create money 'out of thin air'. In contrast, when a company or government issues a new bond, no new money is created, unless the primary issue is financed by the central bank - which is generally forbidden. Usually, when a bond is issued, existing money just moves from one account - that of the bond buyer - to another account - that of the bond issuer. This means that bond-intermediated credit cannot increase demand by creating new money, but only by increasing the velocity of existing money. Whereas bank credit can increase demand by increasing both the amount of money and its velocity. Therefore, changes in bank credit are the much bigger driver of the mini-cycle in economic activity. If a bank issues 100 euros of credit today, then we know that this new money will be spent in the coming days and weeks - because nobody borrows money just to sit on it. If, in the previous period, the bank had issued 90 euros which was spent, it means that economic activity in the coming period will grow by 10 euros. But if the bank had previously issued 110 euros, it means that economic activity in the coming period will contract by 10 euros. In this way, the cycles in credit and activity are interconnected. Mini-upswings in the credit impulse mini-cycle tend to signal mini-upswings in commodity inflation (Chart I-7), overall inflation and bond yields. So if we can identify turning points in the credit impulse then we can correctly position the cyclical stance of our investment strategy. Chart I-7The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The problem is that the bank credit data is slow to come out. For example, although we are in the middle of November, the last bank credit data for the euro area refers to September. This means that if the mini-cycle is turning now, we might not find out until January. Nevertheless, we can still use the mini-cycle framework. We know that the current mini-upswing started in May and that mini-upswings have an average length of 8 months. Hence, we can infer that the mini-upswing is likely to end around January. That said, upswing lengths do have some degree of variation: the current upswing might be longer or shorter than the average. How to avoid being too early or too late? Combining Mini-Cycles With Fractal Analysis To optimise our proprietary mini-cycle framework, we propose combining it with our proprietary fractal analysis framework. As regular readers know, fractal analysis measures whether herding in a specific investment has become excessive, signalling the end of its price trend. The combined mini-cycle and fractal framework works best if we use a 130-day herding indicator (fractal dimension), as it broadly aligns with the mini half-cycle length. Excessive herding signals that an investment's trend is approaching exhaustion because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when the market is split between different herds - say, short-term momentum traders and long-term value investors. This is because the herds disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity. But liquidity starts to evaporate when too many value investors join the momentum herd. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders add fuel to the trend. The tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. Earlier this year, our combined frameworks signalled that the aggressive rise in bond yields was likely to reverse (Chart I-8). Therefore, on February 2 we correctly advised: "Lean against the rise in bond yields and bank equities." Chart I-8Excessive Herding In Bonds Always Signals A Trend Reversal Today, we see the same dynamic in parts of the commodity rally - and specifically the move in the LME Index (Chart of the Week). Hence, on a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. Could Italy Be A Good Surprise? Returning to the concept of the bank credit cycle, the evolution of longer-term impulses also explains the contrasting recent fortunes of Spain and Italy. In 2013, Spain recapitalized its banking system and ring-fenced bad assets within a 'bad bank'. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. As Spanish banks' aggressive deleveraging ended, the bank credit impulse rebounded very sharply and has remained positive for several years. This undoubtedly explains why Spanish real GDP has grown by 13% since mid-2013 (Chart I-9). In contrast, Italy's banking system remained dysfunctional - which meant that its own credit impulse stayed much more muted and barely positive over the past four years (Chart I-10). But now, the Italian banking system is slowly recuperating. Italian banks' equity capital is rising, their solvency is improving, and the share of non-performing loans has fallen sharply this year. Chart I-9Spain's Peak Credit Impulse##br## Is Probably Behind It Chart I-10Italy's Peak Credit Impulse##br## Is Likely Ahead Of It So the contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Credit Slumps While Animal Spirits Soar. Why?' March 30, 2017 available at eis.bcaresearch.com Fractal Trading Model* There are no new trades this week, leaving us with