Economy
Highlights President Trump is as protectionist as Candidate Trump; USD shortage to tighten global financial conditions; Go Long MXN/RMB as a tactical play on U.S.-China trade war; Brexit risks are now overstated; EU will not twist the knife. EUR/GBP is overbought; go short. Feature "We assembled here today are issuing a new decree to be heard in every city, in every foreign capital, and in every hall of power. From this day forward, a new vision will govern our land. From this moment on, it's going to be America First." U.S. President Donald Trump, January 20, 2017, Inaugural Address What are the investment implications of an "America First" world? First, it may be useful to visualize the "America Second" world that President Trump is looking to leave in the rear-view mirror. Chart 1 shows the cost of hegemony. Since the Nixon shock in 1971, the U.S. has seen its trade balance deepen and its military commitments soar, in absolute terms. For President Donald Trump, the return on American investment has been low. Wasteful wars, crumbling infrastructure, decaying factories, stagnant wages, this is what the U.S. has to show for two decades of hegemony. Chart 1United States: The Cost Of Hegemony On the other hand, the U.S. has enjoyed the exorbitant privilege of its hegemonic position. In at least one major sense, America's allies (and China) are already paying for American hegemony: through their investments in U.S. dollar assets. Chart 2 illustrates this so-called "exorbitant privilege." Despite a deeply negative net international investment position, the U.S. has a positive net investment income.1 Chart 2The "Exorbitant Privilege" Being the global hegemon effectively lowers U.S. borrowing costs and domestic interest rates, giving U.S. policymakers and consumers an "interest rate they do not deserve." That successive administrations decided to waste this privilege on redrawing the map of the Middle East and giving the wealthiest Americans massive tax cuts, instead of rebuilding Middle America, is hardly the fault of the rest of the world! Foreigners hold U.S. assets because of the size of the economy, the sustainability and deep liquidity of the market, and the perceived stability of its political system. More importantly, they hold U.S. assets because the U.S. acts as both a global defender and a consumer of last resort. If Washington were to raise barriers to its markets and become a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and decide to diversify more rapidly. Investors can interpret Trump's "America First" agenda broadly as an effort to dramatically reduce the U.S. current account deficit. Certainly we see his statements on renegotiating NAFTA, facing off against China on trade, and encouraging U.S. exports with tax legislation as parts of a broad effort aimed at improving the U.S. trade balance. If the U.S. were to pursue these protectionist policies aggressively, the end result would be a massive shortage of U.S. dollars globally, a form of global financial tightening. The rest of the world is not blind to the dangers of an America focused on reducing its current account deficit. According to the reporting of Der Spiegel magazine, Chancellor Angela Merkel sent several delegations to meet with the Trump team starting in 2015! No doubt Berlin was nervous hearing candidate Trump's protectionist talk, given that Germany runs one of the largest trade surpluses with the U.S. (Chart 3). In the last such meeting, taking place after the election was decided, Trump's son-in-law and White House advisor, Jared Kushner, asked the Germans a point-blank question, "What can you do for us?"2 In the 1980s, the U.S. asked West Germany and Japan the same question. The result was the 1985 Plaza Accord that engineered the greenback's depreciation versus the deutschmark and the yen (Chart 4). Recent comments from Donald Trump suggest that he would like to follow a similar script, where dollar depreciation does the heavy lifting in adjusting the country's current account deficit.3 Chart 3Trump's Black List Chart 4The Impact Of The Plaza Accord The Trump administration may have dusted off the Reagan playbook from the 1980s, but the world is playing a different game in 2017. First, the Soviet Union no longer exists and certainly no longer has more than 70,000 tanks ready to burst through the "Fulda Gap" towards Frankfurt. President Trump will find China, Germany, and Japan less willing to help the U.S. close its current account deficit, particularly if Trump continues his rhetorical assault on everything from European unity to Japanese security to the One China policy. Second, China, not U.S. allies Germany and Japan, has the largest trade surplus with the U.S. It is very difficult to see Beijing agreeing to a coordinated currency appreciation of the RMB, particularly when it is being threatened with a showdown over Taiwan and the South China Sea. Third, even if China wanted to kowtow to the Trump administration, it is not clear that RMB appreciation can be engineered. The country's capital outflows have swelled to a record level of $205 billion (Chart 5) and the PBoC has continued to inject RMB into the banking system via outright lending to banks and open-market operations (Chart 6). Unlike Japan in 1985, China is at the peak of its leveraging cycle and thus unwilling to see its currency - and domestic interest rates - appreciate. At best, Beijing can continue to fight capital outflows and close its capital account. But even this creates a paradox, since the U.S. administration can accuse it of currency manipulation even if such manipulation is preventing, not enabling, currency depreciation!4 Chart 5China: Unrecorded Capital Outflows Chart 6PBoC Injects Massive Liquidity To conclude, the world is (re)entering a mercantilist era and sits at the Apex of Globalization.5 The new White House is almost singularly focused on bringing the U.S. current account deficit down. It intends to do this by means of three primary tools: Protectionism: The Republicans in the House of Representatives have proposed a "destination-based border adjustment tax," which would effectively subsidize exports and tax imports. (It would levy the corporate tax on the difference between domestic revenues and domestic costs, thus giving a rebate to exporters who make revenues abroad while incurring costs domestically.)6 While the proponents of the new tax system argue it is equivalent to the VAT systems in G7 economies, the change would nonetheless undermine America's role as "the global consumer of last resort." In our view, it would be the opening salvo of a global trade war. Dirigisme: President Trump has not shied away from directly intervening to keep corporate production inside the U.S. He has also insisted on a vague proposal to impose a 35% "border tax" on U.S. corporates that manufacture abroad for domestic consumption. (Details are scant: His Treasury Secretary Steven Mnuchin has denied an across-the-board tax of this nature, but has confirmed that one would apply to specific companies.) Structural Demands: Trump's approach suggests that he wishes to force structural changes on trade surplus economies in order to correct structural imbalances in the American economy - and in this process he is not adverse to lobbing strategic threats. While he holds out the possibility of charging China with currency manipulation, in fact he can draw from a whole sheet of American trade grievances not limited to the currency to demand major changes to their trade relationship. The fundamental problem for the global economy is that in order to reduce the U.S. current account deficit, the world must experience severe global tightening. Dollars held by U.S. multinationals abroad, which finance global credit markets, will come back to the U.S. and tighten liquidity abroad. And emerging market corporate borrowers who have overextended themselves borrowing in U.S. dollars will struggle to repay debts in appreciating dollars. These structural trends are set to exacerbate an already ongoing cyclical process. As BCA's Emerging Markets Strategy has recently pointed out, global demand for U.S. dollars is rising faster than the supply of U.S. dollars.7 Our EM team's first measure of U.S. dollar liquidity is "the sum of the U.S. monetary base and U.S. Treasury securities held in custody for official and international accounts." The second measure "is the sum of the U.S. monetary base and U.S. Treasury securities held by all foreign residents." As Chart 7 and Chart 8 illustrate, both calculations indicate that dollar liquidity is in a precipitous decline already. Meanwhile, foreign official holdings of U.S. Treasury securities is contracting, while the amount of U.S. Treasury securities held by all foreigners has stalled (Chart 9). Chart 7Dollar Liquidity Declining... Chart 8... Any Way You Look At It Chart 9Components Of U.S. Dollar Liquidity Chart 10It Hurts To Borrow In USD Concurrently, U.S. dollar borrowing costs continue to rise (Chart 10). Our EM team expects EM debtors with U.S. dollar liabilities to either repay U.S. dollar debt or hedge it. This will ultimately increase the demand for U.S. dollars in the months ahead. Near-term U.S. dollar appreciation will only reinforce and accelerate the mercantilist push in the White House and Congress. President Trump and the GOP in the House will find common ground on the border-adjustment tax, which Trump recently admitted he did not understand or look favorably upon. The passage of the law, or some such equivalent, has a much greater chance than investors expect. So does a U.S.-China trade war, as we argued last week.8 How should investors position themselves for the confluence of geopolitical, political, and financial factors we have described above? The world is facing both the cyclical liquidity crunch that BCA's Emerging Markets Team has elucidated and the potential for a secular tightening as the Trump administration focuses its efforts on closing the U.S. current account deficit. Five investment implications are top of our mind: Chart 11Market Response To Trump Win On High End Chart 12Market Is Priced For 'Magnificent' Events Buy VIX. The S&P 500 has continued to power on since the election, buoyed by positive economic surprises, strong global earnings, and the hope of a pro-business shift in the White House. The equity market performance puts the Trump presidency in the upper range of post-election market outcomes (Chart 11). However, with 10-year Treasuries back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is pricing none of the political and geopolitical risks of an impending trade war between the U.S. and China, nor is it pricing the general mercantilist shift in Washington D.C. (Chart 12). As a result, we recommend that clients put on a "mercantilist hedge," like deep out-of-the-money S&P 500 puts, or VIX calls. For instance, a long VIX 20/25 call spread for March expiry. Long DM / Short EM. Mercantilism and the U.S. dollar bull market are the worst combination possible for EM risk assets. We therefore reiterate our long-held strategic recommendation of being long developed markets / short emerging markets. Overweight Euro Area Equities. Investors should overweight euro area equities relative to the U.S. As we have discussed in the 2017 Strategic Outlook, political risks in Europe this year are a red herring.9 We will expand on the upcoming French elections in next week's report. Meanwhile, investors appear complacent about protectionism and what it may mean for the S&P 500, which sources 44% of its earnings abroad. European companies, on the other hand, could stand to profit from a China-U.S. trade war. Chart 13Peso Is A Buy Versus Trump's Enemy #1 Chart 14Peso As Cheap As During Tequila Crisis Long MXN/RMB. As a tactical play on the U.S.-China trade war, we recommend clients go long MXN/RMB (Chart 13). The peso is now as cheap as it was in early 1995, at the heights of the Tequila Crisis, as per the BCA's Foreign Exchange Strategy model (Chart 14). While Mexico remains squarely in Trump's crosshairs on immigration and security, the damage to the currency appears to be done and has ironically made the country's exports more competitive. In addition, Trump's pick for Commerce Secretary, Wilbur Ross, has informed his NAFTA counterparts that "rules of origin" will be central to NAFTA re-negotiation. This can be interpreted as the U.S. using every tool at its disposal to impose punitive measures on China, including forcing NAFTA partners to close off the "rules of origin" loophole.10 But the reality is that the U.S. trade deficit with its NAFTA partners is far less daunting than that with China (Chart 15). Meanwhile, we remain negative on the RMB for fundamental reasons that we have stressed in our research. Small Is Beautiful. We continue to recommend that clients find protection from rising protectionism in small caps. Small caps are traditionally domestically geared irrespective of their domicile. Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, also points out that small caps in the U.S. will benefit as the new administration follows through with promised corporate tax cuts, which will benefit small caps disproportionally to large caps given that the effective tax rate of multinationals is already low. Moreover, small companies will benefit most from any cuts in regulations, most of which have been written by multinationals in order to create barriers to entry (Chart 16). Of course, we could just be paranoid! After all, much of Trump's proposed policies - massive tax cuts, infrastructure spending, major rearmament, the border wall - would increase domestic spending and thus widen the current account deficit, not shrink it. And all the protectionism and de-globalization could just be posturing by the Trump administration, both to get a better deal from China and Europe and to give voters in the Midwest some political red meat. Chart 15China, Not NAFTA, In Trump's Crosshairs Chart 16Small Is Beautiful But Geopolitical Strategy analysts get paid to be paranoid! And we worry that much of Trump's promises that would widen U.S. deficits are being watered down or pushed to the background. Yes, we have held a high conviction view that infrastructure spending would come through, but now it appears that it will be complemented with significant spending cuts. The next 100 days will tell us which prerogatives the Trump Administration favors: rebuilding America directly, or doing so indirectly via protectionism. If the former, then the current market rally is justified. If the intention is to reduce the current account deficit, look out. Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Brexit: A Brave New World Miranda: O brave new world! Prospero: 'Tis new to thee. — Shakespeare, The Tempest The U.K. Supreme Court ruled on January 24 that parliament must have a say in triggering Article 50 of the Lisbon Treaty, which enables the U.K. to "exit" the European Union. This decision, as well as Theresa May's January 17 "Brexit means exit" speech, caught us in London while visiting clients. Reactions were mixed. The pound continues to rally. January 16 remains the low point in the GBP/USD cross since the vote to leave on June 23 last year (Chart 17). Chart 17Has Brexit Uncertainty Bottomed? Should investors expect more downside to the pound or do the recent events mark a bottom in political uncertainty? The market consensus suggests that further volatility in the pound is warranted for three reasons: Europeans will seek to punish the U.K. for Brexit, to set an example to their own Euroskeptics; Prime Minister May's assertion that the U.K. would seek to exit the common market is negative for the country's economy; Legal uncertainties about Brexit remain. We disagree with this assessment, at least in the short and medium term. Therefore, the pound rally on the day of May's speech was warranted, although we agree that exiting the EU Common Market will ultimately be suboptimal for the country's economy. First, by setting out a clean break from the EU, including the common market, Prime Minister May has removed a considerable amount of political uncertainty. As we pointed out in our original net assessment of Brexit, leaving the EU while remaining in its common market is illogical.11 Paradoxically, the U.K. stood to lose rather than regain sovereignty if it left the EU yet remained in the common market (Diagram 1). Diagram 1The Quite Un-British Lack Of Common Sense Behind Soft Brexit Why? Because membership in the common market entails a financial burden, full adoption of the acquis communautaire (the EU body of law), and acceptance of the "Four Freedoms," including the freedom of movement of workers. Given that the Brexit vote was largely motivated by concerns of sovereignty and immigration (Chart 18), it did not make sense to vote to leave the EU and then seek to retain membership in the common market. Apparently May and her cabinet agree. Chart 18It's Sovereignty, Stupid! Second, now that the U.K. has chosen to depart from the common market, the EU no longer needs to take as hostile of a negotiating position as before. The EU member states were not going to let the U.K. dictate its own terms of membership. That would have set a precedent for future Euroskeptic governments looking for an alternative relationship with the bloc, i.e. the so-called "Europe, à la carte" that European policymakers dread. But now that the U.K. is asking for a clean exit, with a free trade agreement to be negotiated in lieu of common market membership, the EU has less reason to punish London. An FTA arrangement will be beneficial to EU exporters, who want access to the U.K. market, and it will send a message to Euroskeptics on the continent that there is no alternative to full membership. Leaving the EU means leaving the market and falling back - at best - to an FTA-level relationship that the EU shares with Mexico and (most recently) Canada. Third, leaving the EU and the common market are political, not legal, decisions, and