Economy
Highlights Geopolitical tensions eased last week, but there are still a few near term hurdles to clear. Domestic policy uncertainty remains. Investors still can't seem to reconcile the disconnect between weak "hard" data and solid "soft" data. A gradual Fed may be the right response to the recent run of mixed economic data. Housing and housing-related investments led the global economy into the last recession. Housing is still on the mend. The housing sector will contribute about 0.2 percentage points and 0.5 percentage points to real GDP growth in 2017 and 2018, respectively. Investors should look to housing-related assets as a source of potential outperformance over the coming 6-12 months. Feature U.S. equity prices neared record highs and Treasury yields bounced off of their late-March low last week as near term international and domestic political risk melted away in the minds of investors. We continue to expect U.S. equities to beat bonds this year. Oil prices continue to trade near $50/bbl, and the dollar held steady amid all the news-good and bad. Both have upside over the remainder of 2017. In today's report, we examine the following key issues for investors: Since the end of the Great Recession, geopolitical risks have ebbed and flowed, and 2017 has proven to be no different. Are political risks over, or just over for now? How does the recent run of mixed U.S. data influence the Fed, and what does this mean for risky asset prices? Housing and housing-related investments led the global economy into the last recession. Where do we stand now? Are Geopolitical Concerns Over? North Korea failed to test another nuke after a nerve rattling Easter Weekend. The leadup to the presidential election in South Korea on May 9 may have motivated a part (or most) of the uptick in belligerence that we are seeing from North Korea. All leading candidates are more likely to try diplomacy and economic engagement with North Korea than to maintain the past ten years of conservative efforts to strengthen military deterrence via stronger alliances with the U.S. and Japan. In the euro area, the good news is that the polls in the first round of the French election (April 23) were correct. The bad news is that there is still another election. Macron and Le Pen face off on this Sunday (May 7), and markets are betting that the polls will be correct again given Macron's 20 point lead over Le Pen. The June parliamentary elections in France should be a non-event for U.S. financial markets; we still see Italy - where most voters favor Eurosceptic parties - as the biggest risk on the geopolitical scene in the next year or so. In the U.K., the ruling Tories look to add to their majority in June's parliamentary election, which will provide British Prime Minister Theresa May with a stronger hand to negotiate with Europe and increases the odds of a less extreme Brexit outcome (Chart 1). Chart ICGeopolitical Risk Is Ebbing...For Now Chart 1BGeopolitical Risk Is Ebbing...For Now Chart 1AGeopolitical Risk Is Ebbing...For Now There was good news and bad news on the domestic policy front last week as well. The release of the long awaited Trump tax plan and the passage of a spending bill by Congress to avert a government shutdown (at least until later this week) helped to remove some domestic political uncertainty. The bad news is that the plan was more tax cut than tax reform. The one page plan lacked detail and still has to pass muster with the House GOP. The Trump Administration may have started a trade war with Canada (over lumber) and sent trial balloons about pulling out of NAFTA (despite walking back from this position soon after). Is this "negotiator" Trump or something worse? The bad news is that tax reform, trade wars, dynamic scoring, and yes, even Obamacare will be with us until late Summer/early Fall. The good news is that the border adjustment tax may not be. The takeaway for investors is that while geopolitical concerns have not disappeared, they have ebbed, and this will support the relative performance of U.S. equities over 10-year government bonds over the coming year. Italy (not North Korea, France, or Germany) remains the biggest geopolitical risk on the horizon, but the next election there isn't until early-2018. Domestically, Trump's pro-growth agenda is advancing at a pace that is slower than many investors would prefer, but it is advancing, which we believe will continue to support a pro-cyclical asset allocation stance. Bottom Line: Geopolitical concerns have not disappeared, but they have ebbed materially to the benefit of risky asset prices. Investors should stay overweight U.S. stocks vs 10-year government bonds within a multi-asset portfolio. Mixed Data Warrants A Gradual Fed Investors still can't seem to reconcile the disconnect between weak "hard" data and solid "soft" data. The recent uptick in initial claims and the soft Q1 GDP data are the most recent examples. Investors should recall that claims are inherently noisy; a rise in claims of more than 75,000 over a 6-month period is typically needed to signal a recession. Chart 2 makes it clear that the latest wiggles on claims are not sending a recessionary signal. Chart 2Claims Are Not Even Close To Sending A Recession Signal Friday's GDP report highlighted that growth in Q1 was soft again. As we noted in last week's report, GDP growth in Q1 averaged -0.1% over the last 10 years. Q2 growth has averaged more than 2%. Q1 growth has been below Q2 in 8 of the last 10 years. 2017 is shaping up to be a repeat performance. Defense spending - identified by the Cleveland Fed as a key culprit in the unwanted seasonal weakness in Q1 GDP - fell 4% in Q1, subtracting 0.2% from growth. Inventories were also singled out by the Cleveland Fed, and they shaved 0.9% off of GDP in Q1. We expect to see a snapback in all three components of growth (GDP, defense spending and inventories) in Q2. Business capital spending, and housing were bright spots in Q1 (Chart 3). Corporate earnings are the ultimate piece of hard data. Equity prices track earnings growth over the long term. With 288 members of the S&P 500 reporting, 77% have beaten expectations on the bottom line. Healthcare, financials and technology lead the way. Weakness was evident in defensives. More impressive is the 7.1% gain in revenues in Q1 so far (Table 1). But overall, corporations appear to have pricing power. The ECI accelerated in Q1 to +2.4% year-over-year from +2.2%, but remain relatively subdued. This implies that margins will hold up, which will continue to support our view that stocks will beat bonds this year. With no Fed Chair Yellen press conference, a new set of dot plots or a new economic forecast, markets will have to be content with just the FOMC statement this week. A speech by Fed Vice Chair Fischer will be closely watched for signals about the June FOMC meeting. The market has been too quick to price out rate hikes in 2017. Expectations for rate hikes in 2018 have all but disappeared (Chart 4). We expect this gap will close - in favor of the Fed for both 2017 and 2018. We expect Treasury yields and inflation to head higher this year, despite recent soft readings on March CPI. The March PCE deflator - also due this week-is key. Chart 3Markets Shouldn't Be Surprised By Weak##br## Q1 GDP, Or What Caused It Table 1S&P 500: ##br##Q1 2017 Results* Chart 4Still Plenty Of Disagreement Between Fed ##br##And Market; Both Expect Gradual Hikes Though Bottom Line: We continue to expect the hard data to catch up to the soft data in the coming months. Financial markets have overreacted to the weak data and have been too quick to price out Fed rate hikes this year and next. The Fed is taking a gradual approach to rate hikes for a reason; the data-hard or soft-doesn't warrant an aggressive Fed. But a gradual Fed and solid profit growth strongly favor an allocation towards stocks over bonds this year. Housing: Set To Keep A "Slow-Burn" Expansion Burning Housing is one sector of the economy that stands to look relatively good over the coming few years, with some important implications for housing-related asset performance. The monthly Bank Credit Analyst recently published some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment in the labor market, similar to what has occurred since the Great Recession. Chart 5 compares the current cycle (dotted lines) with the average of the 1980s and 1990s long expansions (solid lines). The cycles are all lined up with the beginning of the expansion, indicated by the first vertical line. These long "slow burn" recoveries also extended well beyond the point at which the economy first reached full employment (called late-cycle phases, shaded in Chart 5). Inflation pressures were slower to emerge in these types of recoveries, allowing the Fed to proceed cautiously when normalizing interest rates. Interestingly, earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. We are not making the case that returns will be anywhere near this level in the coming years. The starting point for valuation, for example, is much more extended than it was in previous long cycles. There are also plenty of possible sources of shocks that could end the expansion abruptly. Nonetheless, it is not going to die simply of old age. In the absence of any major shocks, this expansion may continue for a while yet. One reason is that there are no major areas of overspending that would make the economy highly vulnerable. This includes the housing sector, where investment has lagged previous slow-burn recoveries by a wide margin. A lagging housing market is not surprising given the bloated inventory of vacant homes that had to be absorbed in this cycle. The good news is that overhang appears to now be gone. The stock of unsold new and existing homes has returned to low levels by historical standards (inventories of new homes are in fact now rising, after plunging between 2006 and 2012; Chart 6). Chart 5The Current Cycle Is ##br##A "Slow Burn" Expansion Chart 6The Overhang From Housing##br## Inventories Is Gone Other positive factors include the following: Lending standards haven't eased much, but FICO scores have increased sharply, meaning that more renters now qualify for loans and thus might move from rental unit to a single family home (which generates more GDP per unit). This factor was highlighted in a recent Special Report on housing.1 Affordability is favorable, and the cost of owning is cheap relative to the cost of renting. The home-ownership rate has returned to its long-term average (Chart 6, bottom panel). If the pre-Lehman bubble in the homeownership rate has been unwound, it removes a headwind for construction activity because renting favors multi-family construction that produces less GDP per unit than single family homes. The supply of foreclosed homes onto the market has withered along with the foreclosure rate. This might not affect construction activity because it represents families simply swapping homes for other ones, but it supports home prices. Importantly, household formation is still recovering from a period in which young adults stayed with their parents for longer than normal for economic reasons. The tightening in the labor market and cyclical rebound in real disposable income growth is allowing millennials to finally move out, boosting the demand for new housing stock (Chart 7). Chart 8 presents a simple way of estimating the remaining pent-up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the remaining gap implies an extra 540,000 housing units. Chart 7Income Growth Is Helping Young Americans To Leave The Nest Chart 8A Catch-Up Housing Construction Will Occur If This Gap Closes The equilibrium number of housing starts that cover underlying