six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch -##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 There are a number of cracks emerging in global risk assets. Not only have U.S. junk bond prices recently posted sharp declines, but a number of economic and financial market developments within EM also warrant investors' close attention. In particular: Feature The EM manufacturing PMI has rolled over at relatively low levels, despite continued strength in advanced economies' manufacturing PMI (Chart 1). Importantly, the trend in relative manufacturing PMIs heralds EM equity underperformance against DM bourses (Chart 2). Chart 1EM Manufacturing: Rolling Over Chart 2EM Stocks To Underperform DM Stocks The Shanghai Container Freight Index has relapsed in recent months. This index has been a good indicator for EM/Asian export volumes (Chart 3, top panel). That said, DRAM semiconductor prices continue to surge (Chart 3, bottom panel). DRAM prices have jumped five-fold in less than two years, justifying the massive rally in semiconductors' stock prices. It is hard to know how long and how far the ascent in DRAM prices will continue. Nevertheless, our hunch is that non-technology exports in Asia will slow down, regardless of what happens in the global technology sector. Consistently, we expect EM non-technology stocks to relapse sooner than later, even as tech stocks remain a wild card. Global and EM tech stocks rallied exponentially and appear to be in a mania phase that could make any reasonable assessment and investment strategy off-mark. Weighing the pros and cons, we continue to recommend overweighting the tech sector within the EM universe, even as the outlook for their absolute performance remains highly uncertain. Within EM tech, we favor semi stocks (Samsung and TSMC) versus internet and social media stocks. The sheer magnitude of the EM equity rally has been driven by a few names such as Tencent, Alibaba, Baidu, Samsung and TSMC. Their combined market cap as a share of the overall MSCI EM equity index has risen to 19%. Remarkably, the equal-weighted MSCI EM stock index has massively underperformed the market cap-weighted MSCI EM equity index (Chart 4, top panel). In contrast, the same measure for DM equities has held up much better (Chart 4, bottom panel). Chart 3Asian/EM Exports At Risk Chart 4A Perspective On Internal Equity Dynamics: EM And DM EM stock prices have been firm so far despite the rebound in the broad trade-weighted U.S. dollar (Chart 5). As the greenback continues to advance, odds are that EM share prices will dive, as occurred in 2014 and 2015. In China, the effects of triple tightening - the liquidity squeeze by the central bank, the regulatory clampdown on banks and shadow banking by the Banking Regulatory Commission, and the anti-corruption drive that is targeting the financial industry - are gaining momentum. Onshore corporate bond yields and credit spreads over government bonds have risen further since the end of the most recent Party Congress. One of the reasons why policymakers are tightening is to rein in the enormous excesses prevalent in the credit, money and property markets that have developed in recent years. Given that advanced economies have now recovered, the Chinese authorities feel more confident to tighten domestically. Finally, while less recognized by the investment community, inflationary pressures have been rising in China. Although still at 2.25%, core consumer price inflation is clearly trending up, warranting a policy response (Chart 6, top panel). This is especially true given that real deposit rates - deflated by core consumer price inflation - have plummeted into negative territory (Chart 6, bottom panel). Chart 5U.S. Dollar Rebound = EM Pullback Chart 6China: Beware Of Rising Inflation Consistent with tightening, China's official broad money growth has decelerated to an all-time low (Chart 7, top panel). In the meantime, narrow money (M1) growth is falling rapidly. Remarkably, M1 growth has been correlated with Chinese H-share prices (Chart 7, bottom panel). We have extensively documented in past reports1 that China's money and credit impulses are good leading indicators of the mainland's business cycle. The current readings of these indicators signal considerable growth deceleration. In addition, general (central and local) government spending growth has already slowed a lot (Chart 8). Chart 7China: Broad Money Growth Is At Record Low Chart 8China: Aggregate Fiscal Spending Growth Is Also Weak The fundamentally weakest EM currencies such as the South African rand and the Turkish lira have already broken down. Some others have so far been only marginally weak. A chain, however, typically cracks at its weakest link. Hence, it makes sense that the selloff has begun with the fundamentally weakest currencies. We expect other EM currencies to follow. Currency depreciation in EM will undermine returns for foreign investors, and the latter will become marginal sellers in both EM equity markets and local currency bonds. Meanwhile, EM currency depreciation and potentially falling commodities prices will