the lingering legal battles are neither avoidable nor likely to be substantive. Theresa May had already stolen thunder when she said that the final deal with the EU would be put to a vote in parliament. The Supreme Court ruling - as well as other legal hangups - could conceivably give rise to complications that bind the government's hands, but most likely parliament will pass a simple bill or motion granting permission for the government to invoke Article 50. That is because the referendum, and public opinion since then, speak loud and clear (Chart 19). The Conservative Party remains in a comfortable lead over the Labour Party (Chart 20), which itself is not opposing the referendum outcome. In addition, the House of Commons has already approved the government's Brexit timetable by a margin of 372 seats in a 650-seat body - with 461 ayes. That is a stark contrast with a few months ago when around 494 MPs were said to be against Brexit. Chart 19No 'Bremorse' Or 'Bregret' Chart 20Tories Still Triumphant The bigger question comes down to the parliamentary vote on the deal that is to be negotiated over the next two years. Could the Parliament vote down the final agreement with the EU? Absolutely. However, it is unlikely. The economic calamity predicted by many commentators has not happened, as we discuss below. Bottom Line: The combination of the Supreme Court decision and Prime Minister May's speech has reduced political uncertainty regarding Brexit. The EU will negotiate hard with the U.K., but the main cause of consternation - the U.K. asking for special treatment with respect to the common market - is now off the table. Yes, the EU does hold all the cards when it comes to negotiating an FTA agreement, and the process could entail some alarming twists and turns (given the last-minute crisis in the EU-Canada FTA). But we do not expect EU-U.K. negotiations to imperil the pound dramatically beyond what we've already seen. Will Leaving The Common Market Hurt Britain? Does this mean that Brexit is "much ado about nothing?" In the short and medium term, we think the answer is yes. In the long-term, leaving the EU Common Market is a suboptimal outcome for three reasons: Trade - Net exports rarely contribute positively to U.K. growth (Chart 21) and the trade deficit with the EU is particularly deep. As such, proponents of Brexit claim that putting up modest trade barriers against the EU could be beneficial. However, the U.K. has a services trade surplus with the EU (Chart 22). While it is not as large as the trade deficit, there was hope that the eventual implementation of the 2006 EU's Services Directive would have opened up new markets for U.K.'s highly competitive services industry and thus reduced the trade deficit over time. As the bottom panel of Chart 22 shows, the U.K.'s service exports to the rest of the world have outpaced those to the EU, suggesting that there is much room for improvement. This hope is now dashed and the EU may go back to putting up non-tariff barriers to services that reverse Britain's modest surplus with the bloc. Free Trade Agreements rarely adequately cover services, which means that the U.K.'s hope of expanding service exports to a new high is probably gone. Chart 21U.K. Is Consumer-Driven Chart 22Service Exports At Risk After Brexit Foreign Investment - FDI is declining, whether for cyclical reasons or because foreign companies fear losing access to Europe via the U.K. It remains to be seen how FDI will respond to the U.K.'s renunciation of the common market, but it is unlikely to be positive (Chart 23). The U.K.'s financial sector will also be negatively impacted since leaving the common market will mean that London will no longer have recourse to the EU judiciary in order to stymie European protectionism.12 This is unlikely to destroy London's status as the global financial center, but it will impact FDI on the margin. Labor Growth - The loss of labor inflow will be the biggest cost of Brexit. A decrease of immigration from the EU could reduce the U.K.'s labor force growth by a maximum of two-thirds, translating to a 25% loss in the potential GDP growth rate (Chart 24). While the U.K. is not, in fact, closing off all immigration, labor-force growth will decline, and potential GDP with it. Chart 23FDI To Suffer From Brexit? Chart 24Labor Growth Suffers Most From Brexit In addition, the EU Common Market forces companies to compete for market share in the developed world's largest consumer market. This competition is supposed to accelerate creative destruction and thus productivity, while giving the winners of the competition the spoils, i.e. a better ability to establish "economies of scale." In a 2011 report, the Bank of International Settlements (BIS) published an econometric study that compared four scenarios: the U.K. remains in the common market as the EU fully liberalizes trade; the U.K. remains in the EU's single market, but does not fully liberalize trade with the rest of the EU; the U.K. leaves the common market; the U.K. enters NAFTA.13 Of the four scenarios, only the first leads to an increase in wealth for the U.K., with 7.1% additional GDP over ten years. U.K. exports would increase by 47%, against 38.1% for its imports. Wages of both skilled and unskilled workers would increase as well. Meanwhile, the report finds that closer integration with NAFTA would not compensate for looser U.K. ties with the EU. In fact, the U.K. national income would be 7.4% smaller if the U.K. tied up with NAFTA instead of taking part in further trade liberalization on the continent. Why rely on a 2011 report for the assessment of benefits of the common market? Because it was written by a competent, relatively unbiased international body and predates the highly politicized environment surrounding Brexit that has since infected almost all think-tank research. And yet the more recent research echoes the 2011 report in terms of the negative consequences of leaving the common market.14 In addition, the BIS study actually attempts to forecast the benefit of further removing trade barriers in the single market, which is at least the intention of the EU Commission. That said, our concerns regarding the U.K. economy are long-term. It may take years before the full economic impact of leaving the common market can be assessed. In addition, much of our analysis hinges on the Europeans fully liberalizing the common market and removing the last remaining non-tariff barriers to trade, particularly of services. At the present-day level of liberalization, the U.K. may benefit by leaving. In addition, we do not expect a balance-of-payments crisis in the U.K. any time soon. The U.K. current account is deeply negative, unsurprisingly so given the deep trade imbalance with the EU and world. However, our colleague Mathieu Savary, Vice-President of BCA's Foreign Exchange Strategy, has pointed out that the elasticity of imports to the pound is in fact negative, a very surprising result. This reflects an extremely elevated import content of British exports. A lower pound is therefore unlikely to be the most crucial means of improving the current-account position. Certainly leaving the common market will not improve the competitiveness of British exports in the EU. Chart 25The U.K.'s Basic Balance Is Healthy But this raises a bigger question: why does the U.K. have to improve its current account deficit? As our FX team points out in Chart 25, despite having a current-account deficit of nearly 6% of GDP, the U.K. runs a basic balance-of-payments surplus of 12%, even after the recent fall in FDI inflows. The reason for the massive balance-of-payments surplus is the financial account surplus of 6.17% of GDP, a feature of the U.K. being a destination for foreign capital, which flows from its status as a global financial center and prime real estate destination. In other words, leaving the common market will not change the fundamentals of the U.K. balance of payments much. The country will remain a global financial center and will still run a capital account surplus, which will suppress the country's interest rates, buoy the GBP, and give tailwinds to imports of foreign goods. Meanwhile, exports will not benefit as they will face marginally higher tariffs as the country exits the EU Common Market. At best, new tariffs will be offset by a cheaper GBP. As such, leaving the common market is not going to be a disaster for the U.K. Nor will it be a panacea for the country's deep current account deficit. And that is okay. The U.K. will not face a crisis in funding its current account deficit. What is clear is that for the time being, the U.K. economy is holding up. Our forex strategists recently argued that U.K.'s growth has surprised to the upside and that the improvement is sustainable: Monetary and fiscal policy are both accommodative (Chart 26); Inflation is limited; Tight labor market drives up wages and puts cash in consumers' pockets (Chart 27); Credit growth remains robust (Chart 28). Chart 26Easy Money Smooths The Way To Brexit Chart 27British Labor Market Tightening Chart 28U.K. Credit Growth Looking Good This means that the political trajectory is set for the time being. "Bremorse" and "Bregret" will remain phantoms for the time being. Bottom Line: Leaving the common market is a suboptimal but not apocalyptic outcome for the U.K. The combination of decent economic performance and lowered political uncertainty in the near term will support the pound. Given the pound's 20% correction since the June referendum, we believe that the market has already priced in the new, marginally negative, post-Brexit paradigm. The Big Picture It is impossible to say whether the long-term negative economic effects of Brexit will affect voters drastically enough and quickly enough for Scotland, or parliament, to act in 2018 or 2019 and modify the government's decision to pursue a "Hard Brexit." It seems conceivable if something changes in the fundamental dynamics outlined above, but we wouldn't bet on it. At the moment even a new Scottish referendum appears unlikely (Chart 29). Scottish voters have soured on independence, perhaps due to a combination of continued political uncertainty in the EU (Scotland's political alternative to the U.K.) and a collapse in oil prices (arguably Scotland's economic alternative to the U.K.). The issue is not resolved but on ice for the time being. Chart 29Brexit Not Driving Scots To Independence (Yet) More likely, the government will get its way on Brexit and the 2020 elections will mark a significant popular test of the Conservative leadership and the final deal with the EU. Then the aftermath will be an entirely new ballgame for the U.K. and all four of its constituent nations. If Britain's new beginning is founded on protectionism and dirigisme - as the government suggests - then the public is likely to be disappointed. The "brave new world" of Brexit may prove to be rather mundane, disappointing, and eerily reminiscent of the ghastly 1970s.15 Hence the Shakespeare quote at the top of this report. The political circumstances of Brexit resemble the U.K. landscape before it joined the European Economic Community in 1973: greater government role in the economy, trade protectionism, tight labor market, higher wages, and inflation. Yet this was a period when the U.K. economy underperformed Europe's. The U.K.'s eventual era of outperformance was contingent on the structural reforms of the Thatcher era and expanded access to the European market (Chart 30). It remains to be seen what happens when the U.K. leaves the market and rolls back Thatcherite reforms. The weak pound and proactive fiscal policy will fail to create a manufacturing revolution. That is because most manufacturing has hollowed out because of automation, not foreign workers stealing Britons' jobs. Moreover, as for the pound, it is important to remember that currency effects are temporary and any boost to exports that the weak pound is generating will be short-lived, as with the case of China in the 1990s and the EU in the past two years (Chart 31). Chart 30U.K. Growth To Lag Europe's Once Again? Chart 31Export Boost From Devaluation Is Fleeting In addition, we would argue that, in an environment of de-globalization - in which tariffs are rising, albeit slowly for the time being (Chart 32) - the EU Common Market provides Europe with a mechanism by which to protect its vast consumer market. The U.K. may have chosen the precisely wrong time in which to abandon the protection of continental European protectionism. It could suffer by finding itself on the outside of the common market as global tariffs begin to rise significantly. Chart 32Protectionism On The March What about the restoration of the "Special Relationship" between the U.K. and the U.S.? Could moving to the "front of the queue" on negotiating an FTA with the world's largest economy make a difference for the U.K.? Perhaps, but as the BIS study above indicates, an FTA with North America or the U.S. alone is unlikely to replace the benefits of the common market. In addition, it is difficult to imagine how a protectionist U.S. administration that is looking to massively decrease its current account deficit will help the U.K. expand trade with the U.S. By contrast, Trump's election in the United States poses massive risks to globalization, both through his protectionism and the strong USD implications of his core policies. This will reverberate negatively across the commodities and EM space. In such an environment, the U.K. may not be able to make much headway in its "Global Britain" initiatives to conclude fast trade deals with EM economies that stand to lose the most in the de-globalization era. Bottom Line: As a trading nation, the U.K. is likely to lose out in a prolonged period of de-globalization. Membership in the EU could have served as a bulwark against this global trend. Investment Implications We diverge from our colleagues in the Foreign Exchange Strategy and European Investment Strategy when it comes to the assessment of political risk looming over Brexit.16 The decision to leave the common market will alleviate the pressure on Europeans to seek vindictive punishment. Earlier, the U.K. was forcing them to choose between making an exception to the rules and demonstrating the negative consequences of leaving the bloc. Now the U.K. is self-evidently taking on its own punishment - the economic burden of leaving the common market - and the EU will probably deem that sufficient. Will the EU play tough? Yes, especially since the EU retains considerable economic leverage over Britain (Chart 33). But the stakes are far smaller now. Furthermore, investors should remember that core European states - especially France and Germany - remain major military allies of the U.K. and will continue to be deeply intertwined economically. As such, we believe that the pound has already priced in the new economic paradigm and that the expectations of political uncertainty ahead of the U.K.-EU negotiations may be overdone. We therefore recommend that investors short EUR/GBP outright. Our aforementioned forex strategist Mathieu Savary argues that, on an intermediate-term basis, the outlook for this cross is driven by interest rate differentials and policy considerations. Due to the balance-sheet operations conducted by the BoE and ECB, interest rates in the U.K. and the euro area do not fully reflect domestic policy stances. Instead, Mathieu uses the shadow rates. Currently, shadow rates unequivocally point toward a lower EUR/GBP (Chart 34). In fact, balance-sheet dynamics point toward shorting EUR/GBP. Chart 33EU Holds The Cards In FTA Negotiation Chart 34Shadow Rates Point To Stronger GBP For full disclosure, Mathieu cautions clients to wait on executing a short EUR/GBP until after Article 50 is enacted. By contrast, we think that political uncertainty regarding Brexit likely peaked on January 16. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com 1 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive a much lower return on U.S. assets while the U.S. benefits from risk premia in foreign markets. 2 Please see Spiegel Online, "Donald Trump and the New World Order," dated January 20, 2017, available at Spiegel.de. 3 In a widely-quoted interview with The Wall Street Journal, Donald Trump said that the U.S. dollar is "too strong." He continued that, "Our companies can't compete with [China] now because our currency is too strong. And it's killing us." Please see The Wall Street Journal, "Donald Trump Warns on House Republican Tax Plan," dated January 16, 2017, available at wsj.com. 4 We would note that the Trump administration and its Treasury Department have considerable leeway over how they choose to interpret China's foreign exchange practices. In 1992, when the U.S. government last accused China of currency manipulation, it issued a warning in its spring report before leveling the accusation in the winter report. The RMB did not depreciate in the meantime but remained stable, and Treasury noted this approvingly; however, Treasury chose 1989 as the base level for its assessment, and found manipulation. The Trump administration could use much more aggressive interpretive methods than this to achieve its ends. 5 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, and Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 14, 2014, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "The U.S. Dollar's Uptrend And China's Options," dated January 11, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 10 Critics, including Trump supporters, claim that NAFTA sets too low of a threshold for the domestic content of a good deemed to have originated within the NAFTA countries. Goods that are nearly 40% foreign-made can thus be treated as NAFTA-made. This is one of many contentious points in the trade deal. 11 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 12 In 2015, the U.K. took the ECB to court over its decision to require financial transactions denominated in euros to be conducted in the euro area, i.e. out of the City, and won. This avenue of legal redress will no longer be available for the U.K., allowing EU member states to slowly introduce rules and regulations that corral the financial industry - or at least to the parts focused on transactions in euros - out of London. 13 Please see Bank of International Settlements, "The economic consequences for the U.K. and the EU of completing the Single Market," BIS Economics Paper No. 11, dated February 2011, available at www.gov.uk. 14 Please see Her Majesty's Government, "H.M. Treasury Analysis: The Long-Term Economic Impact Of EU Membership And The Alternatives," Cmnd. 9250, April 2016, available at www.gov.uk. and Jagjit S. Chadha, "The Referendum Blues: Shocking The System," National Institute Economic Review 237 (August 2016), available at www.niesr.ac.uk. 15 We were going to use "grey" to describe Britain in the 1970s. However, our colleague Martin Barnes, BCA's Chief Economist, insisted that "grey" did not do the "ghastly" 1970s justice. When it comes to the U.K. in the 1970s, we are going to defer to Martin. 16 Please see BCA Research European Investment Strategy Weekly Report, “May’s Brexit Speech: No Substance,” dated January 19, 2017, available at eis.bcaresearch.com. Geopolitical Calendar