population growth plus the units lost to scrappage is estimated to be about 1.4 million annually. If the household formation 'catch up' occurs over the next two years, adding another 250,000 units per year, total demand could be 1.6 to 1.7 million in each of the next two years. This compares to the just-released March housing starts level of 1.2 million. If starts rise smoothly from today's level to 1.7 million at the end of 2018, then the housing sector will contribute about 0.2 percentage points and 0.5 percentage point to real GDP growth in 2017 and 2018, respectively (Chart 9). Chart 9A Housing Catch-Up Will Boost GDP Growth For the economy, the implication is that this already-aged expansion phase could persist for a couple of more years as long as it is not hit by a negative shock and inflationary pressures remain quiescent, allowing the Fed to proceed slowly. Bottom Line: Housing starts remain well below the equilibrium level implied by underlying household formation, and a "catch up" phase could help keep the current "slow burn" expansion burning over the coming years. Favor Housing-Related Assets The above analysis also has some favorable implications for housing-related financial assets. We originally examined the implications of a rebound in home construction in 2012, during the early phase of the recovery in housing starts.2 Our approach was to test the historical excess return performance of several financial assets as a function of key housing market variables, and concluded that housing-related financial assets were set to outperform their respective benchmarks in a bullish housing scenario over the following year (and beyond). We have updated our original analysis in this report, with a few modifications. First, we examine the relationship between key housing market variables and excess returns of housing-related assets since the onset of the U.S. economic expansion in June 2009, given the structural change in the housing market that occurred following the Great Recession. Second, our analysis is based on a more focused set of housing market indicators, given the relatively poor predictive power of new home sales and the months' supply of homes following the crisis period on housing-related asset returns. Table 2 presents the list of housing-related assets that we examined,3 along with the key housing market variables used to forecast excess returns (and whether they were significant predictors in the post-crisis era). The table highlights that most of the variables do contain useful information, with the exception of the two noted above. The rightmost column presents the share of excess returns explained by a composite model of the factors noted as significant for each asset, which varies from a low of 13% to a high of 20%. Table 2Important Predictors Of Housing-Related Asset Excess Returns* (June 2009-December 2016) Charts 10 and 11 present a set of relatively conservative assumptions for the key housing market variables shown in Table 2, based on a rise in housing starts modestly above the scrappage rate that we noted in the previous section. We assume that house price appreciation and housing affordability moderate due to further rate hikes from the Fed, that the already-elevated homebuilders' confidence index stays flat, that refi applications remain low due to the uptrend in mortgage rates, and that purchase applications rise in lockstep with housing starts. Chart 10A Set Of Conservative Assumptions... Chart 11...For Key Housing Market Variables Finally, Table 3 illustrates the predicted excess returns over the coming 12-months of the housing-related assets that we examined, along with the annualized excess returns in 2016 and over the entire sample period for the purposes of comparison. It is important to note that excess returns of corporate bonds are presented relative to duration-matched government bonds, not a speculative- or investment-grade corporate bond aggregate. Table 3Excess Returns Of Housing-Related Assets* (%) The analysis presented above highlights several important conclusions for investors: The predictive power of key housing market variables has been smaller over the course of this economic expansion than in the past economic cycle (including the recession of 2008-2009), suggesting that housing market developments were more important during the downturn than they have been during the recovery. Still, housing market data is an important driver of excess returns for housing-related assets. All of the housing-related assets that we examined are expected to outperform their respective benchmarks over the coming year, even given the relatively conservative assumptions that we have made about the pace of gains in the housing market. For the three corporate bond assets shown in Tables 2 and 3, our model predicts outperformance even relative to their respective corporate bond benchmarks, albeit only marginally in the case of investment-grade banks. With the exception of S&P 500 homebuilders and banks, the model's predicted excess returns are lower over the coming year than they have been on an annualized basis since the onset of the recovery, highlighting that housing-related assets have front-run at least some of the expected normalization in the housing market over the coming few years. However, a full rise to our equilibrium estimate of 1.7 million starts over the coming two years could potentially lead to even larger outperformance than the model would predict. Charts 12 and 13 do not suggest that valuation will be an impediment to the outperformance of housing-related assets. Chart 12Valuation Won't Be An Impediment... Chart 13...For Housing Related Assets Bottom Line: Investors should look to housing-related assets as a source of potential outperformance over the coming 6-12 months. The historical relationship between key housing market variables and the excess returns of these assets implies the latter is set to outperform even given conservative assumptions about the former. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge Vice President, Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Special Report "U.S. Housing: What Comes Next?", dated March 27, 2017, available at usis.bcaresearch.com 2 Please see U.S. Investment Strategy Weekly Report U-3 Or U-6?", dated February 13, 2012, available at usis.bcaresearch.com 3 Note that we have excluded fixed and floating rate home equity loan ABS from our list of housing-related assets owing to a lack of data, as well as investment-grade REITs because of a very low degree of return predictability from key indicators of the housing market
Highlights Portfolio Strategy Upgrade the financials sector to overweight. This year's consolidation phase is drawing to a close as inflation expectations stabilize. Lift the S&P banks index to overweight. Leading indicators of credit creation are signaling a reacceleration as the year progresses. Trim the S&P health care sector to neutral via profit-taking in medical equipment stocks. Recent Changes S&P Financials - Upgrade to overweight from neutral. S&P Banks Index - Upgrade to overweight from underweight. S&P Health Care - Downgrade to neutral. S&P Health Care Equipment - Downgrade to neutral. Table 1 Feature Chart 1Yields Are Not Yet Restrictive The S&P 500 is challenging the top end of its range. A playable breakout looks increasingly probable, albeit the exact timing is difficult. First quarter profit results have been strong, corporate guidance has been solid and monetary conditions are unlikely to become tight enough in the short run to dent renewed profit optimism. The latest string of economic disappointments is seen as providing the Fed with ample leeway, and investors are willing to overlook ongoing sluggishness because earnings are outperforming the economy via margin expansion. As discussed in detail in recent weeks, earnings growth is supported by a broad-based recovery in sales and pricing power. Top-line growth is critical to sustaining the overall equity market overshoot given sky-high valuations. Indeed, the appeal of equities stems from their attractiveness relative to other asset classes rather than in absolute terms. History shows that an asset preference shift can take time to play out, and push valuations higher than seems justified on fundamentals alone as long as recession is not an imminent risk. The Treasury market can provide clues as to when vulnerabilities will intensify. According to BCA's Treasury Bond Valuation Model, yields usually need to be at least one standard deviation above normal before stocks, and the economy, are at risk of a major downturn (Chart 1). At those turning points, inflation concerns are typically running hot, forcing the Fed to tighten enough to slow growth and undermine economic activity. This simple rule of thumb warned of the most recent stock market peaks, as well as equity slumps in the early-1990s, 1987, and the early-1980s, and supported bond vs. equity outperformance. Recently, the 10-year Treasury yield has returned to fair value, and the U.S. dollar has come off the boil. The implication is that there is no monetary roadblock to halt the upward momentum in equities at the moment. There is ample room for yields to rise before becoming restrictive, especially if the primary driver is the real component. In this light, we will continue with our program of transitioning to a more balanced equity portfolio from its previous defensive tilt. This week we downgrade a defensive sector to neutral and redeploy capital into the financials sector. Upgrade The Financials Sector... The financials sector has given back roughly 50% of its post-election surge this year. The main culprits have been a calming in Fed interest rate hike expectations, a flattening yield curve and softening inflation expectations. Moribund credit creation has also created earnings uncertainty (Chart 2). Nevertheless, the corrective phase appears to be drawing to a close, because financials sector profits are increasingly likely to surpass those of the overall corporate sector going forward. Traditionally, the financials sector benefited from a strong U.S. dollar. A strong dollar exerted downward pressure on interest rates, which spurred domestic economic strength, loan demand and a steepening yield curve. However, since the GFC, the opposite has been true. Zero interest rates and intense deflationary risks were exacerbated by U.S. dollar appreciation, as the corporate sector and commodities suffered. In other words, with the economy operating on a knife's edge between deflation and inflation, a strong currency weighed heavily on financial shares. Thus, the hiatus in the U.S. dollar bull market is a significant positive catalyst, if it arrests the decline in inflation expectations. The yield curve is making an effort to stabilize, suggesting that the risks of falling back close to the deflationary precipice are low. There are already signs of a positive reversal in euro area financials, which had led the U.S. financial sector on the way down after peaking late last year (Chart 2). The euro area has been in a deleveraging phase with acute deflationary risks, underscoring that the signal from share price stabilization in this region is worth noting. The key to a sustained recovery in sector profits is economic reacceleration. Corporate sector profits are healing as a consequence of the pickup in global final demand and the peak in the U.S. dollar, which should ensure that labor market slack does not imminently build. That is necessary to sustain credit quality and generate faster credit demand, and can be illustrated through the positive correlation between the output gap and relative share price performance (Chart 3), at least until the