trigger credit spread widening in EM sovereign and corporate bonds. Investment Positioning Global equity portfolios should continue underweighting EM versus DM. The risk-reward profile for EM stocks' absolute performance is extremely unfavorable. We continue to recommend underweighting EM credit markets relative to U.S. investment grade bonds. Our strongest conviction shorts are a basket of the following currencies: ZAR, TRY, BRL, IDR and MYR. We are also shorting the COP and CLP. For traders who prefer a market neutral currency portfolio, our recommended longs are TWD, THB, SGD, ARS, RUB, PLN and CZK. INR and CNH will also outperform other EM currencies. Unlike in 2014-2015, EM currencies will depreciate not only versus the U.S. dollar but also the euro. This will erode EM returns for European investors, and temporarily halt or reverse capital inflows into EM. Among local currency bond markets, the most vulnerable are Turkey, South Africa, Indonesia and Malaysia. The least vulnerable are Korea, Russia, India, Argentina2 and Central Europe. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Questions From The Road", dated September 20, 2017. 2 Please refer to the Emerging Markets Strategy Special Report, titled "Argentina: A Genuine Bull Market", dated October 25, 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Question 1: Why is U.S. inflation still so low? Question 2: How important is the upcoming change in Fed leadership? Question 3: What are the implications of the U.S. tax cuts? Question 4: What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? Question 5: Are markets underestimating the potential impact from slower growth of central bank balance sheets? Question 6: How much longer can this powerful rally in Emerging Markets continue? Question 7: What are other investors worried about? Feature I have just returned from an extended two-week trip visiting clients in the Asia-Pacific region. The meetings were all very well attended, with even many non-dedicated fixed income investors turning up to ask tough questions about global bond markets. My impression was that given the powerful returns earned in virtually all risk assets this year (equities, credit, Emerging Markets), our clients are growing more concerned about the potential risks from tighter global monetary policy and rising interest rates than they have been for some time. Oddly enough, this is despite not fearing either a serious rise in inflation or a major growth slowdown next year. If such a thing as "nervous complacency" can exist, it seemed widely evident in most of my meetings. This week, I am taking a more personal tone than in a typical Global Fixed Income Strategy Weekly Report to summarize the key client questions from ten days of meetings, spread across six cities in five countries on two continents. Why is U.S. inflation still so low? Chart 1Tightest Global Labor Market##BR##Since The Mid-2000s Almost all of the meetings began with a discussion of the current situation in the U.S., particularly the lack of inflation. The current BCA view that U.S. inflation will accelerate in 2018 was met with some skepticism, particularly when framed in the context of the uncertain unemployment/inflation trade-off. In one meeting, outright laughter actually broke out when the term "Phillips Curve" was mentioned! Clearly, the burden of proof is on the inflation data itself. On that note, I presented several of the best BCA charts from recent months that show how the backdrop is ripe for a turnaround in global inflation. Clients were impressed when shown that nearly ¾ of the countries in the OECD had unemployment rates below the full-employment NAIRU, a level not seen since the period of strong coordinated global growth and rising inflation in the mid-2000s (Chart 1). Yet when I then presented a chart showing the actual inflation/unemployment data in the U.S. over the past 20 years, with a clear "kinked" Phillips Curve and the latest data point well on the steeper portion of that curve (Chart 2), the majority of clients were less convinced. The most cited reason was that the U.S. inflation data simply did not accelerate in 2017 when it was supposed to given the steady fall in unemployment over the preceding few years. Perhaps most surprising was that, rather than believe that the NAIRU rate may simply be lower now than in past business cycles, so many people that I met were willing to discard the entire Phillips Curve concept as a useful framework to forecast inflation. When presented with charts showing non-Phillips Curve reasons to expect higher inflation, however, there was far less skepticism. Perhaps the most compelling chart showed the typical 18-month lag between U.S. economic growth and the "momentum" of U.S. inflation (Chart 3). Upon seeing this, clients were more convinced that inflation would pick up next year in response to the current U.S. growth upturn. Chart 2U.S. Economy Has Moved Into##BR##The "Steep" Part Of The Phillips Curve Chart 3Inflation Typically Follows Economic Growth With A Long Lag I was also able to break down some of the skepticism on the