Highlights Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. The global inflationary versus deflationary impact of U.S. trade protectionism will depend on the magnitude of exchange rate adjustments. Currencies will adjust to redistribute the inflationary and deflationary impact of U.S. tariffs and Border Adjustment Taxes between the U.S. and the rest of the world. Go long three-month volatility in the KRW, the MYR and the THB. The Turkish lira has approached our target of TRY/USD 3.9. Investors should book profits for now and reinstate short if the lira rebounds to 3.5 Feature Chart I-1Are Share Prices Discounting ##br##U.S. Trade Protectionism? The odds of a considerable rise in U.S. trade protectionism have ratcheted up since President Donald Trump's victory in early November, yet global share prices have been sanguine about it. Equities have instead focused on the positives of Trump's agenda such as fiscal stimulus and deregulation. Does this mean that the marketplace is overly complacent? One can argue that potential trade wars are a well-known risk, and as such are already discounted in share prices. It is also possible to argue that the equity markets did not fall at all ahead of and following Trump's victory to discount potential negatives from trade protectionism. The only market that has reacted to discount looming trade restrictions is Mexico, specifically the peso and its fixed-income markets. However, the ramifications of U.S. trade protectionism will reverberate well beyond Mexico. Global ex-U.S. share prices have not corrected at all to discount the potential negatives (Chart I-1). Unless the U.S. dollar surges, U.S. manufacturers will likely benefit from protectionist measures. However, U.S inflation and interest rates will rise in this scenario, weighing on equity valuation multiples. Overall, the majority of America's trade partners are at risk. In this week's report, we assess the vulnerability of various EM countries to the U.S. trade assault. U.S. trade restrictions will take the form of either import tariffs, a Border Adjustment Tax (BAT),1 or a mix of both. We conclude that buying volatility of select EM currencies is one way to profit from budding U.S. protectionism. Vulnerability To A U.S. Trade Assault Below we analyze which EM economies are most at risk from U.S. import tariffs and BAT. Given it is impossible to know whether the U.S. will adopt import tariffs, a BAT, or some combination of the two, we evaluate the impact on developing countries from both measures. Import tariffs: To assess each country's exposure to potential import tariffs, we examine the size of export shipments to America relative to that country's GDP. Table I-1 shows that Mexico, Canada, Malaysia, Taiwan and Thailand have the largest exports to the U.S. as a share of their economy. For Mexico, Canada and Malaysia, we exclude oil shipments to the U.S., as it is not clear whether oil will be subject to import tariffs. BAT: The principal variable gauging a country's vulnerability to a BAT is its trade balance with the U.S. This is because a BAT is both a penalty on imports into the U.S. as well as a subsidy on American exports. Hence, this analysis has to take into consideration not only a country's shipments to the U.S. but also American producers' exports to that country. Table I-2 shows the size of each country's trade balance with the U.S. as a share of its GDP. Table I-1Vulnerability To U.S. Import Tariffs Table I-2Vulnerability To BATs Again, for Mexico, Canada and Malaysia, we exclude the oil trade balance with the U.S. from the calculation. 3. Combined vulnerability ranking. Lack of clarity on trade policy specifics the U.S. is going to adopt means that we may need to synthesize the above analysis, combining the vulnerability ranking on both measures into one. Chart I-2 plots trade balances on the X axis and exports to the U.S. on the Y axis. It appears Malaysia, Mexico, Taiwan and Thailand are the most vulnerable, based on both criteria. Chart I-2Vulnerability To U.S. Import Tariffs And Border Adjustment Taxes Another way to generate a vulnerability ranking is to calculate an aggregate score based on Tables I-1 and I-2 because either import tariffs, a BAT or some combination of the two will be adopted by the U.S. The aggregate vulnerability score is presented in Chart I-3. Chart I-3U.S. Trade Protectionism Vulnerability Ranking According to the overall vulnerability score, Mexico, Malaysia, Taiwan, Thailand and Korea are the most exposed to potential U.S. trade protectionism measures. By contrast, Turkey, Brazil and Chile are the least exposed. Bottom Line: Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. On the flip side, Turkey and Brazil are the least exposed to a U.S. trade assault. We remain short many EM exchange rates versus the U.S. dollar including the Malaysian, Korean and Colombian currencies, and reiterate these positions today. Traders who are not positioned this way or have been stopped out should consider reinstating these trades (the full list of our currency recommendations). As for the Mexican peso, it has undershot relative to other EM currencies. We have not been bullish on the MXN versus the USD, though in recent months have recommended going long the MXN versus the BRL and ZAR. These trades have so far produced large losses, but we expect the MXN to recover some of those losses on its crosses. Are Trade Barriers Inflationary Or Deflationary? We consider three scenarios: Chart I-4U.S.: Rising Unit Labor Costs ##br##Warrant Higher Core Inflation 1. Without an exchange rate adjustment (U.S. dollar appreciation), import tariffs and BATs will be inflationary for the U.S. and deflationary for the rest of the world. In this scenario, the prices of imported goods will rise in U.S. dollars and U.S. consumers will end up paying for the tariff/border taxes or exporters will see their U.S. dollar revenues plummet or some combination of the two. U.S. manufacturers will become competitive with higher prices of imported goods, and U.S. employment and resource utilization will mount, heightening domestic inflationary pressures. Even though non-energy imports make up only 11% of U.S. GDP, the inflationary impact of trade protectionism will be pervasive. The reason being that it will tighten the resource utilization in the American economy in general, and the labor market in particular. Currently, the U.S. labor market is tight, wages are accelerating and unit labor costs are rising (Chart I-4). Further strength in demand due to potential fiscal stimulus, import substitution, and a further revival of confidence, will lead to even higher wage inflation and an acceleration in unit labor costs. This, along with rising prices for imported goods, will produce higher inflation. That said, it is likely that American consumers cannot handle a drastic price hike in imported goods, so higher selling prices will entail less demand. For the rest of the world, the same scenario will be very deflationary. Countries with large exports to the U.S. will experience a plunge in their shipments to America, income/profit growth will tank, and domestic demand will dwindle. In aggregate, this scenario will be inflationary for the U.S. and deflationary for the rest of the world - there will be meaningful losses in global output. 2. With "full" exchange rate adjustments, the import tariffs and BATs will be neutral for the U.S. and the rest of the world. But for this to occur, the U.S. dollar has to overshoot. Chart I-5Exchange Rates Have##br## Made A Difference In this scenario, imported goods prices in U.S. dollars will remain the same, given tariffs/BATs are entirely offset by a strong dollar. For exporters, their U.S. dollar revenues will plunge but their currency depreciation will restore the value of shipments to the U.S. in local currency terms (Chart I-5). In brief, the "full" currency depreciation will reflate exporter economies in local currency terms. Given that the rate of tariffs or BATs will likely exceed 15-20%, potential U.S. dollar appreciation will need to be dramatic to produce this scenario. In turn, the considerable dollar appreciation will cap inflationary pressures in the U.S. There will be little, if any, impact on global output. 3. With "partial" exchange rate adjustment (moderate dollar appreciation), the impact of tariffs or BATs will be split between U.S. consumers facing somewhat higher prices for imports and exporters who will suffer declines in revenues in local currency terms, though not as much as in the case of no currency deprecation. Consequently, this scenario will be mildly inflationary for the U.S. and modestly deflationary for the rest of the world. Yet, there will also be a small loss of global output - i.e., global GDP growth will be negatively impacted. Odds favor scenarios two and three - i.e., the greenback is set to appreciate, but it is not clear whether it will rise enough to entirely offset the impact of import tariffs or BATs and preclude decline in global growth. Bottom Line: The inflationary versus deflationary impact of U.S. trade protectionism will depend on exchange rate adjustments and their magnitude - i.e., currencies will move to redistribute the inflationary and deflationary impact of U.S. tariffs and BATs. Overall, the U.S. dollar is set to appreciate meaningfully and probably overshoot before topping out. Go Long EM FX Volatility Given central banks outside the U.S. - both in DM ex-U.S. and EM - are attempting to keep interest rates low, odds favor considerable appreciation in the U.S. dollar, or at least a material rise in exchange rate implied volatility. When monetary authorities control interest rates, the entire burden of adjustment falls on exchange rates. In brief, exchange rates have to move a lot - the U.S. dollar would have to overshoot - to prevent a hit to global output. Investors should consider betting on higher exchange rate volatility. In spite of rising odds of U.S. trade protectionism, EM and DM currency volatility has so far remained surprisingly tame (Chart I-6). We feel there is a trade opportunity here, and today we recommend investors go long select EM exchange rate volatilities. Chart I-7 plots the U.S. trade vulnerability score on the X axis, and exchange rate volatility - more specifically, the standardized 3-month implied currency volatility - on the Y axis. According to Chart I-7, it appears that by historical standards, the current level of volatility of MYR, THB and KRW are low when considering these countries' vulnerability to U.S. trade protectionism. Therefore, investors should go long 3-month implied volatility for the KRW, the MYR and the THB. Chart I-6Exchange Rate Volatility In ##br##Historical Perspective Chart I-7Go Long Currency VOLs in Korea, ##br##Malaysia, And Thailand In addition, the volatility in these Asian currencies will rise and the RMB depreciate further. Bottom Line: To capitalize on a potential rise in global currency volatility, traders should go long three-month volatility in the KRW, the MYR and the THB. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Taking Profits On Turkish Shorts For Now In our December 7, 2016 Special Report 2 we argued that the odds of the lira being vigorously defended by the authorities or some sort of capital controls being implemented in Turkey would increase as the exchange rate approached USD/TRY 3.9. Given the exchange rate has come close to that level, we recommend that traders book profits on our Turkish short positions. The idea is to protect profits and capital in the case of capital controls. It is impossible to know whether the Turkish authorities will opt for capital controls, as it is a political decision. Yet, the risk is non-trivial. Furthermore, the rhetoric from Turkish President Recep Tayyip Erdogan suggests3 he views foreign investors as the main culprits for the nation's current financial debacle. President Erdogan will not shy away from hurting foreign investors via the introduction of capital controls and create the perception of financial stability. The central bank has been very active in recent weeks. Apart from hiking the overnight lending rate this week, it has recently curtailed liquidity injections into the banking system: Chart II-1Turkey: A Decline in Liquidity Provision On January 10, the Central Bank of Turkey (CBT) announced that it will place borrowing limits of TRY $22 billion in the Interbank Money Market, effectively limiting the volume of liquidity the central bank provides to commercial banks. Given the lira continued to slide, three days later, the CBT decided to move the interbank money market borrowing limit even lower at TRY $11 billion, effective January 16. That said, since January 10, the CBT has injected TRY $9.5 billion, on average per day, via the overnight window, and TRY $27 billion via the late liquidity window, albeit at higher interest rates than at the overnight window. Hence, the CBT has still injected a meaningful amount of liquidity into the banking system, but it has done so at higher interest rates. All in all, the CBT has curtailed liquidity injections in order to avoid further lira depreciation (Chart II-1, top panel). As a result, interest rates have risen sharply (Chart II-1, bottom panel). Yet, it is not certain that the central bank has tightened liquidity enough. Going forward, there are two main risks: either the CBT's liquidity tightening will be too little, and therefore the lira will continue to plunge, or, there will be considerable liquidity tightening, which will stabilize the exchange rate, but cascade the economy into major recession. Both scenarios are bearish for foreign investors holding Turkish stocks and credit. As we have discussed at length in previous reports, monetary authorities can control either the exchange rate or interest rates, but not both simultaneously. The CBT has been trying unsuccessfully to exercise control over both. To stabilize the exchange rate, the CBT has to drastically curtail its injections of local currency liquidity into the system. In such a case, however, interest rates will surge. Continued attempts to cap interest rates entail a further collapse in the lira's value. The only other option is to introduce capital control (i.e. close the capital account) in order to get control over both interest rates and the currency. Higher interest rates are not politically acceptable, as they will push the economy into deep recession. The reason being that domestic credit growth has been enormous in recent years, and higher interest rates will suffocate the economy. Yet not hiking the policy rate, or allowing interbank interest rates to rise, will all but ensure a deeper crash in the exchange rate. With the industrial sector already showing signs of weakness and the consumer sector flat, a decrease in loan growth will send the already weak economy into recession (Chart II-2). Yet, mushrooming money and credit growth, along with very high inflation in Turkey, justify higher interest rates: Local currency money and credit growth is too strong (Chart II-3). Unless these slow down, the lira will continue to decline. Chart II-2Turkey: Economy Is Heading##br## Into Recession Chart II-3Money/Credit Creation ##br##Has Been Too Rampant Genuine inflationary pressures are too ubiquitous: manufacturing and service sector wages have grown by about 20% over the past 12 months (Chart II-4). In brief, such genuinely high inflation, coupled with still low rates, are bearish for the currency. Robust credit and income/wage growth are supporting import demand, and the current account deficit is wide. This is another bearish factor for the exchange rate. In short, the lira has further room to fall. Remarkably, according to the real effective exchange rates based on unit labor costs as well as consumer prices, the lira is still not very cheap, making it vulnerable to further depreciation (Chart II-5) Chart II-4Turkey: 20% Wage Inflation Chart II-5The Turkish Lira Can Get Cheaper Even more surprising, despite a more than 20% depreciation against the U.S. dollar last year, foreign investors' holdings of Turkish equities and government bonds has not dropped significantly (Chart II-6). Finally, bank share prices in local currency terms have risen despite the spike in interest rates (Chart II-7). This entails that this bourse, which is dominated by bank stocks, is not pricing in risks from higher interest rates. Chart II-6Will Foreigners Capitulate On Turkish Assets? Chart II-7Bank Share Prices Have Held Up So Far Investment Recommendations: Currency and fixed income traders should take profits on our short TRY / long USD trade, as well as our short 2-year Turkish bond trade. These have returned a 24% and a 20%, respectively, since January 17, 2011 and June 1, 2016. That said, investors should consider shorting the lira versus the U.S. dollar again if the exchange rate rebounds to TRY/USD 3.5. We recommend equity traders book profits on our short Turkish banks position, which has registered a return of 60% since June 4, 2013. Dedicated EM equity and fixed income investors (both credit and local-currency bonds) should continue to underweight Turkey. Absolute-return and non-dedicated EM investors should minimize their exposure to Turkish financial markets. Stephan Gabillard, Research Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Global Investment Strategy Special Report, titled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017", dated January 20, 2017, available at www.gis.