gap grows too large to generate inflationary pressures and by extension, tight monetary policy. Chart 2Earnings Uncertainty... Chart 3...But A Narrowing Output Gap... Leading economic indicators are consistent with erring on the side of optimism (Chart 4). Our proxy for the supply/demand balance for C&I loans confirms a positive bias for future loan growth (Chart 4). The upturn in the financial sector sales/employment ratio is encouraging (Chart 4). Productivity improvement has begun prior to a reacceleration in loan creation, suggesting that additional upside looms as balance sheets expand. Any unlocking of the regulatory shackles would be a bonus. Strength in our Financials Cyclical Macro Indicator confirms that profits should best those of the overall corporate sector. The financial sector is contributing more to overall GDP growth than it did even during the credit binge/housing bubble (Chart 5), despite the headwind of ultralow interest rates. Chart 4...And Leading Indicators ##br##Are Positive Offsets Chart 5Market Cap ##br##Gains Loom Even though financials represent an ever increasing share of the broad economy, the sector still garners less than its historic median market cap weight (Chart 5). The upshot is that if the economy stays resilient, the correction in relative share price performance should fully reverse, and we recommend further upgrading allocations to overweight via the heavyweight bank group. ...And Bank On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. While seven out of eight lending categories are experiencing a negative credit impulse, forward looking indicators are sending a more positive message. Business and consumer confidence have skyrocketed (Chart 6). If the revival in animal spirits lifts real economic activity later this year, capital demands could finally break out of their slump and reinvigorate moribund loan growth (Chart 6). Importantly, our U.S. Capital Spending Indicator (CSI) snapped back into positive territory. This primarily reflects both the firming in the ISM manufacturing survey and tightness in the labor market. Credit growth has not yet troughed, but should recover in the second half of the year based on our CSI's reading (Chart 6, top panel). Other leading indicators are heralding a pickup in credit demand. A steepening yield curve and the soaring ISM new orders index have an excellent track record in leading the Fed's Senior Loan Officer Survey for overall credit demand (Chart 6). Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7), pointing to the potential for a broad-based bank balance sheet expansion. Overall household leverage has fallen back to 2003 levels and the household debt-service ratio is at multi-decade lows. Chart 6A Turning Point For Loans... Chart 7...As Demand Recovers Bank deposits are still growing, outpacing nominal GDP by 200bps, and the sector is extremely well capitalized. The loan-to-deposit ratio remains low by historical standards (Chart 8). Bank holdings of risk free securities comprise about 15% of the sector's assets, well above the historic average (Chart 8). The upshot is that there is plenty of firepower to crank up credit creation. True, a rundown in Treasury holdings would result in mark-to-market losses, but banks are well positioned to navigate through rising interest rates. According to the FDIC, net interest income as a share of total revenue has climbed steadily at commercial banks with assets greater than $1bn (Chart 9). Thus, if a better economy and rising inflation materialize in the back half of the year, then higher interest rates will boost profitability (Chart 9). Chart 8Banks Have Dry Powder Chart 9A Durable NIM Expansion Table 2 shows a sample of the four largest U.S. banks' earnings sensitivity to interest rate changes. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Table 2Top Four Banks' Interest Rate Sensitivities Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 9). In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag (Chart 10). Chart 10Credit Quality Is Not An Issue, For Now Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 10). This message is corroborated by return on equity (ROE). Bank ROE has recouped most of the losses since the GFC on the back of recovering productivity gains. However, valuations do not yet reflect the ROE improvement. History shows that after a financial crisis, it can take a prolonged period of improved ROE before investors reward the sector with a valuation expansion, as occurred in the early-1990s (Chart 7, bottom panel). Bottom Line: Boost the S&P financials sector to overweight from neutral. Lift the S&P banks index to overweight. The ticker symbols for the stocks in the S&P banks index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Take Health Care Equipment Down A Notch We are making room for the financials sector upgrade by trimming the health care sector to neutral. As discussed in recent weeks, a modest shift away from a defensive to a more balanced portfolio has been on our radar and the surge in equities over the past week suggests that the consolidation phase is now ending in a bullish fashion, as expected. At the beginning of the year we added the S&P health care equipment (HCE) index to our high-conviction overweight list for three main reasons: valuations had undershot owing to health care reform uncertainty, domestic sales were set to improve and leading indicators of foreign sourced revenue also painted a rosy picture. What has changed? Relative share prices have undergone a V-shaped snapback, all of which can be attributed to a valuation expansion. A flurry of recent M&A activity has also buoyed relative valuations, as takeover premiums have been significant. Relative performance is now at a natural spot to expect a breather. On the operating front, a number of positive profit drivers are still intact. The industry's shipments-to-inventories ratio remains at multi-decade highs and the backlog of medical equipment orders is robust (top and bottom panels, Chart 11). HCE exports are primed to accelerate in the coming months likely irrespective of the U.S. dollar's move. In particular, Europe matters most to S&P HCE constituents, as roughly half of international sales originate in the old continent. Forward-looking indicators of European demand are upbeat, especially with the surge in German medical equipment orders (Chart 11). However, domestic sales indicators have downshifted. New health care facility construction has dropped sharply, warning that investment in medical equipment may soon follow suit (Chart 12, second panel). Consumables demand growth may also take a breather. Consumer outlays at hospitals have nosedived on a growth rate basis. This suggests that the growth in patient visits has dried up, and may be a warning that medical equipment new order growth will also decelerate (Chart 12). Moreover, as outlined in recent Weekly Reports, the broad corporate sector has regained pricing power, but medical equipment suppliers have lagged. Chart 12 shows that relative selling prices are contracting at an accelerating pace. This is significant, as deflation concerns could undermine revenues, and halt the valuation expansion. If domestic medical equipment demand cools, then it will sustain downward pressure on industry activity (Chart 13). Already, medical equipment industrial production (IP) has collapsed, in marked contrast with the expansion in overall IP. Chart 11Export Prospects Are Positive... Chart 12...But Domestic Blues... Chart 13...Will Weigh On Activity Worrisomely, the HCE new orders-to-inventories ratio has also lost steam, warning that a recovery in future production growth may not be imminent. The implication is that productivity gains are petering out, denting our confidence in a further valuation re-rating. Bottom Line: Downgrade the S&P health care equipment index and remove it from the high-conviction overweight list for an 9% gain. This also pushes the broad health care index to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HCEP: MDT, ABT, DHR, SYK, BDX, BSX, ISRG, BAX, ZBH, EW, BCR, IDXX, HOLX, VAR. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights Lean against depressed and euphoric interest rate expectations. The ECB will remove or fade the negative deposit rate, with an outside chance that it happens this year. The U.K. economy will determine the nature of Brexit - not the other way round. The snap General Election doesn't change anything. Expect an ongoing narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. Expect the following order of currency performance: euro first, pound second, dollar third. Expect the FTSE100 to outperform the Eurostoxx50. Feature The interplay between interest rate expectations - in the U.K., U.S. and euro area - is one of the most important factors in explaining what has happened, what is happening, and what will happen, to financial markets. Chart of the WeekBrexit Depression Has Unwound; ##br##Trump Euphoria Hasn't... Yet Interest rate expectations convincingly explain the movements in the U.S. T-bond/German bund yield spread, the U.S. T-bond/U.K. gilt yield spread, euro/dollar, and pound/dollar. Thereby, they also explain FTSE100/Eurostoxx50 relative performance which is just an (inverse) currency play. Chart I-2, Chart I-3, Chart I-4, Chart I-5 and Chart I-6 should leave readers in absolutely no doubt. Chart I-2Interest Rate Expectations Explain The ##br##T-Bond/German Bund Yield Spread Chart I-3Interest Rate Expectations Explain The##br## T-Bond/U.K. Gilt Yield Spread Chart I-4Interest Rate Expectations ##br##Explain Euro/Dollar Chart I-5Interest Rate Expectations##br## Explain Pound/Dollar Chart I-6Pound/Euro (Inversely) Explains ##br##FTSE100/Eurostoxx50 Lean Against Depressed And Euphoric Interest Rate Expectations Last year's shock victories for Brexit and Trump dramatically swung the market mood towards the U.K. and U.S. economies. After Brexit, the knee-jerk response was depression; after Trump, the knee-jerk response was euphoria. But extreme mood swings to depression and euphoria are rarely justified, and ultimately tend to unwind. Responding to last year's dramatic mood swings, U.K. and U.S. interest rate policy - both actual and expected - moved very sharply in opposite directions. Following the Brexit vote, the BoE cut the base rate by a quarter percent, and the rate expected two years out plunged by three quarters of a percent. In contrast, following the Trump victory, the Federal Reserve twice hiked the Fed funds rate by a quarter percent, and the rate expected two years out surged by more than a percent. Meanwhile, throughout all this activity, the ECB repo rate and deposit rate were anchored at zero and -0.4% respectively, and the interest rate expected two years out remained in negative territory. Fast forward to today, and the U.K. interest rate expected two years out has fully unwound the Brexit vote depression - the expected BoE policy rate two years out stands exactly where it stood before the EU Referendum. In contrast, the expected Fed policy rate two years out retains its Trump euphoria (Chart of the Week). Meanwhile, the expected ECB policy rate two years out remains anchored close to the realistic limit of negativity. To reiterate, the extreme market moods of depression and euphoria are rarely justified, and tend to unwind. On this basis, we can say that policy rate expectations in relative terms now have the scope to: Get less depressed in the euro area. Remain broadly unchanged in the U.K. Get less euphoric in the U.S.1 Hence, on a 12-month horizon, expect a continued narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. For currencies, expect the following order of performance: euro first, pound