U.S. inflation outlook even more after discussing the bullish oil forecast from our colleagues at Commodity & Energy Strategy. Admittedly, their view that the benchmark Brent oil price will average $65/bbl in 2018 sounds far less dramatic given that the current spot price has risen to nearly that level in the aftermath of the recent political turmoil in Saudi Arabia. Yet clients did appreciate that our bullish oil call was driven more by a view of improving global oil demand and continued production discipline by oil producers (especially for the so-called "OPEC 2.0" nations of Russia and Saudi Arabia). When shown our chart describing how oil prices persistently in the mid-$60s next would put some upward pressure on the inflation expectations component of global bond yields (Chart 4), there was virtually no disagreement from any clients that I met. There was a bit more pushback on the view that, if the BCA forecast of higher U.S. inflation and rising oil prices in 2018 comes to fruition, there is room for a substantial rise in U.S. Treasury yields from current levels. When presented a chart showing that market-based inflation expectations (both using TIPS breakevens and CPI swaps) could rise by 50-60bps just to get back to levels consistent with the Fed's inflation target (Chart 5), most clients politely nodded and basically said "show me the actual inflation first." Although there was widespread agreement with our view that it would take that kind of move in inflation expectations to prompt the Fed to fully deliver on the 100bps of rate hikes it is currently projecting to occur over the next year. Chart 4A Boost To Inflation Expectations##BR##From Higher Oil In 2018 Chart 5The Normalization Of U.S. Inflation##BR##Expectations Will Continue How important is the upcoming change in Fed leadership? The vast majority of clients that I met asked about the BCA view on the nomination of Jerome Powell as the new Fed Chair, replacing Janet Yellen. My impression was that there was not a lot of concern over the potential for serious alterations to the future path of U.S. monetary policy under new leadership. Yet it was still potentially a big enough change to ask questions about it. Most clients agreed with the BCA view that a Fed Chair Powell will not act much differently than Yellen. His voting history has aligned with hers and, by his own admission, he is a very data dependent central banker given that he is not a formally-trained economist. Only by knowing the ins and outs of the data has he been able to debate successfully with the Ph.D economists on the FOMC. Powell will likely be a data-driven Fed Chair that would not look to hike rates without higher inflation (and vice versa). Chart 6A Communications Problem##BR##For Jerome Powell? One point that I raised in all the meetings was that the Fed's communication strategy on future rate increases is the more worrisome issue for financial markets at the moment. The U.S. money market curve is still priced for only 50bps of rate increases over the next year, while the Fed "dots" are signaling 100bps of hikes. We think the Fed will deliver on its projections, which is one of the reasons we are recommending a below-benchmark duration stance in the U.S. (the upside in inflation expectations is the other reason). More importantly, the Fed's so-called "terminal rate" projection is at 2.75%, while our proxy for the market pricing of that rate - the 5-year U.S. Overnight Index Swap rate, 5-years forward - is hovering just above 2% (Chart 6). The persistent disagreement between the market and the Fed over the appropriate level of the terminal rate will become a problem later in 2018 if the Fed does indeed raise the funds rate to over 2% and continues to signal that more rate hikes will come to get the funds rate up to "neutral" (the terminal rate). If the Fed is not able to change the market's mind about the appropriate neutral level of the funds rate, then a move to the Fed's estimated terminal rate of 2.75% would push U.S. monetary policy into what will would be perceived a restrictive stance. This would have implications for the shape of the U.S. Treasury curve (a lot flatter) and for future growth expectations (a lot slower) heading into 2019. My impression from my meetings was that this possibility - that the Fed could engineer what would look to the markets like a policy mistake simply by sticking to its forecasts - was not at the forefront of clients' thinking at the moment. Yet there was no disagreement with the logic of how that could play out. The new Fed leadership under Jerome Powell may have its hands full clearly explaining their policy decisions in 2018, which could create some turbulence in global financial markets later in the year. What are the implications of the U.S. tax cuts? The details of the tax plans from the U.S. House of Representatives and the U.S. Senate were a very hot topic in all of my client meetings. Considering all the ideas being proposed, from cuts in corporate tax rates to changes in the tax treatment of debt interest costs to removing the disincentive to repatriate profits