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report, titled "Turkey: Military Adventurism And Capital Controls", dated December 7, 2016 available at ems.bcaresearch.com 3 President Erdogan, speaking at the 34th meeting with village chiefs at the Presidential Palace in Ankara, said "Everyone already sees and knows the attacks that Turkey has been subjected to also have an economic aspect. There is no difference between a terrorist who has a weapon or bomb in his hand and a terrorist who has dollars, euros and interest in terms of aim. The aim is to bring Turkey to its knees, to take over Turkey and to distance Turkey from its goals. They are using the foreign exchange rate as a weapon". Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Inflation: Inflation will trend higher this year, but at a measured pace. The impact of a tight labor market and accelerating wage growth will be mitigated by deflating import prices. Even if the economic recovery remains on track, year-over-year core PCE inflation is likely to still be below the Fed's 2% target by the end of this year. Yield Curve: With core inflation still low, the Fed will be quick to back away from its rate hike plans if there is any indication that inflation might reverse its uptrend. This supports a bear-steepening of the yield curve and the continued outperformance of TIPS versus nominal Treasuries. Spread Product: Excess returns to spread product are not likely to turn deeply negative until core PCE inflation is above 2% and Fed policy becomes more focused on halting inflation than supporting the recovery. We retain a neutral allocation to spread product in our portfolio. Feature Chart 1A Sustainable Recovery After seven years of false starts and disappointments, a durable recovery in inflation is finally under way (Chart 1). The key difference between the current uptrend and prior episodes of rising inflation - such as those witnessed in 2011 and 2014 - is that this time around most labor market indicators suggest the economy is very close to full employment. For this reason the recovery in core inflation is likely to persist, and will eventually settle at a level close to the Fed's 2% target for core PCE. That being said, it is still far too soon for investors to worry about inflation, particularly as it relates to the performance of risk assets. The remainder of this report discusses why the recovery in inflation is likely to be slow moving, and also how the inflation outlook impacts our major fixed income investment calls. Some Near-Term Headwinds There are two reasons why year-over-year measures of core inflation are likely to moderate during the next three months. First, diffusion indexes for both CPI and PCE inflation have recently dipped below the zero line (Chart 2), meaning that more components of each index have decelerating prices than have accelerating prices. Historically, rising year-over-year core inflation has been associated with diffusion indexes above zero. Second, January and February of last year saw incredibly large price increases in both core CPI and core PCE (Chart 3). This means that gains in January and February of this year will also have to be very strong to overcome the large base effect and cause the year-over-year growth rates to move higher. Chart 2Diffusion Indexes Point To Deceleration Chart 3A Large Base Effect In Jan & Feb Now these are only very short term arguments. The base effects will be out of the way by March and diffusion indexes can reverse course very quickly. However, they do suggest that inflation readings are likely to be relatively weak during the next few months. This will be critical for the near-term path of monetary policy and, in our view, makes it likely that the Fed will keep rates steady until the June FOMC meeting. The Phillips Curve Chart 4A Phillips Curve Model Of Inflation Turning to the longer run outlook for inflation, we employ a Phillips curve model of core PCE inflation based on one that Janet Yellen referred to in a speech from September 2015.1 In this framework, the year-over-year change in core PCE inflation is modeled using: Lagged core inflation Inflation expectations (from the Survey of Professional Forecasters) Non-oil import price inflation relative to core PCE inflation Resource utilization (calculated as the difference between the unemployment rate and the Congressional Budget Office's (CBO) estimate of the natural rate of unemployment) The model does an excellent job capturing changes in core PCE inflation since 1990 (Chart 4), and is also useful because it gives us a glimpse of the mental framework that Fed policymakers apply to the task of inflation forecasting. Most importantly, the model allows us to generate inflation forecasts given estimates for inflation expectations, the unemployment rate and the U.S. dollar (which closely tracks relative import prices). For example, in a base case scenario where we assume that inflation expectations and the dollar remain flat, but that the unemployment rate declines from its current level of 4.7% to 4.5% by the end of this year, the model predicts year-over-year core PCE inflation will rise from its current level of 1.65% to 1.87% by November, still below the Fed's 2% target. If we keep the same forecast for a steadily declining unemployment rate but also incorporate a 5% increase in the value of the trade-weighted U.S. dollar, then core PCE inflation is projected to rise to 1.76% by November. The stronger dollar means that import prices exert a bit more of a drag. Conversely, if we keep the same unemployment assumption but assume that the U.S. dollar depreciates by 5%, then core PCE inflation is projected to reach 1.98% by November. In this scenario import prices actually provide a slight boost to core inflation. Overall, to create a scenario where core inflation reaches the Fed's target before the end of this year we need to make a fairly optimistic assumption about the unemployment rate and also incorporate a substantial dollar depreciation. In our view, it is more likely that the dollar remains under mild upward pressure this year as the U.S. economy continues to de-couple from the rest of the world. Fiscal policy remains the wildcard, as any protectionist measures implemented by the new U.S. government could lead to import price shocks. Although at first blush any watering-down of trade deals, imposition of tariffs, or protectionist tweaks to the tax code would seem likely to send import prices higher, much depends on how much of the adjustment to the new trade policy occurs through the exchange rate or through prices. This is incredibly hard to determine until the details of any protectionist trade measures are known. Our Global Investment Strategy service explored the potential ramifications of one such trade proposal - a border-adjusted corporate tax - in a Special Report published last week.2 A Bottom-Up Perspective An alternative to the Phillips curve approach is to split core inflation into its major sub-components: shelter, core goods and core services excluding shelter. We can then examine each sub-component separately and identify different macro drivers for each (Chart 5). Shelter has been the strongest contributor to core inflation so far in this recovery and can be modeled using home prices, the rental vacancy rate and household formation (Chart 5, panel 1). Based on these relationships, we expect shelter inflation will remain elevated for quite some time, while our model suggests it is even likely to move a bit higher during the next few months. After briefly seeming like it might rebound earlier last year, the rental vacancy rate has since fallen to new lows while home price appreciation continues at a steady rate of just above 4% per year (Chart 6). Further, the vacancy rate should remain under downward pressure and home prices under upward pressure as long as household formation continues to outpace home construction. The top panel of Chart 6 shows that the difference between housing starts and household formation closely tracks the rental vacancy rate. The vacancy rate rose throughout the 1990s and early 2000s as housing starts outpaced the creation of new households, but starts have not been sufficiently robust so far in this recovery. In addition, housing inventory as a percent of households is near the lows of the early 1990s (Chart 6, bottom panel). This inventory calculation includes the "shadow inventory" from foreclosed homes which has almost normalized back to pre-crisis levels, in any case. Chart 5The Components Of Core CPI Chart 6Drivers Of Shelter Inflation We expect that shelter inflation will remain elevated at least until housing construction starts to outpace the creation of new households, but will moderate once that supply response starts to emerge. Chart 7Atlanta Fed Wage Growth Tracker* ##br##Versus Unemployment Rate Core goods inflation (Chart 5, panel 2) has been, and will continue to be, the major source of deflation in this cycle. A large fraction of core goods are imported and, as such, core goods inflation tends to follow the trend in the U.S. dollar. The bull market in the U.S. dollar will continue to keep a lid on core goods prices, and will limit how quickly inflation can rise. Any meaningful increase in inflation this year is likely to come from the core services excluding shelter component, which historically tends to track fluctuations in wage growth (Chart 5, bottom panel). As we have previously highlighted, the labor market is close to full employment and the relationship between the unemployment rate and wage growth remains strong (Chart 7). In this environment, even modest further declines in the unemployment rate should exert meaningful upward pressure on wages. Bottom Line: Inflation will trend higher this year, but at a measured pace. The impact of a tight labor market and accelerating wage growth will be mitigated by deflating import prices. Even if the economic recovery remains on track, year-over-year core PCE inflation is likely to still be below the Fed's 2% target by the end of this year. Investment Implications Duration & TIPS Chart 8Leading Inflation Indicators & Breakevens Long-maturity TIPS breakeven inflation rates still have upside, although the rate of increase is unlikely to maintain its current rapid pace. As core inflation converges with the Fed's target so should long-dated measures of inflation expectations such as TIPS breakevens. Historically, core PCE inflation close to 2% has coincided with long-dated TIPS breakevens in a range between 2.4% and 2.5%. With the 10-year breakeven currently at 2.05%, we expect it has another 35 to 45 basis points of upside. Measures of pipeline inflation pressure, such as producer prices and the prices paid and supplier deliveries components of the ISM manufacturing survey also point to rising breakevens (Chart 8). We continue to recommend an overweight allocation to TIPS versus nominal Treasury securities. With rate hike expectations still relatively depressed,3 real yields do not have much downside. Rising breakevens should therefore also pressure long-dated nominal yields higher in the months ahead. While we currently recommend a benchmark duration stance, we are actively looking for an opportunity to shift to below-benchmark duration, as was discussed in last week's report.4 Yield Curve As breakevens and nominal yields move higher the yield curve should also steepen (Chart 9). The strong positive correlation between the slope of the yield curve and TIPS breakevens is the result of the impact of Fed policy on both variables. Chart 9Wider Breakevens Correlated With A Steeper Yield Curve Fed policy tends to be accommodative in the early stages of a recovery, and this causes the yield curve to steepen and breakevens to widen as investors logically expect that easy money will cause both growth and inflation to move higher. In contrast, the yield curve tends to flatten and breakevens tend to fall later in the recovery once Fed policy turns more restrictive. Chart 105-Year Bullet Still Cheap Given that core inflation and TIPS breakevens both remain below the Fed's targets, it is too soon to expect a shift toward restrictive Fed policy. In other words, the Fed will be quick to back away from its rate hike plans if there is any indication that breakevens or inflation might reverse their uptrends. It is only once core inflation and TIPS breakevens have returned to the Fed's targets that the stated purpose of Fed policy will shift from supporting the recovery to snuffing out inflation. To profit from a steeper yield curve we entered a long 5-year bullet short duration-matched 2/10 barbell trade on December 20. So far this trade has returned 14 bps, and the 5-year bullet continues to look very cheap on the curve (Chart 10). Spread Product In prior research we considered the performance of spread product throughout the four phases of the Fed cycle (Chart 11).5 We define the four phases of the Fed cycle as follows: Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Chart 11Stylized Fed Cycle Using a very simple estimate of the equilibrium fed funds rate based on potential GDP and a long-run moving average of the funds rate itself, we have found that excess returns to investment grade corporate bonds are highest in phase IV and phase I, when the fed funds rate is below equilibrium (Table 1). However, the key problem with this analysis is that it is very difficult to estimate the equilibrium fed funds rate in real time. As stated above, the estimate used in Table 1 incorporates the CBO's estimate of potential GDP which is frequently revised after the fact. So while we are confident that we are currently in phase I of the Fed cycle, the challenge becomes looking for other indicators that might warn us about the transition from phase I to phase II, where excess returns are much worse. We have found that core PCE inflation is one such indicator. We calculated average monthly excess returns to investment grade corporate bonds when year-over-year core PCE inflation is below 1.5%, between 1.5% and 2%, and between 2% and 2.5% (Table 2). Table 1Investment Grade Corporate Bond Excess Returns* Under The Four Phases##br## Of The Fed Cycle (August 1988 To Present) Table 2Investment Grade Corporate Bond Excess Returns* Under Different Ranges##br## For Year-Over-Year Core** PCE (August 1988 To Present) The results show that the highest returns occur when inflation is below 1.5%. This should not be surprising since an environment of low inflation is most likely to coincide with phase IV of the Fed cycle. We found mixed results for when inflation is between 1.5% and 2%. In this environment average monthly excess returns are close to zero and a 90% confidence interval places them between -19 bps and +17 bps. This environment likely encompasses phase I of the Fed cycle and the transition into phase II. It is not until core PCE inflation is above 2% that excess returns turn decisively negative. Monthly excess returns average -13 bps in this environment, with a 90% confidence interval of -35 bps to +10 bps. With inflation likely to remain between 1.5% and 2% for the balance of the year, it is too soon to turn all-out bearish on spread product. For the moment we recommend a neutral allocation, but with an underweight allocation to high-yield bonds where valuations are exceedingly tight. Given that inflation is low and Fed policy is accommodative, we would be quick to upgrade both investment grade and high-yield corporates on any near-term sell off. The current uncertainty surrounding fiscal policy also complicates the outlook for spread product. On the one hand, it raises the risk of a near-term sell off if it appears as though some of the more stimulative aspects of Trump's agenda will not be implemented. On the other hand, in addition to headline-grabbing promises of increased infrastructure spending, there are many other policy details that could also have significant market implications. One example would be the elimination of the tax deductibility of corporate interest expenses. Such a provision is currently included in the Republican's plan for corporate tax reform, and would severely diminish supply in the corporate bond market if it is implemented. Bottom Line: Excess returns to spread product are not likely to turn deeply negative until core PCE inflation is above 2% and Fed policy becomes more focused on halting inflation than supporting the recovery. We retain a neutral allocation to spread product in our portfolio. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 http://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 2 Please see Global Investment Strategy, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017", dated January 20, 2017, available at gis.bcaresearch.com 3 The overnight index swap curve is priced for 54 basis points of rate hikes during the next twelve months. 4 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Investment Strategy / U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27, 2014, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy Media stocks are poised to challenge previous relative performance highs as sales growth reaccelerates. Stay overweight. The materials sector has lagged behind the commodity price rally, a sign of underlying weakness rather than latent strength. Chemicals overcapacity will remain a headwind until U.S. competitiveness improves. Stay clear. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) Feature The broad market has been very strong since the November election. While advance/decline lines have firmed, participation in the rally has been uneven and may be fraying around the edges. For example, the number of groups trading above their 40-week moving average has been diverging negatively from the broad market in the last few months, suggesting diminishing breadth (Chart 1). In fact, the industrials (I) and financials (F) sectors have carried the market since November. Other deep cyclical sectors, such as energy, materials and tech, have mostly matched market performance. The 'IF' rally is based on an expected upgrade to the economic growth plane that matches the surge in various sentiment gauges. If validation does not occur, then the IF rally will become iffy indeed, unless sector breadth improves. Last week we showed that market cap-to-GDP was so far above its long-term average that even if nominal growth boomed at 8% per annum for the next five years this valuation ratio would still not have normalized. That valuation backdrop may not upend additional short-term market momentum, but it is a true measure of just how bullish sentiment has become and should be a critical input to the portfolio construction process, because of its warning about divergences from fundamental supports. Another unconventional sentiment gauge is observed from sub-surface market patterns. Chart 1 shows that the number of defensive groups with a positive 52-week rate of change, in relative terms, is in freefall, plunged to virtually nil. In the last two decades, investors eschewing capital preservation and non-cyclical sectors so aggressively has typically preceded major market peaks (Chart 1). The steep drop in the put/call ratio confirms that euphoria and greed are trumping mistrust and fear. The put/call ratio has recently bounced, but is well below levels that signal investors are accumulating significant portfolio protection. The Fed's tightening bias, contracting U.S. dollar-based financial liquidity amid the strong U.S. dollar all threaten to keep a lid on corporate sector sales prospects. As such, we remain biased toward non-cyclical and consumer sectors, even excluding fiscal policy uncertainty. Chart 2 shows that these areas are in a base-building phase, in relative terms, following their post-election drubbing. We expect momentum to steadily build toward sustained outperformance by midyear. Conversely, a reversal in the 'IF' sectors already appears to be developing, while other capital spending-dependent sectors are unable to gain momentum (Chart 3). This week we highlight both a winning group and an area we expect to disappoint. Chart 1The Rally Is Fraying Around The Edges Chart 2Defensive Base-Building? Chart 3Cyclical Sector Distribution New Highs Ahead For Media While the consumer discretionary sector has a poor track record during Fed tightening cycles, the S&P media sub-component can buck this trend. Media stocks outperformed in the second half of the 1990s and also trended higher in the 1980s while the Fed was tightening. The key was the U.S. dollar (Chart 4). As long as the dollar was strong, media companies sustained a profit advantage over the rest of the corporate sector owing to limited external exposure. A replay is currently playing out, and has the potential to persist for at least the next few quarters based on upbeat cyclical indicators. Media sales growth is in recovery mode. Consumers have significantly boosted spending on media services, as measured by personal consumption expenditures data (Chart 5). Pricing power has surged in response to demand strength (Chart 5, bottom panel). In turn, strong demand is boosting measures of productivity: our proxy for sales/employment is accelerating toward the double-digit growth zone (Chart 5). Productivity is diverging positively from relative forward earnings expectations, implying there is room for a re-rating. As long as the U.S. economy is growing, media companies should be able to garner an increasing share of consumer wallets. Chart 6 shows that real spending on media services has been in a steady uptrend for well over a decade, reflecting its ability to continually innovate, only pausing during recessions when consumers are forced to retrench. Typically, a rise in spending pulls up pricing power (Chart 6). Chart 4Media Stocks Like Dollar Strength Chart 5Sales Are Set To Accelerate Chart 6Secular Strength All of this has spurred a recovery in media cash flow growth (Chart 7, top panel). Relative performance and cash flow move hand-in-hand. Rising cash flows also imply that the media sector can further reduce shares outstanding through buybacks and/or M&A activity (Chart 7), bolstering ROE. The S&P movies & entertainment index has been one of the driving forces behind the broader media index recovery. We upgraded the former to overweight after the vicious selloff related to Disney's ESPN woes and the takeover saga at Viacom had pushed the index to an undervalued extreme. While slightly early, this upgrade is now paying off (Chart 8). The expectations hurdle remains surmountable. Both forward earnings and sales growth estimates are deeply negative (Chart 8), reflecting the well-known cooling in cable subscriber growth. But even here, there is room for potential upside surprises. Consumer spending on recreation has been growing at a low single-digit clip, but the surge in consumer confidence, courtesy of rising wage growth and a positive wealth effect from rising real estate and financial asset prices, should support increased discretionary consumer spending. The message from the jump in the ISM services index is bullish for recreation spending (Chart 9, second panel). Chart 7Shareholder-Friendly Chart 8Cheap With Low Expectations Chart 9Still Early In The Recovery In turn, faster spending would support ongoing pricing power gains (Chart 9). The industry is already sporting one of the most robust selling price increases of all that we track, as advertising rate inflation is growing anew. Importantly, real outlays on cable services have recovered after a steep decline (Chart 9), suggesting that the drag from disappointing cable subscriber growth and cord cutting may be easing. Less churn implies more pricing power. Content cost inflation also remains under wraps. The implication is that the fundamental forces to propel a retest of previous relative performance highs are in place. Technical conditions are also sending a bullish signal. Cyclical momentum, as measured by the 52-week rate of change, is on the cusp of breaking into positive territory (Chart 9), while the share price ratio has already crossed decisively above key resistance at its 40-week moving average. A dual breakout would confirm a new bull trend. Bottom Line: Media stocks have good odds of retesting previous relative performance highs as discretionary consumer spending perks up. Stay overweight the overall media group, and the S&P movies and entertainment index in particular. Chemical Stocks: A Toxic Portfolio Blend The commodity price recovery has not carried over into the S&P materials sector, as relative performance has been moving laterally for much of the last twelve months. Rather than view this as an opportunity to play catch up, the more likely outcome is that the sector has missed its chance to outperform. In fact, downside risks have intensified. The strong U.S. dollar will exact a toll on U.S. exporters, particularly if emerging markets and China do not experience accelerating final demand. While there has been a massive amount of stimulus in China over the past 18 months, the thrust of that impulse is fading. Fiscal spending growth has dropped sharply and the authorities trying to cool rampant real estate speculation. The yield curve remains flat (Chart 10), as local funding costs rise on the back of the authorities attempt to mitigate capital outflows, and loan demand remains weak. Persistent weakness in the Chinese currency may reflect a lack of confidence in local returns, i.e. sub-par growth. All of that argues against expecting a major impetus to raw materials demand, at a time when the materials sector total wage bill is inflating more aggressively. Our Cyclical Macro Indicator for the materials sector is hitting new lows (Chart 10), heralding earnings underperformance, underscoring that below-benchmark allocations remain appropriate. The S&P chemicals group represents for than 70% of the overall materials market cap. It has underperformed since its peak and our underweight call in 2014, pulled lower by the soaring U.S. dollar and sagging industry productivity (Chart 11). Net earnings revisions have been consistently revised lower over the past few years, and are unlikely to recover without a reflationary push (global real yields are shown inverted, second panel, Chart 11) that revives chemical final demand. Analysts have latched on to the firming in global purchasing manager survey sentiment, aggressively pushing up sales growth expectations in recent months (Chart 12). Clearly, manufacturing sector expansion is expected to reverse the contraction in chemical output growth (Chart 12). Chart 10Higher PMIs Are Not Enough Chart 11Higher Yields Are A Bad Omen Chart 12Expectations Are Inflated However, this may be yet another case of analysts chronically overestimating the industry's earnings power. Global manufacturing improvement seems likely to accrue mostly to firms outside the U.S. Chart 13 shows that chemicals relative performance is heavily influenced by the U.S. dollar. Valuations and sentiment are tightly linked with chemical export growth (Chart 13), as the latter represent 14% of total U.S. exports. The U.S. dollar surge is diverting orders away from U.S. manufacturers: German chemical new orders have surged, and the IFO survey of chemical industry executives signals optimism about the future (Chart 14). Chart 13The Dollar Is Hurting The U.S. ... Chart 14... But Helping Foreign Competitors U.S. executives appear to be equally confident, but that optimism is misplaced. The American Chemical Council expects U.S. chemical exports to increase 7% a year through 2021. Over $170B is expected to be invested in U.S. chemical manufacturing capacity, representing nearly 25% of the total industry size, which is anticipated to boost the chemical trade surplus to new records. So far, roughly $76B of projects has either been completed or is under construction. If these planned projects all come to fruition, our concern is that new capacity will be idle rather than productive. The industry is in the crosshairs of anti-globalization and protectionism, and a strong U.S. dollar and rising domestic cost structures threaten to reduce competitiveness. Chemical imports are a fairly large portion of sales, rendering profitability vulnerable should an import-tax ever be introduced. From a cyclical standpoint, deflationary pressures are already very acute. Chemical capacity is growing much faster than production, warning that pricing power will be under significant pressure (Chart 15). Many chemical products are destined for interest rate-sensitive end markets such as autos, underscoring that a Fed tightening cycle is a headwind. While capacity expansion was planned when interest rates and feedstock costs were expected to remain at rock bottom levels for the foreseeable future, this is no longer the case. Chemical companies can either use natural gas (ethane) or oil (naphtha) as a primary feedstock. U.S. production is largely ethane-based, while global capacity is geared to naphtha. Rising U.S. natural gas prices are undermining the U.S. input cost advantage (Chart 16). Chart 15Persistent Deflation Pressures Chart 16U.S. Cost Structures Are Unattractive Increased capacity has also put significant upward pressure on wage costs, as our proxy for the total wage bill is rising at a high single-digit rate (Chart 16). With capital spending slated to stay robust in the coming years, it will likely continue to take a larger share of sales, impairing profit margins. While the planned merger between heavyweights Dow Chemical and Dupont may eventually help to rationalize costs, this is a necessary but not sufficient step in the face of a loss of global market share. Without accelerating sales, U.S. chemical makers will be hard pressed to improve productivity sufficiently to reverse the slide in relative forward earnings estimates. Bottom Line: The S&P materials sector hasn't been able to outperform during a period of improving global manufacturing activity, raising doubts about its performance potential when global output growth inevitably slows. Part of this reflects the challenging outlook for the sector heavyweight chemicals index, and we recommend staying underweight both. The symbols for the stocks in this index are: BLBG: S5CHEM - APD, ARG, CF, DOW, EMN, ECL, DD, FMC, IFF, LYB, MON, MOS, PPG, PX, SHW. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
Highlights Deflation has decisively ended, and the economy is making a gradual transition towards inflation. The upshot is that growth is reviving rapidly in nominal terms. It is unrealistic to expect exports to be a main growth driver for the Chinese economy in the post-crisis world - even without protectionist pressures from President-elect Trump. The "Trump" wildcard serves as a wake-up call for Chinese policymakers to further focus on supporting domestic demand. There is a strengthening case for cyclical improvement in manufacturing investment. This further limits downside risk and sets the stage for potential positive surprises in the coming months. Feature Investors will be paying close attention to President-elect Donald Trump's inauguration speech this coming Friday, which may allow for a clearer understanding of his world view and economic policies, as well as their global implications. The inauguration will overshadow China's key economic statistics to be released later this week, and which we expect to show that the Chinese economy has picked up sequentially. As political uncertainty will stay elevated and deserves close monitoring going forward, it is equally important to keep in mind the economic big picture. In the next two months, China's economic data will once again be heavily distorted by the Chinese New Year holiday, making it more difficult to detect genuine growth trends. In last week's report, we laid out our view on China's growth and policy outlook for 2017.1 This week, we offer a reality check and our take on some key cyclical issues. Watch For Inflation Surprises The biggest change in China's macro condition in the past year, in our view, has been the sharp turnaround in producer prices. Rising PPI has lifted corporate pricing power, reduced real interest rates and eased financial stress in some heavy industries, the weakest link in the corporate sector - all of which are important reasons behind China's growth improvement of late. Looking forward, we expect inflation will remain well behaved. Improving producer prices is to a large extent attributable to RMB depreciation, which has already begun to crest. The trade-weighted RMB's depreciation has halted, and it is unrealistic to expect it to continue to depreciate at an ever-accelerating pace (Chart 1). This should cap the upside of PPI inflation. The headline consumer price index (CPI), the broader inflation measure, was fairly stable throughout last year's roller coaster ride in PPI (Chart 2). Moreover, the fluctuation in headline CPI was mainly attributable to food prices, which have been noisy due to seasonal factors and unexpected supply-demand disruptions, but have been largely trendless in recent years. There is no case for a food-induced inflation outbreak. Chart 1PPI Inflation Is Peaking Chart 2No Case For Food Inflation More fundamentally, although the Chinese economy has strengthened, it is still operating below potential. Historically, runaway inflation has always occurred when the economy overheated, which is far from the current situation (Chart 3). Without a strong growth rebound, it is difficult to expect genuine inflationary pressures. In short, the current environment is best characterized as "easing deflation" rather than "rising inflation," and our base case remains that inflationary pressures will stay at bay. Nonetheless, it is important to note that strong deflationary pressures have prevailed since the global financial crisis, which has led to major adjustments in the world economy. In China's case, for example, capital spending has slowed sharply. Meanwhile, cutting excess capacity has been an explicit policy priority, which, together with strengthening demand may lead to a quick rise in prices. Last year's sharp rebound in steel, thermal coal and some other raw materials prices provided clear evidence of this. Indeed, several factors warn against being overly complacent about the inflation outlook. For producers, the improvement in pricing power appears rather broad based, as both industrial firms and the service sector have been reporting rising levels in their respective output prices. In other words, rising prices are not just contained in resource sectors associated with global commodities prices and Chinese capacity cuts. For consumers, inflation expectations have begun to rise (Chart 4). Consumers' inflation expectations may be just a response to changes in prices rather than a leading indicator for future price moves. However, there has been a significant pickup in confidence on future income growth, which is likely a reflection of a tighter labor market and rising wages. If this trend holds, it would make it a lot easier for producers to pass through rising input costs to end users. Chart 3Inflation Vs Economic Overheating Chart 4Inflation Expectations Are On The Rise Overall, it is premature to worry about an