second, dollar third. And therefore, expect the FTSE100 to outperform the Eurostoxx50. Brexit: A Reductionist View Many millions of words have been written about Brexit, and we suspect that many millions more will be written. But true to our reductionist philosophy, we can reduce those millions of words to a single sentence. Brexit was, is, and always will be, about the trade-off between national sovereignty and access to the European single market. Irrespective of the vote to leave the EU and the start of the divorce proceedings, the full spectrum of possibilities in this trade-off is still open to the U.K. At one extreme the U.K. could get a full divorce, and thereby regain absolute national sovereignty in all areas including law and immigration. But in this full divorce, the EU27 would regard the U.K. as a complete outsider whose status is little different to say, Russia. At the other extreme, the U.K. could near enough replicate its current economic and political relationship with the EU27 in a 'pseudo-marriage'. Technically, the U.K. would be divorced, but practically, there would be only minor differences to being married. Although the U.K. would lose its official place at the EU top table, in all likelihood the EU27 would still listen to the British voice given the U.K.'s size and global standing. But in this pseudo-marriage the EU27 would exact a cost: the U.K. could not regain any national sovereignty. All points on the spectrum between a full divorce and a pseudo-marriage are now available to the U.K. The relationship that the U.K. ends up with depends on the trade-off that the British public - and therefore its political representatives in the government and parliament - will accept. In turn, this will depend on the evolution of the economy and standards of living. A strong economy will embolden the British public to want something close to a full divorce. Conversely, a weakening economy might be blamed, rightly or wrongly, on Brexit. In which case, public opinion would shift towards something closer to a pseudo-marriage. Therefore, the causality runs from the economy to Brexit, not from Brexit to the economy. The U.K. economy will determine where the U.K. ends up on the Brexit spectrum - at least, in terms of the initial deal. The snap General Election doesn't change anything. Nor is the General Election a game changer for the pound. The preceding section demonstrated that relative interest rate expectations - rather than Brexit per se - are driving the pound. We expect the BoE to remain relatively inactive because empirically, U.K. real consumption is hyper-sensitive (inversely) to inflation. When inflation is too high, real consumption growth is undermined, making it difficult to hike rates; and when inflation is too low, real consumption tends to grow strongly, making it difficult to cut rates (Chart I-7). This ties the hands of the BoE, and explains why the post EU Referendum emergency rate cut has been the BoE's only interest rate change since early 2009! Chart I-7Why The Bank Of England's Hands Are Tied While rate expectations can get less depressed in the euro area, and less euphoric in the U.S., they are likely to change least in the U.K. Hence, we like the pound less than the euro; but we like the pound more than the dollar. Role Playing On The ECB Governing Council We are writing ahead of the ECB policy meeting, but we do not anticipate any substantive announcements - given that we are only half way through the French Presidential Election. In the absence of major developments, the euro's strong recent advance might take a tactical breather. But what then? Some people argue that ECB policy should be based not on the aggregate euro area economy, but instead on the weaker links in the euro area economy. These arguments have some merit, as the ECB - unlike other central banks - has to contend with a permanent existential threat. On this basis, let's finish this week with a role playing exercise. Imagine you're on the ECB Governing Council, and the weak link that worries you is euro area bank fragility, particularly in some of the southern member states. Your own (ECB) analysis, illustrated in Chart I-8, shows that extreme accommodative monetary policy has had a negligible net impact on bank profitability. The QE component has probably been a mild net positive - admittedly, a flatter yield has dragged down banks' net interest margins; but it has also generated profits in banks' bond portfolios; and in so far as QE has boosted economic growth, it has reduced bank charge-offs. Chart I-8What Is The Point Of The ECB's Negative Deposit Rate? But the negative deposit rate - charging banks for excess liquidity - has been a clear drag on bank profitability. And there is little evidence that it has encouraged lending. What would you do? Even if the ECB is setting policy for the euro area weak links, the central bank's own analysis suggests that it should remove, or at least fade, the negative deposit rate. Our central expectation is for this to happen early next year, with an outside chance that it is even sooner. With expectations for ECB policy rates still anchored close to the realistic limit of negativity, the euro exchange rate has cyclical upside. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Assuming that the U.S. government does not approve inappropriate fiscal stimulus. Fractal Trading Model* This week's trade is to go long the FTSE100 versus the IBEX35 with a profit target and stop loss of 4%. 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-9 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights China/EM growth will decouple (to the downside) from the business cycle in developed markets (DM). Continued demand strength in DM will not prevent a relapse in EM/China growth. EM is much more leveraged to China than to DM. Higher bond yields in DM, a stronger U.S. dollar and weak China/EM domestic demand are bearish for commodities and EM risk assets. A new equity trade: short KOSPI / long Nikkei. Feature In our recent reports1 we have argued that China's growth is likely to relapse again in the second half of this year based on its aggregate credit and fiscal impulse. Chart I-1 illustrates that this impulse leads Korean, Taiwanese, Japanese, German and U.S. aggregate exports to China by six months, and this indicator is reinforcing the message that shipments from these economies to the mainland have peaked and will stumble. Consistently, the bottom panel of Chart I-1 reveals that Chinese imports of capital goods are set to decelerate significantly and probably contract anew by the end of this year or early 2018. If markets are forward looking, they should begin discounting a potential growth slump very soon. Chart I-2 demonstrates that there is a tight correlation between each of these countries' shipments to China and the mainland's credit and fiscal impulse. Chart I-1Chinese Imports To Relapse Chart I-2Exports To China To Weaken In this context, a relevant question is whether the expansion of U.S. and European imports will be sufficient to safeguard the recovery in EM and global trade as China's imports tumble. Our analysis substantiates that domestic demand strength in the U.S. and Europe will boost these economies but will likely not preclude another downturn in EM/Chinese growth and global trade. In brief, China/EM growth will decouple (to the downside) from the business cycle in developed markets (DM). Our basis is that EM and China trade much more with one another, and as such the DM business cycle has become a less important driver. If DM demand holds up as China's imports tumble anew, EM share prices and currencies will underperform their DM counterparts. In this context, our negative view on EM is contingent on a deceleration in China's business cycle rather than a major relapse in DM domestic demand. In the near term, higher bond yields in DM due to strong domestic demand combined with weakness in EM/Chinese growth will reverse the EM rally. EM Is Much More Leveraged To China Than To DM Chart I-3EM Is Leveraged To China Much More Than DM Chart I-3 shows that the relative performance of EM versus DM stocks typically fluctuates with the relative import volume trend between China and DM. This supports our thesis that the EM world is much more leveraged to China than DM. The following considerations certify China's greater importance for EM economies compared to the U.S. and Europe: Table I-1 shows the share of exports going to China and to the U.S. for individual EM countries. The mean for exports to China is 14.6% of total, and 11.3% for shipments to the U.S. These numbers corroborate the fact that developing countries sell more to China than to the U.S. Chart I-4 is constructed using the numbers from Table I-1. It demonstrates that Korea, Taiwan, Chile and Peru are more exposed to China while India, Turkey, and the Philippines are more leveraged to the U.S. We did not include Mexico and central Europe in this chart because the former trades with the U.S. and the latter predominantly with European countries due to their geographical proximity. Table I-1Export To China And U.S. Chart I-4Exposure To China And Exposure To The U.S. Chinese demand is critical for commodities, particularly for industrial metals prices. China consumes 6-7-fold more industrial metals than the U.S. Unsurprisingly, the mainland's credit and fiscal impulse leads industrial metals prices (Chart I-5). At this moment, we are negative on both metals and oil prices, as we view the 2016 rally as a mean-reverting rally in a structural bear market. As commodities prices drop again, commodities-producing nations will suffer from a negative terms-of-trade shock. This is regardless of which countries they export commodities to. There is one global price for each commodity, and when it deflates commodity producing nations are the ones that get hurt - irrespective of whether they sell that commodity to China, the U.S., Europe or the rest of the world. Countries like Korea and Taiwan do not sell commodities, but their largest export destination is still China (Chart I-6). The latter accounts for 25% of Korean and 27% of Taiwanese exports Chart I-5China's Credit And Fiscal##br## Impulse And Industrial Metals Chart I-6Korea And Taiwan: The ##br##Composition Of Exports. Even if we assume that 30% of goods exported to China by Korea and Taiwan are assembled and then re-exported to other countries, the mainland's domestic absorption of Korean and Taiwanese goods is still considerable. Notably, the recovery in Korean, Taiwanese and Japanese exports has been driven more by China than the rest of the world (Chart I-7). Therefore, China's business cycle is also important for some non-commodity producing countries like Korea, Taiwan and others in Asia. China itself has become much more reliant on its credit origination and fiscal spending than on exports in general and exports to DM in particular (Chart I-8). Chart I-7Asia's Exports Recovery Has Largely ##br##Been Driven By China's Demand Chart I-8China Has Become Reliant ##br##On Stimulus Not Exports Finally, Table I-2 exhibits the product structure of Chinese imports. By and large, China imports three categories of goods: various commodities, capital goods and some luxury goods. All three are at risk of a slowdown because they are leveraged to the nation's credit cycle. Table I-2Composition Of Chinese Imports Bottom Line: China's imports are critical not only for commodity producers (Latin America, Russia, Africa, the Middle East and Indonesia) but also for non-commodity economies in Asia. Altogether this comprises most of the EM universe. EM/China's Importance In Global Trade EM/China account for much larger global trade flows than advanced