earned abroad, it is no surprise that both equity and fixed income clients had a lot of questions on future U.S. tax policy. It is difficult right now to judge the net impact of the tax changes, as not all of the proposals in the two Congressional tax plans will likely be implemented. There will be plenty of horse trading between the Republicans and Democrats (and between the Republicans themselves) before the final tax deal is done. Yet there was a lot of concern among clients in my meetings over the likelihood that the tax cuts will be implemented at all. After seeing President Trump lose the battle on health care reform earlier this year, many clients were worried that a repeat could happen for the Trump tax cut agenda. This would have negative implications for U.S. equity markets, the U.S. dollar and future Fed policy moves. I explained the views from our colleagues at Geopolitical Strategy, who strongly believe that a tax cut will eventually pass (likely in early 2018) given the need for Congressional Republicans to have something positive to present to voters heading into the 2018 U.S. midterm elections. The tax cuts will have a moderate stimulative effect on the U.S. economy that the markets were not yet fully discounting. I also presented the chart from Global Fixed Income Strategy showing that wider U.S. budget deficits usually coincide with a steeper U.S. Treasury curve, almost always because the U.S. economy is slowing down, prompting looser fiscal policy and also Fed rate cuts (Chart 7). This time is different, however, since the Trump tax cuts will be stimulating an economy currently at full employment (middle panel). This has the potential to trigger more inflation through faster economic growth and even tighter labor markets which could prompt the Fed to move more aggressively on interest rate increases next year and eventually flatten the UST curve (bottom panel). Chart 7A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve The idea of a "steeper, then flatter" Treasury yield curve in response to U.S. fiscal policy stimulus generated a lot of discussion in my meetings. Some even noted that the recent flattening of the curve was a sign that the markets were discounting a lower probability of a tax deal being reached in D.C. I described the flat curve as a consequence of inflation expectations remaining too low, as the Treasury curve was much flatter than implied by the low level of the real fed funds rate, which is one of the most reliable relationships in the bond markets (higher real rates = a flatter curve, and vice versa). My conclusion from these meetings (and from the current market pricing) is that clients are a bit skeptical that a tax deal will be reached. This suggests there is room for bond yields to rise, and the Treasury curve to bear-steepen, if our political strategists are right and the tax cuts will happen. What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? While most of the questions in my meetings focused on the U.S. outlook, several clients asked about the next move from the European Central Bank (ECB). This was both from a fixed income perspective and, perhaps even more importantly, with an eye on the future direction of the euro versus the U.S. dollar. I made the straightforward argument that with Euro Area economic growth showing strong momentum that is unlikely to slow much in 2018, and with headline Euro Area inflation likely to surprise to the upside based on our bullish oil call (Chart 8), the ECB would likely be forced to signal a tapering of its asset purchase program to zero by the end of next year. The oil view was especially important, as the ECB is expecting a slowing of headline Euro Area inflation to 1% in early 2018 based on the base effects from comparisons to the rise in oil prices seen in early 2017. If our house view on oil prices plays out, then there is potential for inflation to catch the ECB by surprise in 2018. The key will be how core inflation plays out as oil prices rise further. Core Euro Area inflation has dipped lower in recent months, even as wage growth has accelerated (bottom panel). Given tightening Euro Area labor markets, and robust domestic demand, the recent dip in core inflation is likely to bottom out sometime in the first few months of 2018. But until that happens, there is more potential for higher U.S. bond yields through faster increases in inflation expectations and Fed rate hikes (Chart 9). This will support a higher U.S. dollar versus the euro through wider interest rate differentials (bottom panel). Chart 8ECB Will Fully Taper##BR##By The End Of 2018 Chart 9UST-Bund Spread Will Widen Next Year,##BR##Supporting The USD Clients were generally in agreement with that view on relative interest rates, but the views on the direction of EUR/USD were far more mixed. My impression is that if the Fed delivers the rate hikes that we expect in 2018, EUR/USD has room to move lower as investors were not prepared for this. Are markets underestimating the potential impact from slower growth of central bank balance sheets? I received many questions on the potential