inflation outbreak, and we do not consider inflation as a major policy constraint for the People's Bank of China. However, it appears that deflation has decisively ended, and the economy is making a gradual transition towards inflation. The upshot is that growth is reviving rapidly in nominal terms, supercharged by both improvement in real activity and a rising GDP deflator. Nominal GDP may reclaim a double-digit annual pace in the coming quarters. Exports: Why Has The Historical Correlation Broken Down? China's latest export numbers continued to disappoint, falling by 6.1% in dollar terms from a year ago. Part of the decline is due to falling prices measured in dollar terms; exports in volume terms are considerably stronger. Nonetheless, the export sector has been a chronic underperformer in the Chinese economy in recent years. Historically, China's export sector performance was highly predictable based on some key domestic and global variables - this correlation has clearly broken down since 2015 (Chart 5). If the historical correlation still held, export growth should have rebounded sharply. Many have viewed the divergence as a sign that Chinese exporters have lost competitiveness, which does not seem credible, as Chinese exports have continued to gain global market share. In our view, the chronic disappointment of the Chinese export sector's performance is due to several factors. First, the global financial crisis was a watershed event that marked structural breaks in economic correlations. Since then, consumers in the developed world have been focusing on deleveraging and fixing their balance sheets, and therefore the growth recovery has not led to a corresponding increase in demand - and imports for - consumer goods. Second, protectionist pressures have been on the rise since the global financial crisis, as all countries have tried to protect domestic producers in the face of weak final demand. Anti-dumping measures initiated by World Trade Organization member countries have increased notably in recent years, a growing share of which have been targeted at Chinese exporters (Chart 6). The high profile anti-dumping measures adopted by the Obama administration against Chinese tire and steel products have caused significant damage to Chinese producers and exporters.2 Chart 5Exports Have Disappointed Chart 6Protectionism Is Already On The Rise Finally, Chinese export numbers have been distorted by disguised capital flows driven by speculation on the RMB exchange rate. The sharp swings in Chinese exports to Hong Kong since the global financial crisis can be viewed as proxy for shifting expectations on the yuan (Chart 7). Immediately after the global financial crisis, the RMB was widely expected to rise against the dollar, leading to a massive surge in Chinese sales to Hong Kong as exporters overstated export revenues to bring more foreign currencies onshore. The tide completely reversed in early 2014 when the RMB began to drop against the greenback. Exporters may have been underreporting overseas sales so they could park part of their foreign revenues offshore in anticipation of a weaker RMB, weighing on overall export sector performance. Whatever the reason, the important point here is that it is unrealistic to expect exports to be a main growth driver for the Chinese economy in the post-crisis world - even without protectionist pressures from President-elect Trump. In recent years the Chinese authorities systematically overestimated the vigor of global demand, and export sector performance almost always lagged the government's annual targets, which contributed to chronic growth disappointments. In this regard, the "Trump" wildcard serves as a wake-up call for Chinese policymakers to further focus on supporting domestic demand. Has Investment Bottomed? With exports chronically disappointing, domestic capital spending holds the key for economic growth. Policy driven investment on infrastructure construction has held up strongly since 2013, while private sector investment mainly in the mining and manufacturing sectors has downshifted sharply. Looking forward, infrastructure spending will likely remain buoyant, supported by both public budgetary sources and public-private-partnerships (PPPs).3 What's changing is that capital spending in the manufacturing sector may have bottomed from a cyclical point of view. Inventory destocking in the manufacturing sector has become very advanced. Improving new orders and rising producer prices should lead to a restocking cycle. There has been a notable improvement in corporate sector profitability and confidence of late, which has historically led capital spending in the manufacturing sector (Chart 8). Consistently, the latest credit numbers show a significant pickup in medium- and long-term loans by the corporate sector, which are typically used to finance investment spending rather than replenish working capital. Chart 7Hong Kong Trade And The RMB Chart 8Manufacturing Capex Has Bottomed The long-term outlook for Chinese private capital spending hinges critically on structural reforms on many fronts. As far as the corporate sector is concerned, it is widely recognized that China's overall tax burden is not high by global standards, but is primarily shouldered by the corporate sector rather than households, and a rebalancing is long overdue. The government under incumbent Premier Li Keqiang has been focusing on reducing administrative red tape and mandatary employee benefits provided by employers as ways to cut corporate sector costs. If the Chinese authorities can implement reforms despite the populist resistance to shifting some of the tax burden from the corporate sector to households, it could further boost corporate profitability and revive animal spirits among Chinese entrepreneurs, leading to another round of investment boom. Any tax reform measures in this direction should be viewed as a major positive development. For now, we see a strengthening case for cyclical improvement in manufacturing investment, after decelerating for over six years. The current sub-par "new normal" growth trajectory rules out a sharp revival in capex, but the marginal change in "second derivatives" is still important as it diminishes a chronic growth headwind. This further limits downside risk and sets the stage for potential positive surprises in the coming months. Stay tuned. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1, 3 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Trump's protectionism supercharges our theme of Sino-American tensions. China is at a stark disadvantage to the U.S. in a trade war. China cannot give concessions easily; it may batten down the hatches. Remain short RMB; but go long "One China," i.e. mainland stocks versus Taiwan/Hong Kong. Feature "Life's short span forbids us to enter on far reaching hopes." - Horace, Odes "Of course, you know, this means war." - Bugs Bunny, Looney Tunes President-elect Trump has said he will not designate China a "currency manipulator" on the first day of his presidency, contrary to what he promised during the campaign. Is this a sign that Trump is "normalizing" after the wild threats of his campaign? What are the real risks of a U.S.-China "trade war"? How should investors prepare? Trade War Is More Likely Than You Think BCA's Geopolitical Strategy has long cautioned investors that geopolitical tensions in East Asia were severely underestimated by the market.1 In 2013, we argued that a Sino-American military conflict was more likely than most of our clients dared to think.2 And over the past several years, in one-on-one conversations and in presentations at numerous conferences, we have stressed that tensions in East Asia could imperil the largest trade relationship. Why so alarmist? We have always based our analysis on three key pillars: Multipolarity: With the U.S. in a relative decline, containing China's rise has become a national security issue. The U.S. "Grand Strategy" operates under the imperative that no regional power is allowed to become a regional hegemon, as that would be a stepping stone to global competition. "Pivot" To Asia: The U.S. geopolitical deleveraging from the Middle East was from the start designed to free up more U.S. resources for Asia. While the Obama Administration pursued the pivot cautiously, it was putting the infrastructure in place for a confrontation with China. Regional dynamics: China is surrounded by neighbors that are cautious about Beijing's intentions for geographic, historical, and strategic reasons. They have therefore sought to balance their increasing economic addiction to China with deeper military and political links to the U.S. Chart 1China, Not NAFTA, In Trump's Crosshairs Trump's victory has made markets considerably less oblivious to the risks we have stressed to clients for the past five years. The idea that a trade war might erupt is now widely discussed. And Trump's repeated statements about Taiwan, North Korea, and the South China Sea have awoken some investors to the reality that a trade conflict could spill over into strategic areas, and vice versa. Nevertheless, judging by the ebullient market reaction relative to previous U.S. presidential transitions, most investors think that cool heads will inevitably prevail. They may be right, but from where we sit it is premature - and imprudent - to bet on it. Make no mistake, China, not NAFTA, will suffer the brunt of Trump's efforts to fulfill his protectionist campaign promises (Chart 1). We see 70% odds that a "crisis event" will affect U.S.-China trade patterns in a significant way over the next four years. How Did We Get Here? The Global Financial Crisis caused a sharp break in Sino-American relations: It interrupted the economic symbiosis between China and American households refused to keep re-leveraging, forcing China to become more internally driven economy (Chart 2). With final demand in the U.S. declining, China decided to re-leverage with credit, injecting its existing overproduction and overcapacity with steroids. But this only accelerated China's capture of global export market share, while supercharging the deflationary global effects (Chart 3). On top of its credit policies, China has struggled to internationalize the RMB. So now, it is not only still washing the world with its industrial overcapacity but also inadvertently - or not so innocently - reducing the prices of its goods with the weakening of its currency (Chart 4). Chart 2U.S.-China Symbiosis Has Died Chart 3China's Historic Export Grab Chart 4China Still Exporting Deflation U.S.-China trade disputes have a long history. China's WTO entrance was agreed only with the stipulation that China be treated as a "non-market economy" for 15 years. Punitive trade bills almost passed through Congress in 2005 and 2010-11, for instance, but were held back at the last minute.3 Since 2009, in particular, protectionist policies have emerged. President Obama began his term with an unprecedented use of the authority under Section 421 of the 1974 Trade Act to punish China for "market distorting" exports of car tires, and with protectionist "Buy America" provisions in his economic stimulus package. After that, a sequence of tit-for-tat punitive measures took place affecting a range of goods on both sides, attempted Chinese investments in the U.S., and American companies operating in China. China's meteoric rise, surging trade surpluses with the U.S., and the rapid loss of U.S. manufacturing jobs was the main cause of tension (Chart 5). Americans benefited from China's rise, namely from cheaper goods and lower interest rates, but it caused significant economic dislocations.4 Meanwhile Chinese protectionism discouraged American elites that had endorsed China's rise on the hopes of gradually unfolding market access. Amid the heightened political risks of the global recession and its aftermath, China intensified intellectual property theft, non-tariff barriers, indigenous innovation policies, and cyber-attacks.5 The saving grace, for markets, was that the aforementioned tensions always remained within bounds. The WTO was a mutually recognized adjudicator. Also, the rival American and Chinese commercial authorities played a slow, step-by-step, predictable game, with the punitive measures being mostly proportional. When pressures flared in the U.S., the executive branch stayed Congress's hand; meanwhile China's government could steamroll any internal opposition to its trade policies. No more. Hillary Clinton might have helped contain trade tensions, but the outlook has darkened irrespective of Trump. Notably, American multinational corporations have increasingly decried Chinese protectionism and lobbied for the U.S. government to help persuade China to give them greater market access and a better legal-regulatory climate (Chart 6). As the Obama administration exited the stage in December 2016, the U.S., Japan and others refused to accept China's "market economy" status despite the fifteen-year deadline coming due. This means the U.S. and its allies explicitly wanted to reserve the power to impose anti-dumping duties more easily on China, which is what "Non-Market Economy" status entails (Chart 7).6 China considers this delay an outright violation of U.S. commitments under WTO. Chart 5A Tale Of Two Manufacturers Chart 6American Business Under Pressure In China Chart 7China's Non-Market Status A Liability Further, Clinton had promised to create a special prosecutor for trade disputes and to triple the number of enforcement officers. More broadly, she wanted to continue Obama's "Pivot to Asia" policy that had roiled U.S.-China strategic relations. Bottom Line: U.S.-China trade relations had already turned sour as a result of the divergence of interests following the Global Financial Crisis. China has emerged as a trade juggernaut and the U.S. corporate and political establishments have become far more anxious about it recently. Now Trump has supercharged the situation. Will Trump "Normalize" In Office? With Trump, the U.S. is likely to undergo a "regime change" in terms of how trade policy is conducted - the only question is how long-lasting it will be. U.S. presidents have very few constraints on trade and foreign policy (Table 1). Ignore Trump's statements and look at his team: Incoming Commerce Secretary Wilbur Ross, National Trade Council chief Peter Navarro, and U.S. Trade Representative Robert Lighthizer.7 This group, especially Navarro, is stridently hawkish on China and appears ready to bring the full weight of the United States' economic and strategic advantages to the table in order to negotiate a new framework of relations. Table 1Trump Is Not Constrained On Trade Policy The model is the renegotiation of trade relations with an ascendant Japan in the 1980s. And China looks ripe for a crackdown by this yardstick. The penetration of Chinese exports meet or exceed Japan's position at its peak in the 1980s (Chart 8). Meanwhile the RMB has not appreciated nearly as much as the yen had done by this time (Chart 9). Ultimately the two resolved their differences because Japan acceded to major U.S. demands, strengthening its currency after the 1985 Plaza Accord and accelerating financial liberalization. It helped that the two were staunch allies without genuine security tensions (unlike the U.S. and China today). Chart 8China Has Gotten Away ##br##With More Than Japan Did Chart 9Reagan Forced Faster ##br##Appreciation On Japanese Yen From the Trump administration's point of view, the standard trade remedies have failed given that U.S. trade deficits have deteriorated all along. True, China has made considerable structural adjustments in recent years (Chart 10). But relative to the U.S., China has not really changed its ways. In fact, the current account surplus, which has collapsed from 10% to around 2% since 2008, is now roughly equal to the trade surplus with the United States (Chart 11). Chart 10China's Economic Rebalancing Under Way Chart 11China's Trade Surplus With U.S. Indispensable Therefore we do not put much stock in Trump's claim that he will not call China a currency manipulator on day one - this does not signal a "normalization" or softening of Trump's protectionist line. There was always a technical issue with this pledge that made the timing awkward.8 The manipulator charge will remain a Sword of Damocles hanging over China this year and next, but it is also only one tool in Trump's toolkit - and not the most intimidating one either (Diagram 1). Diagram 1Calling China A Currency Manipulator: The Process At a minimum, Trump could easily do what Obama did in February 2009 on tires - simply approve recommendations from his own Treasury Department for tariffs on specific goods. At a more aggressive level, he has the example of Richard Nixon before him. Nixon imposed a 10% surcharge on all dutiable goods in 1971. We would not put it beyond Trump to take arbitrary actions within the four-year term if international economic conflicts heat up dramatically. (We will be especially leery in the lead-up to the 2018 or 2020 elections if Trump's touted deal-making is not going his way.) Congress is not likely to prove a major constraint, at least not at first. Trump's election is a strong signal that the U.S. populace wants more protectionist policies. Congressional Republicans are limited, given the laws empowering the president on trade, and they will face the reality that his electoral strategy succeeded in great part because of voter demand for protectionism in key Midwestern states. Democrats, in these and other competitive states, have to perform verbal gymnastics to oppose Trump's positions on trade that substantially echo their own. And as mentioned, U.S. multinationals are not likely to "domesticate" Trump - rather, they will lobby for relative moderation or tactfulness within his general framework. Bottom Line: Trump is relatively unconstrained on trade policy. We expect his administration to begin with a "shot across the bow" in the first 100 days - a mostly but not entirely symbolic punitive measure against China - and then to seek high-level negotiations toward a framework for the administration's relations with China over the next four years. We expect the initial shot to rattle markets, then for a calming period to ensue, which will give a false sense of security. But given the lack of constraints on Trump, we are not optimistic. What Are China's Options? In a trade war with the U.S., China is outgunned on every front. Its economy is far more vulnerable to a disruption of exports to the U.S. than vice versa (Chart 12). It does not have ready alternatives to the U.S., given that U.S. imports of Chinese goods are roughly equal to Japanese, South Korean, German, Vietnamese and British imports combined. And China is most competitive in goods that the U.S. can easily source elsewhere (Chart 13). Chart 12The Numbers Favor The U.S. In A Trade War Chart 13The U.S. Can Find Substitutes For China Yes, China can disrupt the supply chain for the iPhone, but no, the Trump administration is not going to confuse Apple's interests with what it views as the "National Interest." Certainly China will favor non-American companies - Airbus over Boeing, etc - but the U.S. growth model is not reliant on exports, so it is not clear that the Trump administration will heed Boeing's cries about long-term competitiveness. The states most exposed to Chinese retaliation - Alaska, Oregon, Washington, Louisiana, and South Carolina - will not harm his electoral base. His Midwestern Rust Belt states could suffer, according to some research, but voters there may approve of his protectionist measures and Trump's other economic policies may blunt the short-term impact of Chinese retaliation.9 Looking at major Chinese export categories to the U.S., like textiles, electrical machinery, and equipment, suggests that 30 million Chinese jobs could be affected - perhaps ten times as many as the comparable U.S. jobs at risk from Chinese retaliation (far more than proportional given population). There is one factor that stands in China's favor. The history of trade wars says something different than the raw balance of trade. Like all wars, trade wars seek political ends, and a government's internal unity and resilience can be critical to its ability to bear out the worst.10 Politically, it is not clear that the U.S. has a better stomach for a full trade war than China: The U.S. remains divided - Polarization will worsen under Trump given his low approval ratings, low favorability, narrow popular victory margin, and controversial policy inclinations. Though China-bashing and economic patriotism can win some support, and we do not expect Congress or the corporate lobby to prevent Trump from launching a trade crusade if he wishes, nevertheless we see a fair chance that Trump would lose credibility and be forced to moderate his stance once negative trade consequences began to be felt at home. China is relatively unified - Xi has set himself up to be the "core" of power in the Communist Party in anticipation of worsening domestic conditions.11 It is worth remembering that the original use of the "core leader" moniker emerged in the wake of the Tiananmen Square crackdown when the Western world imposed sanctions on a newly liberalized China and it was forced to retreat into its shell from 1989-1992 (Chart 14). China's leadership wants to make the country less dependent on the U.S., and more autarkic, but is having difficulty imposing austere changes on itself. Trump may hasten the reforms while giving Chinese leaders a convenient "foreign devil" to distract the populace from the pain of restructuring. Chart 14China Rode Out Western Pressure In 1989 The above should not suggest that China wants a trade war, however. Trump is threatening to kick the export leg out from under its growth model at a time when the other leg - investment - stands at risk from domestic credit excesses.12 But the recent case study of Russia and economic sanctions is instructive. President Vladimir Putin used sanctions to blame all of the economic ills that befell Russia on the West, even though the Kremlin was often at fault. That policy largely worked. Bottom Line: China stands to suffer the most economically in a trade war with the United States. Chinese policymakers may therefore choose to ride out the economic costs of a trade war while blaming the U.S. for the pain. But closing its economy today would derail global growth and cause a dramatic spike in geopolitical risk, unlike in 1989. Strategic Spillover Trump's approach is likely to increase geopolitical risk because he wants to use the strategic disagreements plaguing Sino-American relations as leverage to get concessions on trade. The three hot spots are: Taiwan - Tensions with Taiwan spiked when Trump revealed that his administration considers the "One China" policy to be up for negotiation. China has engaged in serious saber-rattling in response, both around Taiwan and in the South China Sea. By linking trade disputes with Taiwan, Trump likely made it harder for Xi to compromise on the former without looking weak on the latter. Trump's negotiating style may work in business, but will not work with China on Taiwan, which is a matter of sovereignty and a clear red line. North Korea - Trump has said North Korea will not manage to test an Intercontinental Ballistic Missile (ICBM), which it is preparing to do. He is threatening to hold China to account for not curbing the North's violations of UN resolutions on nuclear proliferation and missile development. This would likely mean an expansion of the practice adopted under Obama of sanctioning Chinese entities for dealing with North Korean partners. This situation would likely shake up markets that have normally been able to ignore North Korea. South China Sea - Trump has repeatedly signaled that China has militarized the South China Sea, and his incoming Secretary of State Rex Tillerson suggested that China be deprived of access, a policy that would trigger a shooting war if operationalized. Persistent tensions here are unlikely to go away anytime soon and could spark a diplomatic crisis or naval conflict (if not with the U.S. then with regional players like Vietnam). Thus Trump's administration is likely to make serious demands on China regarding its strategic situation and national security even while demanding an overhaul of trade policies that will force difficult economic reforms on China. Bottom Line: China's political strengths at home make it unlikely to compromise on Trump's major strategic demands. Contrary to adding leverage in trade negotiations - where the U.S. already has the upper hand - using these issues as negotiating tools is likely to cause China to fear for its security and thus become more defiant. Risks To The View The risk to this view would be that the U.S. and China manage to negotiate a new framework and actually improve relations, with the U.S. giving more respect to China's legitimate rights and regional initiatives in exchange for Chinese concessions. But is China capable of conceding significantly on Trump's major demands? RMB appreciation? No. Many commentators have pointed out that Trump's view of the RMB is outdated - the PBoC is now propping it up, not suppressing it. The driver of RMB weakness is China's excessive monetary and credit expansion, weakening productivity growth, domestic investors' desires to move capital out, corporate deleveraging, the need for stimulus, tightening Fed policy, and rising geopolitical risks. While it is possible that the PBoC will defend the RMB to the hilt, the near-term path of least resistance is down, and that sets China on a collision course with the Trump administration. Market access and dumping? Yes. Trump complains that China taxes U.S. imports unfairly and dumps goods into the American market, killing jobs. To appease the U.S., China could take concrete steps to remove non-tariff barriers and open wider investment avenues for U.S. businesses - it has recently suggested it might do so.13 Less likely, it could accelerate overcapacity cuts and reduce subsidies to state-owned enterprises. These moves would fit with its avowed reform goals and strengthen Chinese self-sufficiency in the long run, and Xi's administration likely has the power to do them. China could also improve intellectual property protections and declare a ceasefire on cyber-attacks on companies. All of this is possible, but clearly extremely difficult to achieve. Strategic concerns? Maybe. It is conceivable but unlikely that China could de-escalate matters in the South China Sea and agree to a "freedom of navigation" guarantee for the United States, which is not a party to the territorial disputes. A significant compromise on North Korea would be even less likely, since China is unwilling to move beyond the usual, ineffective management and impose real hardship on the regime for its violations of UN resolutions and improving nuclear and missile capabilities. One impetus for China to concede on these points is that it is fearful of creating instability in a politically sensitive year in which it will oversee a major five-year leadership rotation at its National Party Congress. Trump may deliberately threaten to disrupt the transition in order to extract concessions. Bottom Line: We operate on a constraint-based methodology: Trump has very few constraints on trade policy, China has major constraints on making these concessions, so there is no basis for assuming that the two countries will skip conflict and go directly to a new level of cooperation. Investment Recommendations We remain short the RMB. The currency has fallen by 5.62% since we initiated this trade. The trade itself has suffered a bit since the end of last year as a result of the PBoC's efforts to fight speculation. But monetary expansion sans productivity improvements continues apace in China, and we expect USD strength to persist, so we think there is room for the RMB to fall further. In the near term, however, the USD could experience further pullback as investors start pricing the negatives of the Trump administration. Therefore we are closing our long USD/EUR trade for a 4.55% gain. We remain somewhat positive on China relative to EM - because of the relative unity and centralization of its government and financial resources at its disposal - but we would not recommend investing in Chinese assets in the absolute due to the heightened internal and external risks outlined above. Hence we propose going long the "One China" policy, i.e. long Chinese mainland stocks versus Taiwan and Hong Kong (Chart 15). This enables us to play the fact that mainland valuations are depressed while the global trend of de-globalization and the conflicts within Greater China and with the U.S. are likely to increase uncertainties about Hong Kong and Taiwan. These two are particularly vulnerable to tighter regulations or sanctions from Beijing. Yan Wang, Senior Vice-President at BCA's China Investment Strategy, argues that while there is no case for a clear directional move in Chinese stocks - especially given the ongoing tightening of policies on the property sector - nevertheless they should be favored relative to global equities, given that growth is improving, fiscal policy will remain accommodative, and valuations are depressed (Chart 16).14 Meanwhile our negative outlook on China in absolute terms supports a globally negative outlook on cyclical equities relative to defensives. Cyclicals move with EM in general and China in particular. Anastasios Avgeriou, Vice President in charge of U.S. Equity Strategy, notes that EM performance does not warrant the sharp rise in U.S. cyclicals versus defensives, nor that in globally oriented versus domestically oriented stocks (Chart 17).15 This creates the opportunity for a tactical short. Chart 15Chinese Stocks Are Cheap Chart 16China Trades With Cyclicals Chart 17Go Long The 'One China Policy' Finally, we caution investors about investing in companies with major exposure to China (Table 2). We would recommend that clients short a "China, Inc" Index of the top 20 S&P 500 stocks exposed to trade with China relative to the rest of S&P 500. The "China, Inc" stocks have been outperforming the market for a while (Chart 18). We fear that China may retaliate against some of these firms as the trade war with the U.S. heats up. Table 2'China, Inc.' May Suffer From Trade War Chart 18Short 'China, Inc.' Relative To Market Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President, marko@bcaresearch.com Jesse Anak Kurri, Research Analyst 1 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 3 Please see Imad Moosa, The U.S.-China Trade Dispute: Facts, Figures And Myths (Northampton, MA: Edward Elgar, 2012). 4 For prominent research on this topic, please see David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning From Labor-Market Adjustment To Large Changes In Trade," Annual Review of Economics 8 (2016), pp. 205-40, available at www.annualreviews.org; Autor et al., "Foreign Competition And Domestic Innovation: Evidence From U.S. Patents," NBER Working Paper No. 22879, December 2016, available at www.nber.org. 5 Please see BCA Geopolitical Strategy Special Reports, "Reflections On China's Reforms," dated December 11, 2013, and "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 6 Scholars have shown that countries granting China market economy status have subsequently initiated fewer antidumping cases against it. Please see Francisco Urdinez and Gilmar Masiero, "China And The WTO: Will The Market Economy Status Make Any Difference After 2016?" The Chinese Economy 48:2 (2015), pp. 155-172. Technically speaking, the difference in duty rates can be substantial between market and non-market economies; please see the U.S. Government Accountability Office, "U.S.-China Trade: Eliminating Nonmarket Economy Methodology Would Lower Antidumping Duties For Some Chinese Companies," GAO-06-231, January 2006, available at www.gao.gov. 7 Ross has criticized China more heavily since joining Trump; Navarro is the author of Death By China: Confronting The Dragon, A Global Call To Action (Pearson, 2011); together they criticized China in a paper for Trump's campaign, "Scoring The Trump Economic Plan: Trade, Regulatory, & Energy Policy Impacts," dated September 29, 2016, available at assets.donaldjtrump.com. Lighthizer worked on Ronald Reagan's Treasury Department's team that engaged in the tough trade negotiations with Japan in the mid-1980s. 8 The existing statutory procedure, now enshrined in Title VII of the Trade Facilitation and Trade Enforcement Act of 2015, involves the Treasury Department making semi-annual assessments and potentially initiating bilateral or multilateral negotiations. According to the more or less standard time frame since 1988, any charges of currency manipulation would occur in the April report at earliest, and more likely in the October report or thereafter. For Trump to have designated China a manipulator on day one, he would either have had to issue a simple statement of intent or an executive directive that bypassed the formal foreign exchange review process. 9 Please see Andy Kiersz, "Here's Every State's Biggest International Trading Partner," Business Insider, October 20, 2016, available at www.businessinsider.com. See also Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 10 Serbia "defeated" the much larger Austria-Habsburg in their "Pig War" in the early 1900s, while Ireland won most of its key demands from England despite losing the "Economic War" of the 1930s. Russia's attempts over the past decade to bully Ukraine into submission have not succeeded in achieving Russia's political aims. In each of these cases, a far greater economic disparity existed than currently exists between the U.S. and China, and yet even then the weaker country's popular support, and the willingness of neighbors to exploit the new trade opportunities that opened up, enabled the weaker country to win the political clash of wills. 11 Please see "China: Xi Is A "Core" Leader... So What?" in BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 12 Please see BCA Emerging Markets Strategy Special Report, "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 13 Please see "China unveils new plan to further open economy to foreign investment," Reuters, January 17, 2017, available at www.reuters.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017, available at cis.bcaresearch.com. 15 Please see BCA U.S. Equity Strategy Weekly Report, "2017 High-Conviction Calls," dated January 9, 2017, available at uses.bcaresearch.com.
Highlights Global Growth: If global demand follows the recent improvements seen in economic sentiment, growth will surprise positively relatively to expectations in 2017. With global inflation also likely to continue drifting higher over the course of the year, the medium-term bearish implications for bonds are clear. Duration Technicals: Government bond markets remain technically stretched, as the bearish positioning from late 2016 is still intact. Combined with price momentum measures that have barely corrected from oversold extremes, yields are not quite ready to resume their ascent. It is too soon to reduce portfolio duration exposure to position for the higher yields that we expect this year. Canada: The Canadian economy has shown clear signs of improvement of late. This trend can continue in the first half of 2017, thus we are closing our short Canadian corporates/long Canadian provincial debt trade and entering a new position - shorting Canadian 10-year government bonds versus 10-year U.S. Treasuries. Feature Chart of the Week Post-Truth: relating to or denoting circumstances in which objective facts are less influential in shaping public opinion than appeals to emotion and personal belief. - Oxford Dictionary Oxford voted that term, "post-truth", as the 2016 international word of the year. That is not a surprise, as the two dominant news stories of the past twelve months, Brexit and Trump, represented triumphs of hot emotional arguments over cold hard facts. Pessimists may argue that what we are currently seeing in the U.S. is a "post-truth" economic upturn, where confidence is soaring in expectation of the potential positive impact from Donald Trump's proposed pro-business agenda, but without a corresponding boost in actual growth. Financial markets appear to have already discounted a more rapid pace of growth, as evidenced by the surge in government bond yields in November/December and sharp outperformance of economically-sensitive asset classes like equities and high-yield (Chart of the Week). We do expect growth to deliver some upside surprises in 2017, putting additional upward pressure on government bond yields and downward pressure on credit spreads. In the meantime, however, markets need to consolidate the recent moves while the hard economic data catches up to booming sentiment. This leads us to maintain a cautious tactical investment stance, both towards duration exposure and credit allocations, while looking for more attractive levels to position for the improving global growth dynamic in 2017 by re-establishing below-benchmark duration positions and increasing corporate bond exposure. Real Growth Or Fake News? In our previous Weekly Report, we discussed how improving U.S. business confidence within the corporate sector could lead to a revival of capital spending after three years of decline.1 Not all of this is attributable to the "Trump effect", though. Global leading economic indicators were already starting to tick upward even before the U.S. election, while actual data in the major economies was surprising to the upside. This suggests that some pickup in global growth is likely in the next few quarters which would put additional upward pressure on the real component of government bond yields (Chart 2). Growth forecasts remain subdued, however, even with the recent bump in sentiment. The Bloomberg consensus expectation for real global GDP growth in 2017 is 3.2%. The International Monetary Fund is slightly more optimistic, projecting growth of 3.4% in 2017 but with only 2.3% growth in the U.S. (this is an updated forecast released yesterday, so after the U.S. election). Central bank growth forecasts at the country level are also relatively downbeat; for example, the Fed is expecting U.S. growth of only 2.1% in 2017 while the European Central Bank (ECB) is projecting Euro Area growth of 1.7%. Given the relatively high level of uncertainty over the potential effects of the incoming Trump administration's economic agenda, it is no surprise that professional forecasters are being cautious as they wait for the details to unfold. Yet while improving sentiment among consumers and businesses does not guarantee a faster pace of economic growth in the absence of rising household incomes and healthier corporate profits. However, greater confidence (i.e. "animal spirits") is often a prerequisite before a cyclical upturn can blossom, turning "post-truth" sentiment into a true recovery. Looking at the data among the major economic regions shows that, if the confidence indicators are to be believed, then global growth could deliver some upside surprises this year: United States: Consumer confidence is soaring, with the Conference Board measure reaching an 8-year high at the end of 2016. The December reading for U.S. National Federation of Independent Business (NFIB) survey released last week showed a similar spike in confidence among U.S. small businesses, with capital expenditures, hiring plans and overall optimism returning to levels not seen since before the Great Recession (Chart 3). This is a similar move to the strong confidence data for corporate CEOs that we presented in last week's report. Chart 2A Cyclical Upturn In Growth & Yields Chart 3U.S. Economic Confidence Improving Euro Area: Euro Area sentiment measures, such as the European Commission confidence surveys or the widely-followed German IFO and ZEW indices, hooked upward at the end of 2016 (Chart 4). Both household and business confidence improved, underscoring how the current cyclical upturn in the Euro Area is broad-based. Japan: While Japan should not be expected to be a major contributor to overall global growth given its well-known structural economic impediments (contracting population, weak productivity, high government debt, etc), the most recent data does show a slight uptick in consumer confidence, business confidence and the Japan leading economic indicator (Chart 5). Chart 4A Solid Uptick In Euro Area Confidence Chart 5Japanese Sentiment Inching Higher Chart 6Upside Risks For Chinese Growth? China: Both consumer and business confidence have improved alongside the cyclical Chinese recovery seen in 2016, but this has not been enough to boost consensus forecasts for Chinese growth this year. Importantly, this creates the possibility of an upside growth surprise as both the OECD leading indicator for China and the proprietary GDP growth model from our colleagues at BCA China Investment Strategy are calling for faster growth in 2017 (Chart 6).2 A potential increase in trade or even military tensions between China and the U.S. is a potential risk to this sunny scenario but, given what we know now about the underlying economy, China looks poised to deliver another year of solid growth. The data does show that the improvement in economic sentiment goes beyond what is happening in the U.S. Some of that could be the spillover effect from greater optimism on the Trump-fueled U.S. economy to the rest of the world. The synchronized uptick in global leading economic indicators, however, suggests that there is more going on than a simple post-election hope that Trump can deliver faster U.S. growth. A genuine synchronized global upturn is underway, which is not "fake news" (which we expect will be the Oxford word of the year in 2017!) Bottom Line: If global demand follows the improvements seen in economic sentiment, growth will surprise positively relative to expectations. With global inflation also likely to continue drifting higher over the course of 2017, the bearish implications for bonds are clear. Bond Market Technicals Have Not Moved Much Normally, such a growing body of evidence pointing to improving global economic sentiment would be a bearish development for bond prices. Fixed income markets have already moved very rapidly, however, to discount a more optimistic outlook for growth. The rise in yields over the final two months of 2016 has left the major sovereign bond markets in a highly stretched position. This was one of the reasons we shifted our recommended duration stance from below-benchmark to neutral in early December.3 Looking at technical indicators such as the deviation of 10-year government bond yields from their 200-day moving averages, or momentum measures such as the 26-week total return for the sovereign bond indices, show that bonds remain deeply oversold in the main "G-4" markets: the U.S. (Chart 7), Germany (Chart 8), the U.K. (Chart 9) and Japan (Chart 10). Chart 7UST Technicals: Stretched Chart 8German Bund Technicals: Stretched Chart 9U.K. Gilt Technicals: Stretched Chart 10JGB Technicals: Stretched In the case of U.S. Treasuries, indicators of market positioning suggest that most traders have not unwound their bearish bets. The Commitment of Traders report shows that speculators currently have the largest net short position in Treasury futures in the history of the data. Meanwhile, the Market Vane index of Treasury sentiment has bounced slightly off the recent lows, but remains at generally downbeat levels (Chart 11) - and still above the levels that heralded prior peaks in yields in 2010, 2013 & 2015. Only the JPMorgan duration survey has shown a closing of net short positions for the more "active" trader base, but not for the overall set of bond investors. We will continue to monitor these positioning and momentum indicators in the weeks ahead to assess when the oversold market conditions have unwound enough to justify a shift back to a below-benchmark duration stance. For now, keep portfolio duration exposure at benchmark. Bottom Line: Government bond markets remain technically stretched, as the bearish positioning from late 2016 is still intact. Combined with price momentum measures that have barely corrected from oversold extremes, yields are not quite ready to resume their ascent. It is too soon to reduce portfolio duration exposure to position for the higher yields that we expect this year. Encouraging Signs From Canada Last October, this publication laid out a sobering view on the Canadian economy.4 Softening exports were a concern, especially in the non-commodity related sectors and even with a weaker Canadian dollar. Growth in corporate capital spending growth was still contracting, constrained by tight lending conditions. Moreover, household consumption appeared at risk, given the depressed labor force participation rate and low wage increases. This view led us to adopt: a neutral stance - but with a positive bias - on Canadian bonds versus global hedged benchmarks; a slightly more dovish view then the consensus on the next monetary policy move by the Bank of Canada (BoC), not discarding the possibility of a rate cut in 2017 and; a short position on Canadian corporates versus Canadian provincial government debt. Since then, however, the Canadian economic cycle has taken a positive turn. The euphoria surrounding Trump's economic plan for Canada's largest trading partner has definitely prompted some of the improvements. The enthusiasm towards possible pro-business American economic policies seems to have seeped into Canadian business owners' mindset as well (Chart 12). Chart 11UST Positioning Still Very Short Chart 12Trump Is Also Influencing Canada's Mood But there is more to it than that. First, employment data have firmed up. The net change in Canadian employment has been positive in each of the last five months, increasing on average by a robust 47.5k. The previously declining labor force participation rate has stabilized, posting a 65.8% reading in December versus the July low of 65.3%. Plus, more jobs have been created in the private sector versus the public sector and in more stable "regular" employment rather than self-employment (Chart 13). Second, the business sector's mood has brightened. According to the BoC's Winter Business Outlook Survey, sales expectations, investment plans and employment intentions are all recovering.5 More striking, firms' pricing power has jumped higher; prices of products and services sold are expected to increase substantially in the next twelve months (Chart 14, top panel). Better pricing power should help Canadian corporate profits, going forward. Chart 13Employment Firming up Chart 14A Business Cycle Reversal? Chart 15Exports Perking Up This, combined with better credit conditions, could potentially turn the Canadian economic cycle around. Real capital expenditure has been the big missing ingredient to a healthy economic expansion in the last few years. This is about to change as the BoC's Senior Loan Officer survey shows that Canadian bank lending conditions re-entered "easing" territory in Q4 2016 (Chart 14, bottom panel).6 Looser credit conditions usually lead to faster loan growth and stronger investment spending. Third, better sentiment globally, and especially in the U.S., has lifted demand for Canadian products, with growth for both commodity and non-commodity-related exports showing improvement in the last quarter of 2016. While higher commodity prices have certainly boosted commodity-related exports, improving U.S. consumer confidence suggests that Canadian goods exports numbers will perk up in the coming months (Chart 15). Fourth, Canadian housing prices could still grind higher for a while longer and a broad retrenchment in the construction sector might be avoided again in 2017. Granted, the backdrop remains quite risky given high prices and soaring household debt levels. According to the BoC, about 15% of high loan-to-income mortgages issued in 2016 would have been ineligible under the new regulatory framework for allowable mortgage lending.7 Hence, the construction sector will face some headwinds going forward as some new mortgage loans will be harder to come by, on the margin. However, it is not a given either that housing affordability (or lack thereof) has reached peak levels yet (Chart 16).8 Lately, the housing market has held up relatively well, despite the regulatory tightening measures put in place to reduce the systemic risks from overvalued Canadian real estate. New house prices grew at a 3% year-over-year rate in December - the fastest pace in four years - while housing starts have averaged 198k in the last twelve months, surpassing the levels seen during the previous three years. In sum, the Canadian economy has performed better than we previously expected. As such, we remain open to the idea that it could continue in that vein over at least the first half of 2017. That said, our optimism remains guarded. The health of the Canadian non-financial, non-energy corporate sector has been deteriorating over the last two years, limiting the potential for the kind of revival of animal spirits that we are seeing in the U.S. Plus, the cyclical data for Alberta - Canada's fourth most important province - remains moribund. A more robust expansion in that province would be necessary to solidify our conviction level towards the strength of the overall economy. Chart 16Not That Unaffordable Chart 17No Inflation On The Horizon Canada remains fragile; consumer indebtedness levels are elevated by international standards. Accordingly, this economy remains a hiccup away from disappointing in the event of an external shock. A global equity market correction, softer oil prices, a reversal in the latest Chinese reflationary push, a Trump geopolitical blunder and/or a move toward more trade protectionism in the U.S. (especially concerning NAFTA9) could negatively impact Canada at any moment - and in a much bigger fashion compared to most other developed economies. As such, the BoC will be prudent and probably stay on hold in 2017. Inflationary pressures are simply not strong enough to justify turning hawkish. Unemployment at 6.9% remains close to half a percentage point away from full employment levels.10 Our Canadian weekly earnings diffusion index is pointing to lower wage pressures, as well (Chart 17). The 30% probability of a rate hike by year-end currently discounted in the OIS market could easily be priced out if inflation remains subdued. Nonetheless, we have to acknowledge the improving backdrop in our portfolio recommendations: we are choosing to close our trade, shorting Canadian corporates versus Canadian provincial debt, at a loss of -53bps. The defensive characteristics of that trade, which also incurs negative carry, now appear less appealing, especially considering the global "risk on" environment currently in place. For now, we are maintaining our neutral stance on Canadian bonds in our global model portfolio, with Canada unlikely to see the same degree of upside inflation pressures that we expect in the other developed economies. However, we are opening a tactical trade, shorting Canadian government bonds versus U.S. Treasuries at the 10-year maturity. From a historical stand point, Canadian yields are very low compared to the U.S., offering an interesting entry point. In addition, the Canada-U.S. employment ratio and the price ratio of Brent oil to lumber - which have been broadly correlated to the Canada-U.S. spread over the years - are both hooking up, pointing to a wider Canada-U.S. spread and representing an interesting macro signal (Chart 18). U.S. inflation prospects add to this trade's attractiveness. Our colleagues at BCA U.S. Investment Strategy recently made a compelling case for U.S. inflation not being a major threat in 2017 after assessing the prospects for the main components of U.S. core PCE inflation (shelter, core goods and core services).11 Core PCE should converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot beyond that is not the base case (Chart 19). That could allow Canadian bonds yields to catch up to higher U.S. yields, especially if the oversold conditions in the U.S. Treasury market described earlier persist. Chart 18Go Short Canadian Bonds Versus U.S. Treasuries Chart 19Only A Mild Uptrend Is Likely In 2017 Bottom Line: The Canadian economy has shown clear signs of improvement of late. This trend can continue in the first half of 2017, thus we are closing our short Canadian corporates/long Canadian provincial debt trade and entering a new position - shorting Canadian 10-year government bonds versus 10-year U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "4 Big Questions For Bond Markets In 2017", dated January 10, 2017, available at gfis.bcaresearch.com 2 Please see BCA China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard", dated January 12, 2017, available at cis.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Vigilantes Take A Break For The Holidays", dated December 6, 2016, available at gfis.bcaresearch.com 4 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Bear Phase Continues", dated October 11, 2016, available at gfis.bcaresearch.com 5 http://www.bankofcanada.ca/2017/01/bos-winter-2016-17/ 6 http://www.bankofcanada.ca/wp-content/uploads/2017/01/slos-winter2016.pdf 7 http://www.bankofcanada.ca/2016/12/fsr-december-2016/ 8 A description of the Bank of Canada Housing Affordability Index can be found at http://credit.bankofcanada.ca/financialindicators/hai 9 NAFTA (the North American Free Trade Agreement) is a treaty between Canada, the United States, and Mexico aimed at removing trade barriers and encouraging economic activity. 10 NAIRU stands at 6.5% 11 Please see BCA U.S. Investment Strategy Weekly Report, "Inflation In 2017: An Idle Threat", dated January 9, 2017, available at usis.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