economies. In short, global trade will relapse again if global shipments to China and the rest of the EM universe slump. EM including Chinese imports (but excluding the mainland's imports for re-exports) in U.S. dollars are equal to imports by the U.S., EU and Japan combined (Chart I-9). Chinese imports for processing - imports that are used to manufacture goods for exports - are excluded from the calculation of this chart. Only Chinese imports for domestic consumption are accounted for. Also, this EM aggregate excludes Mexico and central European countries because their manufacturing is intertwined with the ones in the U.S. and EU. Exports to EM countries account for 25%, 28% and 17% of German, Japanese and U.S. exports, respectively. As a share of GDP, exports to vulnerable EM economies stand at 2%, 5% and 5% of U.S., German and Japanese GDP, respectively (Chart I-10). Chart I-9EM Imports Are Equal To Combined##br## Imports Of U.S., EU And Japan Chart I-10Japan And Germany Are More ##br##Exposed To EM Than The U.S. Japan and Germany are much more vulnerable to an EM/China slowdown than the U.S. and the rest of Europe (Europe ex-Germany). China's exports are exposed more to EM than DM. Chart I-11 shows that 45% of Chinese exports are shipped to Asia ex-Japan, 18% to Latin America, Russia, the Middle East, Africa, Australia and Canada and only 18% to the U.S. and 16% to the EU. Capital spending in China and EM ex-China makes up 5% and 5% (together 10%) of global GDP in real terms (Chart I-12). By comparison, EU and U.S. capital expenditures are 5% and 4.5% of world GDP in real terms. Hence, EM and especially China's investment outlays are big enough to matter for the global economy. Chart I-11China Sells More To EM Than DM Chart I-12EM/China Capex Is Large As Chart I-1 indicates, China's imports of industrial goods will soon tumble. Capital goods imports for EM ex-China have revived, but as their bank loan growth slumps the recovery in capital goods imports is likely to be short lived. Bottom Line: Two-pronged trade flows between EM and China are considerable for their own economies as well as global trade flows. Continued demand strength in DM countries will not prevent a relapse in EM/China growth. Market Observations And Conclusions Our conviction is that China's imports are set to dwindle in the second half of this year. This is bearish for commodities producers and Asian economies selling to China. If markets are forward looking, they should begin discounting this now. Moreover, bank deleveraging in EM/China has further to run. Altogether, this leads us to maintain the strategy of underweighting EM risk assets relative to their DM counterparts, and maintaining a negative stance on EM in absolute terms. Furthermore, it appears the U.S. dollar and U.S. bond yields have recently bounced from their technical support levels, and odds are they will rise further (Chart I-13). DM bond yields will move higher for now before the EM/China slowdown becomes visible later this year. For the time being, rising U.S. bond yields and a stronger greenback (versus EM, Asian and commodities currencies) will weigh on EM risk assets. Remarkably, Chinese interest rates are rising and corporate bond prices are plunging as the People's Bank of China continues along a gradual tightening path (Chart I-14). Chart I-13The U.S. Dollar And U.S. Bond Yields To Rise Chart I-14China: Borrowing Costs Are Rising As long as economic data from China and DM remain positive, financial regulators in Beijing are determined to curb leverage and speculative activities in China's credit system. Higher interest rates and regulatory tightening amid the lingering credit bubble are bound to cause meaningful stress in China's financial system and lead to a deceleration in credit growth. EM risk assets are very complacent about this risk. Interestingly, the commodities currencies index - an equal-weighted average of the Australian, New Zealand and Canadian dollars - has already halted its rally and begun depreciating even versus safe-haven currencies like the Swiss franc (Chart I-15). Such poor showing by commodities currencies should be taken seriously because it has occurred at a time when the U.S. dollar has been soft and global share prices have been well bid. As such, we read this message from the commodities currencies as a harbinger of a major top in commodities prices and EM risk assets. There is no reason why EM ex-China currencies should diverge from the commodities currency index this time around (Chart I-16). Chart I-15Commodities Currencies Versus ##br##Safe-Haven Currency Chart I-16EM Currencies ##br##To Tumble In short, we are reiterating our bearish strategy on EM currencies and recommend shorting a basket of the following currencies: ZAR, TRY, BRL, CLP, COP, MYR and IDR versus the U.S. dollar or a basket of the U.S. dollar and the euro. The main risk to our downbeat view on EM risk assets is not EM/China fundamentals but the rally in DM share prices. That said, DM stocks and credit markets were well bid in 2012-2014 yet EM stocks and currencies did very poorly during that period. This could be repeated again in the next couple of months before fundamental problems/weaker growth in China/EM become evident and stem the rally in DM equities too, as occurred in 2015. A New Equity Trade: Short KOSPI / Long Nikkei We have identified a tactical opportunity for a relative equity trade: short Korean / long Japanese stocks, currency unhedged. The Korean won is overvalued versus the Japanese yen, according to the relative real effective exchange rate based on unit labor costs (Chart I-17). This will provide a competitive advantage to Japanese manufacturers and will dent performance of the KOSPI versus the Nikkei. Even though the won could still appreciate versus the yen, equity prices in Japan will still fare better than their Korean counterparts in common currency terms. Japan's more competitive positioning is also reflected in its manufacturing PMI, which is much stronger than Korea's (Chart I-18). This should lead to outperformance of Japanese manufacturers versus their Korean peers. Chart I-17The Korean Won Is Expensive ##br##Versus The Yen Chart I-18Manufacturing PMI: ##br##Korea And Japan Korea is much more exposed to China than Japan. Exports destined to China make up 25% and 18% of Korean and Japanese exports, respectively. In the meantime, combined exports to the U.S. and EU account for 22% of Korea's total exports and 31% of Japan's total exports (Chart I-19). Provided our view that China's growth will disappoint relative to U.S. and EU growth pans out, Japan is in better position than Korea. Japanese policymakers continue to be much more aggressive in reflating their economy than Korean policymakers. Bank loan growth is accelerating in Japan but is slowing in Korea, albeit from a higher level (Chart I-20). Finally, the technical profile of relative performance between Korean and Japanese share prices favors the latter (Chart I-21). Chart I-19Japan And Korea: Structure Of Exports Chart I-20Bank Loan Growth Is Stronger In Japan Than Korea Chart I-21Short KOSPI / Long Nikkei Bottom Line: Short KOSPI / long Nikkei, currency unhedged. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Reports titled, "A Time To Be Contrarian", dated April 5, 2017, "Signs Of An EM/China Growth Reversal", dated April 12, 2017 and "EM: The Beginning Of The End", dated April 19, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Overall Duration: The factors that have driven global bond yields lower over the past month are not sustainable. Maintain a below-benchmark duration exposure, with current yield levels looking attractive to add to underweight/short positions as we did last week. French Election: We got the market-friendly outcome in the French election that we were expecting. We are closing our recommended long 10-year France vs 10-year Germany Tactical Overlay trade after the post-election spread tightening, at a profit of 1.3%. Feature Investors breathed a sigh of relief yesterday, after the French presidential election produced the most market-friendly result - a Macron-Le Pen matchup in the May 7 run-off. Pre-election polling showed that the pro-Europe reformer Macron and his En Marche ("On The Move") party would easily trounce the anti-Europe populist Le Pen in a head-to-head showdown. That outcome would eliminate the possibility of a confidence-shattering "Frexit" along the lines of last year's U.K. vote that could stall the current global economic expansion. Elevated political risks in Europe, and geopolitical risks in Syria and North Korea, have been a factor driving volatility higher, and bond yields lower, in recent weeks. There have also been some data disappointments in the U.S. that have occurred at the same time (Chart of the Week). It is difficult to tell which factor has been more important for government bond markets. The fact that yields jumped worldwide yesterday after the French election result and, more importantly, the lack of any serious repricing in global equity and credit markets alongside the recent pop in volatility, suggests that bond markets are likely not sniffing out a sustained growth slowdown. Government bond yields remain too low relative to underlying economic and inflation trends, and we continue to recommend below-benchmark duration exposure and above-benchmark allocations to corporate credit versus government bonds (especially in the U.S.). Falling Bond Yields: Some Shifting Expectations, But Not A Change In Trend The recent decline in global bond yields began in mid-March. The move in most of the major markets was largely driven by falling inflation expectations, with real yields staying relatively stable, although in the U.S. the split was more 50/50. Importantly, both the nominal 10-year U.S. Treasury and German Bund yield are bouncing off the bottom of their upward sloping trend channels that started in early 2016 (Chart 2). Chart of the WeekA Series Of Unfortunate Events Chart 2Upward Trend In Yields Still Intact We see those upward trending channels as being the primary medium-term trend for bond yields. The recent pullback in yields has been the result of several individual factors that have occurred at the same time that are likely to reverse in the months ahead: Slower U.S. growth & inflation: The latest soft readings on U.S. retail sales and core CPI inflation are not consistent with the robust readings on business confidence and manufacturing activity, as well as the accelerating trend in U.S. corporate profit growth that our models expect will continue in the coming quarters (Chart 3). The latter is being driven by significant improvements in corporate pricing power that are helping boost profit margins, according to our equity strategists (bottom panel).1 We find it hard to believe that there can be a prolonged slowdown in the U.S. economy if earnings growth is accelerating and firms are not forced to cut back on hiring and investment to preserve profitability. The U.S. Overnight Index Swap (OIS) curve is now only discounting 38bps of rate increases over the next year, Treasuries look expensive as the Fed is likely to deliver at least 50bps worth of hikes by year-end and the large short positions in the Treasury market have been unwound (Chart 4). Chart 3The U.S. Economy Is Not Rolling Over Chart 4Treasuries Are Expensive & Positioning Is Now Long Softer U.S. wage inflation: Some of that boost to U.S. profit margins is also due to the recent slower pace of wage growth, which we do not expect to continue given the tightness in the U.S. labor market and the continued robust readings on labor demand indicators (Chart 5). We expect wage growth to begin ticking higher in the months ahead, as will overall U.S. inflation expectations which still appear too low. The Cleveland Fed Median CPI has been steady around 2.5%, which is where we expect headline CPI inflation to be if the Fed's inflation target of 2% on the PCE deflator is met.2 We see TIPS breakevens gravitating towards those levels in the coming months, driving longer-term U.S. Treasury yields higher. Setbacks on the Trump economic agenda: President Trump's failure to get health care reform passed in Congress was interpreted as a sign that the more pro-growth parts of his agenda, like tax reform and infrastructure spending, would also have difficulties getting implemented. We are not strong believers in the idea of a significant "Trump trade" impact on growth and bond yields, as the U.S. economy was already showing improvement before Trump won the presidency. Nonetheless, any delay in the fiscal easing that Trump promised during the campaign would act to dampen expectations for U.S. growth and Fed rate hikes on the margin, to the benefit of U.S. Treasuries. Trump announced that he will unveil his tax reform proposals this week, with Congressional hearings on the subject also set to begin. Our colleagues at BCA Geopolitical Strategy expect Trump to try and move quickly to get a deal done, especially after the initial failure on health care reform. The political risks for the Republicans are very real in next year's mid-term elections, with current polling pointing to large losses of seats that could return the House of Representatives to Democrat control. If the Republicans want to push through their reform agenda and try and boost growth heading into the 2018 midterms to try and avert a loss of the House, they cannot delay on tax reform this year. While the U.S. political situation is always a wild card, we do not think that "Trump trade" disappointment will be a factor weighing on Treasury yields over the rest of 2017. Lower oil prices: Some of the decline in the inflation expectations component of global bond yields can be attributed to the pullback in oil prices since late February. Our colleagues at BCA Commodity & Energy Strategy continue to have a bullish outlook on global oil prices, however, and view the recent dip as a buying opportunity.3 They expect Russia and Saudi Arabia to honor their agreement to remove 1.8mm barrels/day of production from the global oil market our by mid-2017, as visible inventory levels remain too high. Combined with stronger expected demand, our strategists expect oil prices to move toward the $60/bbl level by year-end (Chart 6). That move would boost help to raise inflation expectations, and bond yields, in the months ahead. Chart 5U.S. Inflation Expectations Still Too Low Chart 6Oil Prices Set To Move Higher Slower Euro Area inflation: Just like in the U.S., there was a pullback in Euro Area inflation expectations after the dip in realized inflation readings in March. While some cooling was expected simply from base effects related to swings in oil prices and the Euro, our headline CPI diffusion index indicates that an increasing majority of sectors are seeing accelerating price growth (Chart 7). If our commodity strategists are correct on the call for higher oil prices, we would expect to see some re-acceleration of Euro Area inflation, and more bear-steepening of Euro Area government bond yield curves, in the coming months. Especially if the European Central Bank (ECB) begins to send a signal about a tapering of its asset purchases - an outcome that is more likely if the polling data proves correct and Macron wins the French Presidency in two weeks, thus reducing the near-term political uncertainty in Europe. The ECB meets this week, and while we still think any shift in the ECB's tone is more likely at the June meeting (when a new set of economic projections will be produced), this will be the first opportunity for comments after the French election result. French Election Uncertainty: The pre-election rise in French risk premia fully unwound yesterday in a matter of hours (Chart 8). Implied volatilities on Euro Area equities and the EUR/USD exchange rate plunged, as did France sovereign CDS spreads. France-Germany government bond spreads tightened sharply as well, with the benchmark 10-year OAT-Bund spread declining -19bps from last Friday's closing levels. With Macron having a 20 point lead on Le Pen in a two-way race according to the latest opinion polls - which proved to be very accurate in the first round of voting - we think that current spread levels are consistent with a Macron victory on May 7. Chart 7Only A Brief Setback##br## In Euro Area Inflation Chart 8Taking Profit On Our Long France/Short ##br##Germany Spread Trade We do not expect much additional spread tightening if Macron does indeed win, especially if the ECB does begin to signal a tapering of bond purchases in 2018. That would result in wider risk premia across all European bond markets as valuations start to return to levels more in line with fundamentals. Given France's high sovereign debt levels and low productivity growth vis-à-vis Germany, we do not see the OAT-Bund spread returning to the pre-election lows if the ECB slows its bond buying. Thus, we are taking profits on the long France/Short Germany 10-year bond trade in our Tactical Overlay Portfolio, which we established back in early February when the spread was 76bps; 26bps higher than yesterday's close.4 Bottom Line: The factors that have driven global bond yields lower over the past month are not sustainable. Maintain a below-benchmark duration exposure, with current yield levels looking attractive to add to underweight/short positions as we did last week. We got the market-friendly outcome in the French election that we were expecting. We are closing our recommended long 10-year France vs 10-year Germany Tactical Overlay trade after the post-election spread tightening, at a profit of 1.3%. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Pricing Power Comeback," dated April 24 2017, available at uses.bcaresearch.com 2 That assumes a difference between headline CPI and PCE deflator inflation in line with its historical average of around 50bps. 3 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017/H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20 2017, available at ces.bcaresearch.com 4 Please see BCA Global Fixed Income Strategy Special Report, "Our Views On French Government Bonds," dated February 7 2017, available at gfis.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
Highlights Duration: The market is now priced for only 30 bps of rate hikes between now and the end of the year, despite little evidence that growth is actually slowing. Stay at below-benchmark duration and remain short the January 2018 Fed Funds Futures contract. TIPS: Although we still expect TIPS breakevens to widen as inflation rises, this week we review possible arguments for why breakevens might have shifted to a permanently lower post-crisis equilibrium. Remain overweight TIPS versus nominal Treasuries. Corporate Valuation: Our Default-Adjusted Spread remains at reasonably attractive levels, suggesting that corporate spreads will tighten in the coming months if the economic recovery remains on track. Remain overweight corporate bonds within U.S. fixed income portfolios. Feature Chart 1Yields Lower Since March FOMC In last week's report we argued that recent bond market strength was caused by a politically-induced flight-to-quality. In particular, we noted that the term structure of implied equity volatility had inverted - investors were paying more to hedge equity positions over a 1-month horizon than over a 3-month horizon. But political tensions have eased somewhat during the past week. President Trump promised to unveil his administration's tax reform plan this Wednesday, and the first round of the French election resulted in centrist candidate Emmanuel Macron securing a significant advantage over far-right candidate Marine Le Pen. As a consequence, 1-month implied equity vol fell back below 3-month vol, and the bond rally ebbed with the 10-year Treasury yield edging up to 2.29% from 2.17% at this time last week. Nonetheless, bond yields are still far below the levels seen following the last FOMC meeting in mid-March. Since that meeting, the 10-year Treasury yield has fallen 27 bps, split between a 12 bps decline in the real yield and a 15 bps drop in the cost of inflation compensation (Chart 1). Real Yields Are Too Low As shown in the top panel of Chart 1, the 10-year real yield is tightly linked to the number of rate hikes discounted in the overnight index swap curve during the next 12 months. Further, the drop in both of these series since mid-March occurred alongside a string of economic data disappointments, as evidenced by the sharp fall in the Economic Surprise Index (Chart 2). Our assessment, however, is that the mean reversion in the surprise index represents excessively optimistic expectations rather than a trend change in the pace of U.S. growth. Chart 2Disappointments Are Discounted To test this theory, we looked at the New York Fed's Nowcast for Q1 GDP growth and noted that it has been revised lower from 2.96% (as of March 24) to 2.65% (as of April 20). We observed that the data releases responsible for the bulk of the downward revision were: Real consumer spending Retail sales and food services Import & Export growth Housing starts As can be seen in Chart 3, with the exception of real consumer spending, all of the other data disappointments represent small corrections from elevated levels. As for real consumer spending, we noted last week that the recent weakness is probably explained by problems with Q1 seasonal adjustments.1 Taking a step back, U.S. growth still appears to be on solid footing. The BCA Beige Book Monitor, introduced last week by our U.S. Investment Strategy service,2 scans the Federal Reserve's Beige Book3 for the words "strong" and "weak" (and their derivatives like stronger, weakened, etc...). The Monitor is the number of "strong" words less the number of "weak" words, and it has been an excellent coincident indicator of GDP growth since the mid-1990s (Chart 4). At present, the Beige Book Monitor is sending a robust signal for U.S. growth. Similarly, despite supposed weakness in housing starts and trade data, our preferred leading indicators point to continued strength in both the residential investment and net export components of GDP (Chart 4, bottom 2 panels). Chart 3What Weak Data? Chart 4Growth Still Looks Strong Bottom Line: The market is now priced for only 30 bps of rate hikes between now and the end of the year, despite little evidence that growth is actually slowing. We still expect the Fed will lift rates by at least 50 bps between now and the end of the year. Stay at below-benchmark duration and remain short the January 2018 Fed Funds Futures contract. TIPS Breakevens: How Far From Fair Value? As was mentioned above, the cost of 10-year inflation compensation has also declined since mid-March alongside some weakness in the headline non-seasonally adjusted Consumer Price Index (see Chart 1). Our Financial Model of TIPS Breakevens - which models the 10-year TIPS breakeven rate using the stock-to-bond total return ratio, the price of oil and the trade-weighted dollar - attributes the recent decline to weakness in the stock-to-bond ratio and the fact that the 10-year breakeven rate was already quite elevated compared to our model's fair value (Chart 5). The 10-year breakeven rate is still somewhat wide compared to our model's fair value, but much less so. We remain overweight TIPS versus nominal Treasuries on the view that growth will be strong enough to keep measures of core inflation on a steady upward trajectory, eventually converging with the Fed's 2% inflation target. The fair value reading from our TIPS Financial Model should also trend gradually higher in this environment. Historically, core PCE inflation anchored around the Fed's 2% inflation target has corresponded with a 5y5y TIPS breakeven inflation rate in the range of 2.4% to 2.5% (current value 1.89%) and a 5y5y CPI swap rate between 2.8% and 2.9% (current value = 2.31%) (Chart 6). These remain our target levels for TIPS breakevens and CPI swaps, respectively. Chart 5TIPS Financial Model Chart 6Still Below Target However, we must also consider the possibility that these target ranges, based on the mid-2000s, may no longer be applicable. Put differently, it is possible that the market for inflation protection underwent a structural shift following the financial crisis and the appropriate level for long-maturity TIPS breakeven rates when core PCE is anchored around 2% might now be lower. A Structurally Lower Inflation Risk Premium? It is common to think of the 10-year TIPS breakeven inflation rate as: TIPS Breakeven Inflation = Inflation Expectations + Inflation Risk Premium The inflation risk premium is the extra return required by nominal bond investors to bear the risk that future inflation will differ from expected inflation. In theory, this premium can be influenced by uncertainty about the inflation outlook, but also by structural factors that make it more or less attractive to include TIPS in a portfolio. For example, any asset that is negatively correlated with equities is more valuable as a hedge in the context of an overall portfolio and investors should demand less of a risk premium to hold that asset. As one recent Fed paper4 noted, the correlation between long-maturity TIPS breakeven rates and equities has shifted from being negative in the 1980s to being sharply positive in recent years. This means that TIPS have become less valuable as a hedge against equity positions. All else equal, this should increase the yield that investors demand to hold TIPS and thus lower the TIPS breakeven inflation rate. We acknowledge the strong positive correlation between equities and TIPS breakevens, but are inclined to view it as more of a cyclical phenomenon. Chart 7 shows that the correlation between inflation expectations5 and equities was negative when inflation was above the Fed's 2% target in the 1980s and also that the correlation becomes more positive when the Fed eases and more negative when the Fed tightens (Chart 7, bottom panel). Chart 7Correlation Between Breakevens & Equities Is Cyclical In other words, when inflation is low the Fed has an incentive to maintain an accommodative monetary policy. It does not react strongly when inflation rises, and this supports increases in both inflation expectations and equity prices. However, when inflation becomes too high, the correlation between inflation expectations and equity prices shifts because higher inflation now signals a more rapid pace of Fed tightening which tends to depress equities. It therefore seems likely that the correlation between TIPS breakevens and equity prices will weaken as inflation rises and the Fed tightens policy. So we do not view this as a compelling reason for why TIPS breakevens might be permanently lower. Structural Limits To Arbitrage? A potentially more interesting line of argument comes from a 2010 paper by Fleckenstein, Longstaff and Lustig.6 In this paper, the authors document a persistent arbitrage opportunity between TIPS and nominal Treasury bonds. Investors can earn risk-free returns using inflation swaps and TIPS to replicate the cash flows from a nominal Treasury bond. The authors also find that this arbitrage opportunity biases TIPS breakeven rates lower, and that this bias worsens in times of increased financial market volatility. Chart 8Repo Market Less Efficient Specifically, the authors demonstrate that the size of the downward bias in TIPS breakevens increases as repo market fails trend higher. The rationale being that repo fails occur when market participants are unable to acquire specific Treasury collateral. This is taken as a signal that the supply of government bonds is constrained, which makes it more difficult to take advantage of the arbitrage between TIPS and nominal Treasuries. Interestingly, repo fails have been trending higher since the financial crisis as repo market activity has been reduced by strict post-crisis regulations (Chart 8). The case has been made that new regulations - specifically the Supplementary Leverage Ratio which forces dealer banks to set aside a fixed amount of capital for any assets they hold, regardless of riskiness - have caused dealers to shy away from low margin businesses such as making markets in repo.7 It is conceivable that reduced activity in the repo market has resulted in less available collateral and increased fails. If this is the new state of affairs, then it is possible that TIPS breakevens will be permanently lower in the post-crisis world because lack of liquidity in the repo market has reduced the attractiveness of arbitraging the difference between nominal and real yields. So far, we are reluctant to draw any sweeping conclusions from this analysis. In fact, if the Fed believes that the fair value for long-maturity TIPS breakevens is between 2.4% and 2.5%, then does the "limits to arbitrage" argument even matter? Also, Manmohan Singh of the IMF has argued that the act of the Fed unwinding its balance sheet would free up balance sheet space for dealer banks, mitigating some of the regulatory burden and leading to a more efficient repo market.8 If this is correct, then repo fails could decline as the Fed starts to let its balance sheet run down, a process that is likely to start later this year. For now, we consider the theory of a permanently lower equilibrium for TIPS breakevens a risk to our view that merits further research in the coming weeks. Corporate Bond Valuation Update With the release of the Moody's Default Report for March we were able to update our High-Yield Default-Adjusted Spread (Chart 9). Our Default-Adjusted Spread is equal to the average option-adjusted spread from the Bloomberg Barclays High-Yield index less a 12-month forecast of default losses. That 12-month forecast is based on Moody's baseline forecast for the speculative grade default rate and our own forecast of the recovery rate. Chart 9Default-Adjusted Spread Moody's data show that the speculative grade default rate was 4.7% for the 12 months ending in March, and the baseline forecast calls for it to fall to 3% during the next 12 months. Using this forecast we calculate that the current Default-Adjusted Spread is 228 bps. Our analysis shows that excess returns for both Investment Grade and High-Yield corporate bonds are usually positive unless the Default-Adjusted Spread is below 100 bps. The relationship between excess returns and the Default-Adjusted Spread for both Investment Grade and High-Yield corporates is shown graphically in Charts 10 & 11 and also in Tables 1 & 2. Chart 1012-Month Excess Investment Grade Returns ##br##Vs. Ex-Ante Default-Adjusted Spread (2003 - Present) Chart 1112-Month Excess High-Yield Returns Versus Ex-Ante ##br##Default-Adjusted Spread (2003-Present) Table 112-Month Investment Grade Excess Returns & Ex-Ante Default-Adjusted Spread Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Given our relatively optimistic outlook for U.S. growth, we tend to view current valuation levels as attractive and see scope for spread tightening during the next few months. However, the weakening state of corporate balance sheets means spreads are at risk once inflation starts to bite and monetary policy turns less accommodative, possibly as early as next year.9 Bottom Line: Our Default-Adjusted Spread remains at reasonably attractive levels, suggesting that corporate spreads will tighten in the coming months if the economic recovery remains on track. Remain overweight corporate bonds within U.S. fixed income portfolios. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Fade The Flight To Safety", dated April 18, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Investment Strategy Weekly Report, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com 3 According to the Fed, the Beige Book provides "an up-to-date depiction of regional economic conditions based on anecdotal information gathered from a diverse range of business and community contacts." 4 Chen, Andrew Y., Eric C. Engstrom, and Olesya V. Grishchenko (2016). "Has the inflation risk premium fallen? Is it now negative?," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, April 4, 2016, http://dx.doi.org/10.17016/2380-7172.1720 5 In order to benefit from more back-data, in Chart 7 we use the Cleveland Fed's measure of inflation expectations rather than TIPS breakeven rates. Details about the Cleveland Fed's methodology can be found here: https://www.clevelandfed.org/en/our-research/indicators-and-data/inflation-expectations.aspx 6 Fleckenstein, Matthias, Francis A. Longstaff, and Hanno Lustig (2010). "Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle", NBER Working Paper No. 16358. September 2010. JEL No. E6,G12,G14. http://www.nber.org/papers/w16358 7 https://www.forbes.com/sites/lbsbusinessstrategyreview/2016/03/11/why-are-big-banks-offering-less-liquidity-to-bond-markets/#64286f5729de 8 https://ftalphaville.ft.com/2017/04/24/2187716/guest-post-why-shrinking-the-fed-balance-sheet-may-have-an-easing-effect/ 9 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights It is difficult to judge how much of the recent unwind of the Trump Trades has been due to data disappointments versus rising geopolitical tensions. We do not believe that an attack on North Korea is imminent. Rather, U.S. military muscle-flexing is designed to force the rogue state to the negotiating table. On the economic front, the U.S. "hard" data have disappointed surveys in Q1. However, we believe this largely reflects weather and seasonal adjustment distortions. The Leading Economic Indicator and our new Beige Book Monitor support this view. Our profit growth model is very bullish for earnings this year, and is supported by our proxies for corporate pricing power. The latter is improving relative to wage growth recently, suggesting that there is more upside for margins this year. Returning cash to shareholders has not been particularly strong in this expansion relative to past expansions, contrary to popular belief. Nonetheless, buyback activity will continue to boost EPS growth by about 2 percentage points. Cyclical conditions and a significant improvement in relative valuation suggests that investors should continue to favor small over large cap stocks. Feature Treasury yields fell to their lowest level last week since just after the U.S. Presidential election. The solid start to the Q1 earnings reporting season was not enough to offset the disappointing economic reports and geopolitical fears, leaving U.S. equity prices mostly lower on the week (Chart 1). We thought that the "hard" data would improve to meet the accelerating "soft" data, but that clearly didn't occur last week. Unusual weather in March may have been a factor. We will return to the outlook for the economy and corporate profits later in the report. Chart 1Q1 Growth Disappoints It is difficult to judge how much of the bond rally has been due to data disappointments versus rising geopolitical tensions. President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances.1 The market's political focus will likely turn back to Washington this week. Congress has until April 28 to pass a bill to keep the U.S. government running through the end of fiscal year 2017. Our Geopolitical Strategy Service continues to expect a deal to get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. While the negotiations surrounding both of events could weigh on Treasury yields in the near term, our view is that they are unlikely to prevent an uptrend in yields over the coming 6-12 months. As for North Korea, the safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. But, near term, this situation is a huge wildcard. We cannot rule out another wave of risk aversion in financial markets. As this week's publication goes to press, the results of the first round of the French presidential election are being tabulated. Please consult BCA's Daily Insight on Monday, April 24, 2017 for our first take on the election results. A Temporary Soft Patch Or Something Worse? In last week's report, we wrote that the weak readings from the "hard" economic data would soon catch up with the surging "soft" economic data. In fact, the opposite has occurred since mid-April. Is this the start of a prolonged weak patch in the U.S. economy? Or is the softness perhaps related to weather and poor seasonal adjustment? We favor the later explanation for now. The first quarter GDP report is due out this Friday, April 28. The Bloomberg consensus is looking for just a 1.2% gain in the quarter after the 2.1% increase in Q4 2016. The Atlanta Fed's "GDP Nowcast" puts Q1 GDP at just 0.5% (Chart 1). The New York Fed's "Nowcast" is at 2.7%. Both estimates have been moving consistently lower since early March, dragging down 10-year Treasury yields (with U.S. stock prices along for the ride). Financial markets should be used to weak readings on first quarter GDP by now. Between 1950 and 1996, Q1 GDP was the weakest quarter of the year in just 14 of 47 years, or 30% of the time (Table 1). Q2 growth was stronger than Q1 growth about half the time. This is just about what you would expect if the U.S. Bureau of Economic Analysis' (BEA) seasonal adjustment program was functioning properly. But something has gone awry since 1997, despite the government statisticians' recent attempts to correct the problem. Over the past 20 years, the first quarter has been the weakest GDP reading of the year 10 times, or 50% of the time, and Q2 GDP growth has been faster than Q1 growth 70% of the time. Table 1The Gap Between GDP Growth In Q1 And Q2 Has Widened In The Past 20 Years A recent study by the staff at the Federal Reserve Bank of Cleveland2 suggests that the main culprits in this anomaly are in the private investment and government consumption components of GDP. More specifically, the Cleveland Fed cites defense spending as the key driver of the weakness in Q1 GDP relative to other quarters. We'll expand on this theme in next week's U.S. Investment Strategy report, but for now our view remains that the weakness in U.S. economic growth is temporary. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have backed off of their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in weather-impacted "hard" data like retail sales, housing starts and industrial production. The April update of our Beige Book Monitor, which we introduced last week, confirms that the economy is stronger than the GDP data suggest (Chart 2). The Monitor is simply the difference between the percentage of "strong" versus "weak" descriptors for growth in the document. Chart 2BCA Beige Book Monitor Upbeat For Growth The Monitor edged higher in April to 65%, from 51% in the March reading. "Weather" was mentioned 18 times, after just 6 mentions in March. More than two thirds of the 18 mentions of weather in April cited it as having a negative impact on economic activity. This supports our view that weather had a non-negligible impact on the hard data in March. Thus, if the weather in the first three weeks of April persists into the final week of the month, the stage is set for a noticeable improvement in U.S. economic data released in May. All else equal, this should temper fears that the U.S. economic expansion has lost momentum, supporting stock prices and allowing the recent bond rally to unwind (depending on geopolitics). The soft March CPI also appeared to be quirky, revealing that the core measure actually contracted in March (Chart 3). We note, however, that the weak March reading followed two months of extremely strong gains. In addition, it still appears as though measures of core inflation put in a cyclical bottom in early 2015. While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Our "inflation words" indicator based on the Beige Book remains in an uptrend (Chart 2). Chart 3Has U.S. Inflation Peaked? A rebound in the activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A rate hike in next month is unlikely, but we would not rule out June if the economic data firm as we expect. Positive Signs For U.S. Corporate Pricing Power Another 82 S&P 500 companies report first quarter results this week, making it the busiest week of the season. The consensus for Q1 earnings growth remains near 10% on a 4-quarter trailing basis. That forecast is likely to be met. We highlighted the positive 2017 outlook for U.S. corporate profits in the April 10, 2017 Weekly Report. The U.S. experienced a profit recession in 2016 that did not coincide with an economic recession. Oil prices were part of the story, but we have seen this pattern occur several time since the late 1990s; nominal GDP growth (a proxy for top line growth) decelerates temporarily relative to labor compensation growth. Margins get squeezed but, since the economy manages to avoid a recession, nominal GDP growth subsequently rebounds relative to labor compensation. This resulted in a 'catch up' phase when earnings-per-share growth accelerated sharply and equity returns were favorable. We believe that U.S. earnings are in the same type of catch-up phase now, which has been accentuated by the rebound in oil prices. Proprietary indicators from our sister publication, the U.S. Equity Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart 4). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly based across industries (as shown by the diffusion index in the chart). As a side note, the Proxy provides some evidence that softness in core CPI will not last. At the same time, the upward march of wage growth appears to be taking a breather (Chart 4). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching (perpetually optimistic) bottom-up estimates for 2017 (Chart 5). Chart 4Corporate Sector Gaining ##br##Some Pricing Power Chart 5Profit Model##br## Is Very Bullish Companies have supported per share profits in this expansion in part via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart 6 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same has been true for GDP growth. Chart 6Comparison Of Corporate Outlays Across Four Economic Expansion Phases Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity withdrawal since 2009, which includes the net impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions. Bottom Line: CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Buyback Tailwind To Continue How important are buybacks to EPS growth? Chart 7 (second panel) presents a rough proxy for the historical impact of equity withdrawal that is based on the S&P 500 divisor. It is the difference between EPS growth and growth in total dollar earnings. When the line is above zero, it means that EPS growth has been lifted above dollar earnings growth via equity withdrawals. Chart 7Buybacks Adding Almost ##br##2 Percentage Points To EPS Growth This proxy must be taken with a grain of salt due to the manner in which the divisor is calculated. Nonetheless, it suggests that buybacks have boosted EPS growth by 2 percentage points in the year to 2016Q4. We expect that buyback activity will continue to be a mild tailwind in the coming quarters given the positive reading from our Capital Structure Preference Indicator (Chart 7, third panel). This Indicator is defined as the equity risk premium minus the default adjusted high-yield corporate bond yield. When the indicator is above zero, there is financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The Indicator is currently positive, although not as high as it was in 2015. Bottom Line: Buybacks have not had an outsized impact on EPS growth in this cycle, but the good news is that this tailwind is likely to continue. Capitalization Strategy: Stick With Small Caps The relative performance of U.S. small vs large cap stocks surged following the November election, but has since retraced about two-thirds of its post-election gains and has recently been trading below its 200-day moving average. Small cap stocks have been one of several "Trump trades" that have waned over the past three months, but our view is that several positive tailwinds for small cap relative performance continue to warrant an overweight stance: Panel 1 of Chart 8 highlights that our cyclical capitalization indicator has moved sharply into positive territory following the election, and has remained positive despite the recent weakness in small cap relative performance. Small cap stocks have been a reliably high-beta segment of U.S. capital markets since the middle of the last economic cycle (panel 2), which argues for a bullish stance given our overweight positions in U.S. equities versus bonds. Our relative valuation indicator for U.S. small caps has moved back towards neutral valuation territory, which is a significant change from the conditions that prevailed in the early part of the U.S. economic recovery. Chart 9 shows that the indicator was consistently elevated from 2009 until early-2015, but has since fallen back to zero. While relative prices have accounted for some of this adjustment, the relative (trailing) earnings trend for small cap stocks remains in an uptrend and has recently risen to an all-time high, despite a disappointing Q1. Chart 10 highlights one risk to the small cap trade that will be important to monitor. The chart shows the NFIB's outlook survey along with the percentage of respondents citing "red tape" as the most important problem facing their business. The consistent rise in concerns about red tape under the Obama administration, especially the strong rise that began in 2010, suggests that small firms have found elements of the Affordable Care Act to be particularly burdensome for their business. This suggests that a portion of the sharp rise in the outlook for small businesses following the election has occurred due to expectations that the ACA will be repealed, in turn implying that confidence may wither following the failure of the American Health Care Act (AHCA) to even be subjected to a vote in the House. Chart 8Beta And The Cycle Argue ##br##For Small Caps Chart 9Small Caps Are##br## No Longer Expensive Chart 10Watch The Change Of A "Trump Slump" ##br##In Small Business Sentiment While several planned policies of the Trump administration have indeed been delayed due to the failure of the AHCA, we remain of the view that a legislative agenda that at least appears to be pro-business remains in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation that we noted above. Bottom Line: Cyclical conditions and a significant improvement in relative valuation suggests that investors should continue to favor small over large cap stocks. The failure of the AHCA may cause a near-term pullback in small business confidence, but we doubt that this will be sustained over the coming 6-12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge Vice President, Special Reports jonathanl@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 2 "Lingering Residual Seasonality in GDP Growth," Federal Reserve Bank of Cleveland, March 28, 2017.