impact of central banks either shrinking balance sheets (the Fed) or slowing their expansion (the ECB and Bank of Japan). The chart showing how the growth in central bank money printing since 2015 (when the ECB began buying bonds) has correlated strongly with the bull markets in virtually all global risk assets garnered a lot of attention (Chart 10). This was especially true when I showed the chart that converted the level of the major central bank balance sheets to a growth rate and plotted that versus the returns on global equities and credit markets (Chart 11). The implication - expect lower returns on global equity markets, and MUCH lower returns from corporate bond markets next year. Chart 10CB Liquidity Has Supported Risk Assets... Chart 11...But That Tailwind Will Fade Next Year On this point, there was almost no disagreement from clients. There is widespread awareness that this era of puny interest rates, spurred on by central banks buying up huge quantities of government bonds and other financial assets, was forcing investors to take on far more risk in their portfolios to achieve acceptable returns. The key is when this will all turn around. Clients were generally in agreement with my view that the final leg of this liquidity-driven global bull market in risk assets will best be played through equity markets over corporate credit. These stable, earnings-driven rallies seen in global equity markets have not yet reached a "blowoff" phase that would suggest a larger correction is imminent. Perhaps it will take a final asset allocation decision to move more money out of bonds into equities to trigger that final run-up in equity prices before tighter monetary policies and slower growth expectations begin to damage returns later in 2018 into 2019. How much longer can this powerful rally in Emerging Markets continue? This is a topic that generated a healthy amount of debate in my meetings, particularly given the bearish views on Emerging Market (EM) assets from my colleagues at Emerging Markets Strategy. Here again, clients were generally looking at EM as a way to achieve acceptable returns in their portfolios while also participating in the global economic upturn through growth-sensitive assets. The previous chart showing the impact of diminished central bank liquidity on EM credit markets got some clients a bit nervous about the outlook for EM markets. What also spooked them were the charts from our EM strategists showing accelerating Chinese inflation (Chart 12) and slowing Chinese money growth. There is obviously a connection between the two, as China's policymakers are being forced to tighten monetary policy, and clamp down on excess credit creation, in response to accelerating inflation and very high debt levels. The chart showing how our "China M3 Impulse" had turned negative this year and was pointing to slower growth in industrial metals prices and China capital goods imports (Chart 13) was particularly unnerving for even the most bullish of EM clients. Chart 12This Is Why China Is Tightening Monetary Policy Chart 13Prepare For Slower Chinese Growth In 2018 My impression is that the clients I met were fully loaded up on EM assets but were comfortable holding those positions based on expectations of solid Chinese economic growth and continued inflows into EM assets from yield-starved global investors. If BCA's view that Chinese growth will slow next year comes to fruition, combined with rising U.S. interest rates and a stronger U.S. dollar as the Fed tightens more than currently discounted by the markets, then there is potential for outflows from EM markets to accelerate, to the detriment of EM returns. What are other investors worried about? This is a question that comes up a lot at BCA meetings, as clients are always curious as to what we are hearing from other investors. Perhaps this can be chalked up to a version of "confirmation bias", where investors like to hear that their own views are shared by others in the markets. In my meetings over the past two weeks, however, I got the sense that clients are heavily exposed to risk assets, which have performed beyond their expectations, and are growing more worried about how things can go wrong. Like an end to the current low volatility regime, for example. Given the BCA views on the likelihood of global inflation increasing next year, triggering a more hawkish response from policymakers, I noted that I did not believe that clients were prepared for that outcome. This suggests that the beginning of the end of the current low volatility regime, which is seen across all asset classes (Chart 14), will occur through a pickup in bond volatility. This will take place from a rise in inflation expectations first, and a rise in policy rate expectations later. My advice to clients was that if realized bond volatility picks up, this is the signal to reduce exposure to credit and equity markets. We anticipate making such a recommendation sometime during 2018. Chart 14The Low Market Volatility Backdrop Will End When Bond Volatility Rises Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns